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 22% each of the last three years. He has computed the cost and revenue estimates for each product as follows: Product A Product B $ 370,000 $ 570,000 Initial investment: Cost of equipment (zero salvage value) Annual revenues and costs: Sales revenues Variable expenses Depreciation expense Fixed out-of-pocket operating costs $ 400,000 $ 180,000 $ 74,000 $ 88,000 $ 480,000 $ 214,000 $ 114,000 $ 68,000 The company's discount rate is 20%. Click here to view Exhibit 7B-1 and Exhibit 7B-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: Complete this question by entering your answers in the tabs below. Reg 1 Req 2 Reg 3 Reg 4 Reg 5 Reg 6A Reg 6B Calculate the payback period for each product. (Round your answers to 2 decimal places.) Product A Product B Payback period years years < Reg 1 Req 2 >

Answer 1

$ Ques 1 Sales Revenues Variable Expesnes Fixed out of pocket operating costs Annual Net cash Inflows Product A Product B 400,000 $ (180,000) $ (88,000) $ $ 132,000 $ 480,000 (214,000) (68,000) 198,000 $ The second step is to compute each product's payback period as follows: Investment Required(a) Annual Net cashflow(b) Payback period(a/b) Product A Product B $ 370,000 $ $ 132,000 $ 2.80 570,000 198,000 2.88 Product A 0 1 2 3 4 5 $ (370,000) 2)NPV of Each Product Time Purhase of Equipment Sales Revenue Variable Expesnes Fixed out of pocket operating costs $ $ $ 400,000 $ (180,000) $ (88,000 $ 400,000 $ (180,000) $ (88,000) $ 400,000 $ (180,000) $ (88,000) $ 400,000 $ (180,000) $ (88,000) $ 400,000 (180,000) (88,000) (370,000) $ 1 Total Cah flows(a) Discount factor @ 20%(b) Present value(a)*(b) NPV(Cash inflows-cash outflows) 132,000 $ 0.833 109,956 $ 132,000 $ 0.694 91,608$ 132,000 $ 0.579 76,428 $ 132,000 $ 0.482 63,624 $ 132,000 0.402 53,064 $ $ (370,000) $ 24,680 Product B 0 1 2 3 5 $ (570,000) Time urhase of Equipment Sales Revenue Time Purhase of Equipment $ $ $ 480,000 $ 480,000 $ (214,000) $ (214,000) $ (68,000) $ (68,000) $ 480,000 $ (214,000) $ (68,000) $ 480,000 $ (214,000) $ (68,000) $ 480,000 (214,000) (68,000) $ Total Cah flows(a) Discount factor @ 20%(b) Present value(a)*(b) NPV(Cash inflows-cash outflows) (570,000) $ 1 (570,000) $ 22,020 198,000 $ 0.833 164,934 $ 198,000 $ 0.694 137,412$ 198,000 $ 0.579 114,642 $ 198,000 $ 0.482 95,436 $ 198,000 0.402 79,596 $ $ 3)Internal Rate of return Investment Required(A) Annual Net cash flow(B) Factor of internal rate of return(A/B) IRR Product A Product B $ 370,000 $ $ 132,000 $ 2.803 23% 570,000 198,000 2.879 22% Looking in Exhibit 13B-2 and scanning along the 5-period line, a factor of 2.815 is closest to 2.803 so we take rate as 23%, so we'll estimate an internal rate of return for Product A of 23%. A factor of 2.847 is closest to 22%, so we'll estimate an internal rate of return for Product B of 22%. For A=23% & B=22% you can use excel formula of IRR also gives the same result The internal rate of return is the rate at which NPV is 0 4) Profitability Index NPV(a) Investment Required(b) Profitability Index(a/b) Product A Product B $ 24,680$ $ 370,000 $ 0.07 22,020 570,000 0.04 5) Simple rate of return Annual Net cash Inflows Depriciation Expense Annual Incremental net operating Income Product A Product B $ 132,000 $ $ (74,000) $ $ 58,000 $ 198,000 (114,000) 84,000 Annual Incremental net operating Income(a) Investment Required(b) Simple Rate of return(a/b) $ 58,000 $ 370,000 $ 15.68% 84,000 570,000 14.74% Ques 6-a NPV Poduct A PI payback period Poduct A IRR Poduct A Simple ROR Poduct A Poduct A Ques 6-b Reject both