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 22% each of the last three years. He has computed the cost and revenue estimates for each product as follows: Product A Product B Initial investment: Cost of equipment (zero salvage value) $380,0ee $575,ee0 Annual revenues and costs: Sales revenues Variable expenses Depreciation expense Fixed out-of-pocket operating costs 89,00 70,e00 $410,000 $490,eee $186,00e $218,e00 $ 76,000 $115,0e0

Explanation / Answer

Answer:

Step 1: In order to compute the payback period of the equipment, we need to workout the net annual cash inflow by deducting the total of cash outflow from the total of cash inflow associated with the equipment.

Computation of net annual cash inflow:

Project A = 410000 – (186000+89000)

              = $135000

Project B = 490000 – (218000 +70000)

                = $202000

Investment Amount

Project A = $380000

Project B = $575000

Pay Back period = Initial Investment / net annual cash flow

Pay Back period, Project A = 380000 / 135000 = 2.81 years (approx.)

Pay Back Period, Project B = 575000 / 202000 = 2.85 years (approx.)

Note: Depreciation is a non-cash expense and has therefore been ignored while calculating the payback period of the project.

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