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. He has computed the cost and revenue estimates for each product as follows ProductAProduct B Initial investment Cost of equipment (zero salvage value) Annual revenues and costs: Sales revenues Variable expenses Depreciation expense Fixed out-of-pocket operating costs 390,000 585,000 420,000 500,000 $ 185,000 222,000 $ 78,000 117,000 $ 90,000 70,000 The company's discount rate is 21% Ignore income taxes. Note that Excel or a financial calculator must be used to calculate items 2- 4 Requirec 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. 6a. For each measure, identify whether Product A or Product B is preferred Complete this question by entering your answers in the tabs below Req 1 Req 2 Req 3 Req 4 Req 6A Calculate the payback period for each product. (Round your answers to 2 decimal places.)

Explanation / Answer

Payback Period Product A Initial Investment -390000 Free cash flow Sales revenue 420000 Less : Variable Expense -185000 Operating costs -90000 145000 Payback period = Initial investment/cash flow 390000/145000 2.689655 2.69 yrs Product B Initial Investment -585000 Free Cash flow Sales Revenue 500000 Less : Variable costs -222000 operating costs -70000 208000 Payback period = Initial investment/cash flow 585000/208000 2.8125 2.81 yrs As per payback method, product A is preferable since it has lower payback period Net Present Value Year Cash flow Discount factor @ 21% Present Value 0 -390000 1 -390000 1 145000 0.826446281 119834.7 2 145000 0.683013455 99036.95 3 145000 0.56447393 81848.72 4 145000 0.46650738 67643.57 5 145000 0.385543289 55903.78 34267.73 The Net present value of Product A is $ 34267.73 Product B Year Cash flow Discount factor @ 21% Present Value 0 -585000 1 -585000 1 208000 0.826446281 171900.8 2 208000 0.683013455 142066.8 3 208000 0.56447393 117410.6 4 208000 0.46650738 97033.54 5 208000 0.385543289 80193 608604.7 23604.74 The Net present value of Product B is $ 23604.74 As per Net present value method, Project A is preferable as it has higher NPV Internal Rate of Return Year Cash flow 0 -390000 1 145000 2 145000 3 145000 4 145000 5 145000 Using the IRR function in excel we get the IRR as IRR(G56:G61,25%) 24.993197094000% The IRR is approx 25% Year Cash flow 0 -585000 1 208000 2 208000 3 208000 4 208000 5 208000 IRR(G68:G74,25%) 22.8476969832643000% The IRR is approx 23% As per IRR method, Product A should be selected as it has higher IRR Profitability Index Product A Profitability Index = Present value of cash flows/Initial investment 424267.73/390000           1.09 Product B 608604.74/585000           1.04 As per profitability Index method, product A is preferable as it has higher profitability index Hence, based on all the above mthod, Product A is more preferable

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