Lou Barlow, a divisional manager for Sage Company, has an opportunity to manufac

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 20% each of the last three years. He has computed the cost and revenue estimates for each product as follows: Product A Product B nitial investment Cost of equipment (zero salvage value) $250,000 Annual revenues and costs Sales revenues Variable expenses Depreciation expense Fixed out-of-pocket operating costs 460,000 $300,000 400,000 $140,000 $ 190,000 50,000 $ 92,000 $ 75,000 55,000 The company's discount rate is 18%.

Explanation / Answer

Answer

Calculation of Payback period Product A Product B Payback Period 2.94 years 2.88 years Calculation of Net Present Value of the products Product A Product B Net Present Value          15,795          40,320 Calculation of Profitability Index Product A Product B Initial Investment       250,000       460,000 Annual Cashflows          85,000       160,000 Profitability Index              0.34              0.35 Simple Rate of Return of the projects Product A Product B Initial Investment       250,000       460,000 Annual Cashflows          85,000       160,000 Simple Rate of Return 34% 35% Net Present Value Profitability Index Payback Period Product B Product B Product B Based on Simple rate of return Project B should be accepted Workings Calculation of Cashflows Product A Product B $ $ Sales Revenue       300,000     400,000 Less Variable Cost     (140,000) (190,000) Less: Fixed Cost ( excluding depreciation)       (75,000)     (50,000) Net Cashflow          85,000     160,000 Payback Period = Initial Investment/ Annual Cashdlows Product A Product B Initial Investment       250,000     460,000 Annual Cash flow          85,000     160,000 Payback period              2.94            2.88 Calculation of Net Present Value of the products Year Discount Factor @ 18% Product A Product B Cashflow Present value of Cashflow Cashflow Present value of Cashflow 0 1     (250,000)     (250,000) (460,000) (460,000) 1 0.847          85,000          71,995     160,000     135,520 2 0.718          85,000          61,030     160,000     114,880 3 0.609          85,000          51,765     160,000        97,440 4 0.516          85,000          43,860     160,000        82,560 5 0.437          85,000          37,145     160,000        69,920 Net Present Value          15,795        40,320

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