Question

Lou Barlow, a divisional manager for Sage Company, has an opportunity to manufacture and sell one of two new products for a five- year period. His annual pay raises are determined by his division's return on investment (ROI), which has exceeded 23% each of the last three years. He has computed the cost and revenue estimates for each product as follows: Product Product B $ 310,000 $ 510,000 Initial investment: Cost of equipment (zero salvage value) Annual revenues and costs: Sales revenues Variable expenses Depreciation expense Fixed out-of-pocket operating costs $ 360,000 $ 164,000 $ 62,000 $ 81,000 $ 460,000 $ 214,000 $ 102,000 $ 65,000 The company's discount rate is 18%. Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor using tables. Required: 1. Calculate the payback period for each product. 2. Calculate the net present value for each product. 3. Calculate the internal rate of return for each product. 4. Calculate the project profitability index for each product. 5. Calculate the simple rate of return for each product. 6a. For each measure, identify whether Product A or Product B is preferred. 6b. Based on the simple rate of return, Lou Barlow would likely:

Answer 1

Solution 1:

OP р - W X Y AA AB Computation of Annual cash inflows Payback period Particulars Product A Product B Particulars Choose Numerator/Choose Denominator = Payback Period $360,000 $164,000 $460,000 $214,000 Initial Investment / Annual Cash inflows $310,000/ $115,000 Payback Period 2.70 Years Product A Sales revenue Variable expenses Fixed Out of pocket operating cost Annual cash inflows Product B $510,000/ $181,000 2.82 Years $81,000 $115,000 $65,000 $181,000 15 16 28 et887 Sheet890 Sheet60 (4) Sheet26 (20) Sheet65 (7) Sheet894 Sheet473 (3) Sheet864

Solution 2:

H Sage Company Computation of NPV Product A Product B Particulars Period PV Factor (18%) Amount Present Value Amount Present Value Cash outflows: Initial investment $310,000 $310,000 $510,000 $510,000 Present Value of Cash outflows (A) $310,000 $510,000 Cash Inflows Annual cash inflows 1-5 3.127 $115,000 $359,605 $181,000 $565,987 Present Value of Cash Inflows (B) $359,605 $565,987 16 Net Present Value (NPV) (B-A) $49,605 $55,987 17 et887 Sheet890 Sheet60 (4) Sheet26 (20) Sheet65 (7) Sheet894 Sheet473 (3) Sheet864

Solution 3:

RS 50 51 Computation of IRR 52 53 54 Period IRR | IRR 55 56 57 Project A Cash flows $310,000 $115,000 $115,000 $115,000 $115,000 $115,000 Project B Cash flows $510,000 $181,000 $181,000 $181,000 $181,000 $181,000 24.9% 22.8% 3 58 59 60 5 62 63 64 65 68 69 70 71 et887 Sheet890 Sheet60 (4) Sheet26 (20) Sheet65 (7) Sheet894 Sheet473 (3) Sheet864

Solution 4:

O 24 25 26 29 30 31 Computation of Profitability Index Particulars Product Net present value $49,605 Initial investment $310,000 Product B $55,987 $510,000 32 33 34 Profitability Index (PV of cash inflows / Initial investment) 0.16 35 36 37 38 39 40 41 et887 Sheet890 Sheet60 (4) Sheet26 (20) Sheet65 (7) Sheet894 Sheet473 (3) Sheet864

Solution 5:

AB AC AD AE AF AG AH AI AJ Computation of Annual Operating income Particulars Product Product B Annual cash inflows $115,000 $181,000 Less: depreciation $62,000 $102,000 $79,000 Annual operating income $53,000 Simple rate of return Choose Denominator Particulars Choose Numerator Annual operating income $53,000/ Simple rate of return Simple rate of return 17.1% Initial investment $310,000 = Product A Product B $79,000/ $510,000 = 15.5% 14 15. et887 Sheet890 Sheet60 (4) Sheet26 (20) Sheet65 (7) Sheet894 Sheet473 (3) Sheet864

Solution 6a:

38 39 40 41 42 43 44 45 46 Product Preference Net Present Value Profitability index Payback Period IRR Simple rate of Return 47 Product B Product A Product A Product A Product A 48 49 50 51 et887 Sheet890 Sheet60 (4) Sheet26 (20) Sheet65 (7) Sheet894 Sheet473 (3) Sheet864

Solution 6b:

Based on Simple rate of return, Lou Barlow would likely reject both projects as their Simple rate of return is less than Division's ROI (23%).