3. Our company is considering developing a new product that would require an $8,
ID: 2486320 • Letter: 3
Question
3. Our company is considering developing a new product that would require an $8,550,000 investment in equipment with a useful life of five years and no salvage value. The company’s discount rate is 20%. The project would provide net operating income each year for five years as follows:
Sales
$7,200,000
Variable expenses
2,550,000
Contribution margin
$4,650,000
Fixed expenses:
Sales & Admin Costs
950,000
Depreciation
2,450,000
Total fixed expenses
3,400,000
Net operating income
1,250,000
1. What is the project’s net present value?
2. What is the project’s simple rate of return?
3. What is the project's payback period?
4. Discuss the benefits and weaknesses of each of these evaluation methods. Based on these three outcomes should we develop this new product? Why or why not?
3. Our company is considering developing a new product that would require an $8,550,000 investment in equipment with a useful life of five years and no salvage value. The company’s discount rate is 20%. The project would provide net operating income each year for five years as follows:
Sales
$7,200,000
Variable expenses
2,550,000
Contribution margin
$4,650,000
Fixed expenses:
Sales & Admin Costs
950,000
Depreciation
2,450,000
Total fixed expenses
3,400,000
Net operating income
1,250,000
1. What is the project’s net present value?
2. What is the project’s simple rate of return?
3. What is the project's payback period?
4. Discuss the benefits and weaknesses of each of these evaluation methods. Based on these three outcomes should we develop this new product? Why or why not?
Explanation / Answer
1. Initial investment required = $8,550,000
Annual Cash flow = $1250000 + 2450000 = $3,700,000
the project’s net present value = $3,700,000 * PVIFA(20%, 5) - $8,550,000 = ($3,700,000 * 2.991) - $8,550,000 = $2516700
2. the project’s simple rate of return = $1250000 / $8,550,000 = 14.62%
3. the project's payback period = Initial Investment / Annual Cash Flow = $8,550,000 / $3,700,000 = 2.31 years
4. Net present value considers the future returns and the present value of future cash flow. The simple rate of return do not consider the future cash flows but the return annually the investment is making. The payback period method considers the future cashflows and tells us by what time the initial investment got squared up, but it do not consider the present value of cash flow.
The new product should develop because the NPV is positive at $2516700 and payback period is 2.31 years.
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