Lou Barlow, a divisional manager for Sage Company, has an opportunity to manufac
ID: 2472337 • Letter: L
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 22% each of the last three years. He has computed the cost and revenue estimates for each product as follows:
Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor using tables.
Calculate the payback period for each product. (Round your answers to 2 decimal places.)
Calculate the net present value for each product. (Round discount factor(s) to 3 decimal places.)
Calculate the internal rate of return for each product. (Round percentage answer to 1 decimal place. i.e. 0.1234 should be considered as 12.3% and Round discount factor(s) to 3 decimal places.)
Calculate the project profitability index for each product. (Round discount factor(s) to 3 decimal places. Round your answers to 2 decimal places.)
Calculate the simple rate of return for each product. (Round percentage answer to 1 decimal place. i.e. 0.1234 should be considered as 12.3%.)
For each measure, identify whether Product A or Product B is preferred.
Based on the simple rate of return, Lou Barlow would likely:
Product A Product B Initial investment: Cost of equipment (zero salvage value) $ 350,000 $ 550,000 Annual revenues and costs: Sales revenues $ 390,000 $ 470,000 Variable expenses $ 178,000 $ 210,000 Depreciation expense $ 51,000 $ 93,000 Fixed out-of-pocket operating costs $ 87,000 $ 67,000Explanation / Answer
1. Depreciation is a non cash item hence ignored.
Payback period = Initial Investment/ Annual Cash Flows
Product A = 350000 / (390000 - 178000 - 87000) = 350000 / 125000 = 2.8 years
Product B = 550000 / (470000 - 210000 -67000) = 550000 / 193000 = 2.85 years
2. NPV = PV of cash inflows - PV of cash outflows
Product A : 125000/(1.20) + 125000/(1.20)^2 + 125000/(1.20)^3 + 125000/(1.20)^4 + 125000/(1.20)^5 - 350000 = $23826.52
Product B : 193000/(1.20) + 193000/(1.20)^2 + 193000/(1.20)^3 + 193000/(1.20)^4 + 193000/(1.20)^5 - 550000 = $27188.14
3. IRR is the rate at which PV of Cash Inflows = PV of cash Outflows
Product A : 125000/(1+r) + 125000/(1+r)^2 + 125000/(1+r)^3 + 125000/(1+r)^4 + 125000/(1+r)^5 = 350000
r = 23.059% (approx)
Product B : 193000/(1+r) + 193000/(1+r)^2 + 193000/(1+r)^3 + 193000/(1+r)^4 + 193000/(1+r)^5 = 550000
r = 22.225% (aprox)
4. Profitability Index = PV of Cash Inflows/ Initial Investment
Product A = 373826.62 / 350000 = 1.068
Product B = 577188.14 / 550000 = 1.049
5. Simple rate of return = Annual Cash Flow/ Initial Investment * 100
Product A = 125000 / 350000 * 100 = 35.714%
Product B = 193000 / 550000 * 100 = 35.091%
6.a. Payback Period : Product A
NPV : Product B
IRR : product A
Profitability Index : Product A
Simple Rate of return : Product A
6 b Accept Product A
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