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 21% each of the last three years. He has computed the cost and revenue estimates for each product as follows: Product A Product $ 270, eee $ 480,000 Initial investment: Cost of equipment (zero salvage value) Annual revenues and costs: Sales revenues Variable expenses Depreciation expense Fixed out-of-pocket operating costs $ 320, eee $ 148,00 $ 54, eee $ 77,00 $ 420,888 198,888 $ 96,809 $ 57,080 The company's discount rate is 19%. Click here to view Exhibit 128-1 and Exhibit 126-2. 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. 6. Based on the simple rate of return. Lou Barlow would likely Complete this question by entering your answers in the tabs below. Reg 2 Reg2 Reg 4 Reg 68 Reg 5 Reg EA Calculate the payback period for each product. (Round your answers to 2 decima place. Product B

Answer 1

Solution Required rate of return (discount rate) of the Company Life span of both the Product A & B 19% 5 Years Yearly Operating cash in-flows for both the products Particulars Sales revenues Less: Variable expenses Less: Fixed out-of-pocket operating costs Operating cash in-flows Product Product B $320,000 $420,000 ($148,000) ($198,000) ($77,000) ($57,000) $95,000 $165,000 The above yearly cash in-flows for both the product shall remain constant for all the five years. Requirement 1 : Calculate the Payback period for each product Particulars (a). Initial Investment (b). Yearly operating cash in-flows (c). Payback period (in years) - (a) / (b) Product $270,000 $95,000 2.84 Years Product B $480,000 $165,000 2.91 Years Product A 2.84 Years Product B 2.91 Years Payback period Requirement 2 : Calculate the net present value for each product O Product A Product B Present Present Cash flow PV factor @ value of Cash flow PV factor @ value of 19% 19% cash flow cash flow ($270,000)| 1.0000 ($270,000) (S480.000) 1.0000l ($480,000) $95,000 0.8403 $ 79,829 $165,000 0.8403 $138,650 $95,000 0.7062 $67,089 $165,000 0.7062 $116,523 $95,000 0.5934 $56,373 $165,000 0.5934). $97,911 $95,000 0.4987 $47,377 $165,000 0.4987) $82,286 $95,000 0.4190|| $39,805 $165,000 0.4190 $69,135 NPV = $20,472 NPV = $24,504 5 Product A $20,472 Product B $24,504 Net Present Value Note: To calculate, the present value of cash in-flow for periods from 1 to year 5, Present value factor for annuity of $1 for 5 annual periods @ discount rate 19% may be used.

Requirement 3 : Calculate the Internal rate of return of each product Internal rate of return (IRR) is the rate at which the NPV of the Product shall be zero. In above requirement 2, it may be noted that at 19% discount rate, the NPV for both the product is positive, hence the IRR is above 19%. To calculate the IRR for each product, we shall apply the trial and error method. IRR for product A Lets assume that the IRR of product A is 22%. Present value factor for annuity of $1 for 5 annual periods at 22% discount rate Present value of cash inflows from Year 1 to Year 5 (2.8636 x $95,000) Present value of cash outflows (initial investment) Net present value at discount rate 22% 2.8636 $272,042 ($270,000) $2,042 Since the NPV is positive at discount rate 22%, this indicates that the IRR is more than 22%, we shall adjust the rate to 23% and recalculate the NPV at 23%. Present value factor for annuity of $1 for 5 annual periods at 23% discount rate Present value of cash inflows from Year 1 to Year 5 (2.8035 x $95,000) Present value of cash outflows (initial investment) Net present value at discount rate 23% 2.8035 $266,333 ($270,000) ($3,668) Since at discount rate 23%, NPV is negative, this indicates that the IRR is below 23%. At discount rate 22%, we have noted that the NPV is positive, hence we shall use the average mean technique to calculate the IRR. This IRR shall be the approximate IRR at which the NPV will be zero. IRR = 22% + - $2,042 x (23% -22%) ($2,042 + $3,668) 22.36%

IRR for product B Lets assume that the IRR of product B is 22%. Present value factor for annuity of $1 for 5 annual periods at 22% discount rate Present value of cash inflows from Year 1 to Year 5 (2.8636 x $165,000) Present value of cash outflows (initial investment) Net present value at discount rate 22% 2.8636 $472,494 ($ 480,000) ($7,506) Since the NPV is negative at discount rate 22%, this indicates that the IRR is below 22%, we shall adjust the rate to 21% and recalculate the NPV at 21%. Present value factor for annuity of $1 for 5 annual periods at 21% discount rate Present value of cash inflows from Year 1 to Year 5 (2.9260 x $165,000) Present value of cash outflows (initial investment) Net present value at discount rate 21% 2.9260 $482,790 ($ 480,000) $2,790 Since at discount rate 21%, NPV is positive, this indicates that the IRR is above 21%. At discount rate 22%, we have noted that the NPV is negative, hence we shall use the average mean technique to calculate the IRR. This IRR shall be the approximate IRR at which the NPV will be zero. IRR = 22% - $7,506 x (22% -21%) ($7,506 + $2,790) 21.27% Product A Product B Internal Rate of Return 22.36 % 21.27% Requirement 4 : Calculate the project profitability index Project Profitiability Index = PV of future cash flows Initial Investment Product A Product B Year Cash flow PV factor @ 19% Cash flow PV factor @ 19% Present value of cash flow $79,829 $67,089 $95,000 $95,000 $95,000 $95,000 $95,000 $56,373 0.8403 0.7062 0.5934 0.4987 0.4190 | $165,000 $165,000 $ 165,000 $165,000 $165,000 $165 Present value of cash flow $ 138,650 $116,523 $97,911 $82,286 $69,135 $504,504 0.8403 0.7062 0.5934 0.4987 0.4190| 5 $47,377 $39,805 $290,472

Product A's Profitiability Index $290,472 $270,000 1.08 Product B's Profitiability Index $504,504 $480,000 = 1.05 Product A Product B Project Profitiability Index 1.08 1.05 Requirement 5 : Calculate the simple rate of return for each product Simple rate of return = Yearly Incremental net income Initial investment - x 100 Product A $95,000 ($54,000) $41,000 $270,000 15.2% Operating cash inflows Less: Depreciation expense Yearly Incremental net income Initial Capital investment Simple rate of return (cx 100/d) Product B $165,000 ($96,000) $69,000 $480,000 14.4% (c) (d) (e) Product A Product B Simple rate of return 15.2% 14.4% Requirement 6a : For each measure, identify whether Product A or Product B is preferred Payback period Product A Net Present Value Product B Internal rate of Return Product A Profitability Index Product A Requirement 6b : Based on the simple rate of return, Lou Barlow would likely: Accept Product A Accept Product B Reject both products Y