Question

1 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 20% each of the last three years. He has computed the cost and revenue estimates for each product as follows: 8.5 points Product A Product B $ 220,000 $ 410,000 Initial investment: Cost of equipment (zero salvage value) Annual revenues and costs: Sales revenues Variable expenses Depreciation expense Fixed out-of-pocket operating costs $ 280,000 $ 130,000 $ 44,000 $ 73,000 $ 380,000 $ 182,000 $ 82,000 $ 60,000 The company's discount rate is 14%. 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:

Answer 1

Low Barlow Sales less: Variable expenses Fixed Costs Net Cash Inflow less: Depreciaton Net Operating Income Product A $ 2,80,000 $ $ -1,30,000 $ $ -73,000 $ $ 77,000 $ $ -44,000 $ $ 33,000 $ Product B 3,80,000 -1,82,000 -60,000 1,38,000 -82,000 56,000 Required 1 Computation of Payback period Product A Product B Initial Investment (a) $ 2,20,000 $ 4,10,000 Annual Net cash inflows (b) $ 77,000 $ 1,38,000 Payback period (a/b) 2.86 2.97 Required 2 Computation of Net Present value PV Annuity factor (14%,5 yrs) А B Net Cash inflows PV annuity factor Present Value of Net inflows less: Initial Investment Net present Value 3.43308 Product A Product B $ 77,000 $ 1,38,000 3.43308 3.43308 $ 2,64,347.16 $ 4,73,765.04 $ 2,20,000.00 $ 4,10,000.00 $ 44,347.16 $ 63,765.04 AxB Required 3 Computation of Internal rate of return Net Cashflows Year Product A Product B 0 $ -2,20,000 $ -4,10,000 1 $ 77,000 $ 1,38,000 2 $ 77,000 $ 1,38,000 3 $ 77,000 $ 1,38,000 4 $ 77,000 $ 1,38,000 5 $ 77,000 $ 1,38,000 SIRR(range) =IRR(range) 22.11% 20.30% Product A Product B 22.11% 20.30% Internal rate of return

Required 4 Computation of Project profitability Index Product A Product B Initial Investment (a) $ 2,20,000.00 $ 4,10,000.00 PV of Cash inflows (b) $ 2,64,347.16 $ 4,73,765.04 Profitability Index (b/a) 1.20 1.16 Required 5 Computation of Project profitability Index Product A Product B Initial Investment (a) $ 2,20,000.00 $ 4,10,000.00 Annual Net Income (b) $ 33,000.00 $ 56,000.00 Simple rate of return (b/a) 15.00% 13.66% Required 6a Measure Payback period Net Present Value Internal rate of return Profitabilty Index Simple rate of return Product Pref. Product A Product B Product A Product A Product A Required 6b Based on simple rate of return, Lou Barlow would likely invest in Project A

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