Question

13-87 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 18% each of the last three years. He has computed the cost and revenue estimates for each product as follows: Product A Product B Initial investment Cost of equipment (zero salvage value) ..... $170,000 $380,000 Annual revenues and costs: Sales revenues $250,000 $350,000 Variable expenses $120,000 $170,000 Depreciation expense $34.000 $76,000 Fixed out-of-pocket operating costs $70,000 $50,000 The company's discount rate is 16%. 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 6. Which of the two products should Lou's division pursue? Why? McGraw. Education. All rights reserved. Authorized only for instructor ae the classroom No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education

Answer 1

Answer:

Annual Cash Flow of Product A = Sales revenues - Variable expenses- Fixed out-of-pocket operating costs

Annual Cash Flow of Product A = 250000-120000-70000

Annual Cash Flow of Product A = $ 60000

Annual Cash Flow of Product B = Sales revenues - Variable expenses- Fixed out-of-pocket operating costs

Annual Cash Flow of Product B= 350000-170000-50000

Annual Cash Flow of Product B= $ 130000

1.Calculate the payback period for each product.

   Payback period for Product A = Initial investment/Annual Cash Flow

   Payback period for Product A = 170000/60000

   Payback period for Product A = 2.83 Years

   Payback period for Product B= Initial investment/Annual Cash Flow

   Payback period for Product B = 380000/130000

   Payback period for Product B = 2.92 years

     

2.Calculate the net present value for each product.

Product A

Net present value = - Initial investment + Annual Cash Flow*PVIFA(16%,5)

Net present value = - 170000 + 60000*3.274

Net present value = 26440

Product B

Net present value = - Initial investment + Annual Cash Flow*PVIFA(16%,5)

Net present value = - 380000 + 130000*3.274

Net present value = 45,620

3.Calculate the internal rate of return for each product.

Product A

- Initial investment = Annual Cash Flow*PVIFA(rate,5)

170000 = 60000*PVIFA(rate,5)

PVIFA(rate,5) = 170000/60000

PVIFA(rate,5) = 2.833

IRR = 22.5%

Product B

- Initial investment = Annual Cash Flow*PVIFA(rate,5)

380000 = 130000*PVIFA(rate,5)

PVIFA(rate,5) = 380000/130000

PVIFA(rate,5) = 2.923

IRR = 21.0%

4.Calculate the project profitability index for each product.

Product A

project profitability index for each product = 1 + NPV/Initial Invetsment

project profitability index for each product = 1+ 26440/170000

project profitability index for each product = 1.16

Product B

project profitability index for each product = 1 + NPV/Initial Invetsment

project profitability index for each product = 1+ 45620/380000

project profitability index for each product = 1.12

Note: Sometime Question ask net profitable index and answer shows wrong than you must subtract by 1

therefore net profitable index of product A = 0.16 and net profitable index of product B = 0.12

5.Calculate the simple rate of return for each product.

simple rate of return = Net Income/Average investment

Product A

Net Income = Sales revenues - Variable expenses- Fixed out-of-pocket operating costs - depreciation

Net Income = 250000-120000-70000 - 34000

Net Income = 26000

Average Investment = (170000+0)/2 = 85000

simple rate of return = Net Income/Average investment

simple rate of return = 26000/85000

simple rate of return = 30.6%

Product B

Net Income = Sales revenues - Variable expenses- Fixed out-of-pocket operating costs - depreciation

Net Income = 350000-170000-50000-76000

Net Income = 54000

Average Investment = (380000+0)/2 = 190000

simple rate of return = Net Income/Average investment

simple rate of return = 54000/190000

simple rate of return = 28.4%

         

6

Net Present Value	Profitability Index	Payback Period	Internal Rate of Return
Product B	Product A	Product A	Product A

Based on the simple rate of return, Lou Barlow would likely:

Accept Product A