Question

Problem 8-23 Comprehensive Problem [LO8-1, LO8-2, LO8-3, LO8-5, LO8-6]

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:

  

	Product A			Product B
Initial investment:
Cost of equipment (zero salvage value)	$	250,000		$	460,000
Annual revenues and costs:
Sales revenues	$	300,000		$	400,000
Variable expenses	$	140,000		$	190,000
Depreciation expense	$	50,000		$	92,000
Fixed out-of-pocket operating costs	$	75,000		$	55,000

  

The company’s discount rate is 18%.

  

Click here to view Exhibit 8B-1 and Exhibit 8B-2, to determine the appropriate discount factor using tables.

  

Required:

1. Calculate the payback period for each product. (Round your answers to 2 decimal places.)

2. Calculate the net present value for each product. (Round discount factor(s) to 3 decimal places.)

3. Calculate the internal rate of return for each product. (Round percentage answers to 1 decimal place. i.e. 0.1234 should be considered as 12.3% and round discount factor(s) to 3 decimal places.)

4. Calculate the project profitability index for each product. (Round discount factor(s) to 3 decimal places. Round your answers to 2 decimal places.)

5. Calculate the simple rate of return for each product. (Round percentage answers to 1 decimal place. i.e. 0.1234 should be considered as 12.3%.)

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:

	Accept Product A
	Accept Product B
	Reject both products

Answer 1

Project A:

Initial Investment = $250,000

Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $300,000 - $140,000 - $50,000 - $75,000
Annual Net Income = $35,000

Annual Net Cash flows = Annual Net Income + Depreciation
Annual Net Cash flows = $35,000 + $50,000
Annual Net Cash flows = $85,000

Project B:

Initial Investment = $460,000

Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $400,000 - $190,000 - $92,000 - $55,000
Annual Net Income = $63,000

Annual Net Cash flows = Annual Net Income + Depreciation
Annual Net Cash flows = $63,000 + $92,000
Annual Net Cash flows = $155,000

Answer 1.

Project A:

Payback Period = Initial Investment / Annual Net Cash flows
Payback Period = $250,000 / $85,000
Payback Period = 2.94 years

Project B:

Payback Period = Initial Investment / Annual Net Cash flows
Payback Period = $460,000 / $155,000
Payback Period = 2.97 years

Answer 2.

Project A:

Net Present Value = -$250,000 + $85,000 * PVA of $1 (18%, 5)
Net Present Value = -$250,000 + $85,000 * 3.127
Net Present Value = $15,795

Project B:

Net Present Value = -$460,000 + $155,000 * PVA of $1 (18%, 5)
Net Present Value = -$460,000 + $155,000 * 3.127
Net Present Value = $24,685

Answer 3.

Project A:

Let IRR be i%

$250,000 = $85,000 * PVA of $1 (i%, 5)
PVA of $1 (i%, 5) = 2.941
Using table values, i = 20.8%

So, IRR is 20.8%

Project B:

Let IRR be i%

$460,000 = $155,000 * PVA of $1 (i%, 5)
PVA of $1 (i%, 5) = 2.968
Using table values, i = 20.3%

So, IRR is 20.3%

Answer 4.

Product A:

Profitability Index = Net Present Value / Initial Investment
Profitability Index = $15,795 / $250,000
Profitability Index = 0.06

Product B:

Profitability Index = Net Present Value / Initial Investment
Profitability Index = $24,685 / $460,000
Profitability Index = 0.05

Answer 5.

Project A:

Simple Rate of Return = Annual Net Income / Initial Investment
Simple Rate of Return = $35,000 / $250,000
Simple Rate of Return = 14.0%

Project B:

Simple Rate of Return = Annual Net Income / Initial Investment
Simple Rate of Return = $63,000 / $460,000
Simple Rate of Return = 13.7%

Answer 6-a.

Net Present Value = Project B
Profitability Index = Project A    
Payback Period = Project A
Internal Rate of Return = Project A
Simple Rate of Return = Project A

Answer 6-b.

Based on the simple rate of return, Lou Barlow would not accept any project as simple rate of return is lower than the return on investment.