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 17% 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) $180,000 $390,eee Annual revenues and costs: Sales revenues Variable expenses Depreciation expense Fixed out-of-pocket operating costs $ 71,eee $ 50,0ee $260,000 $360,000 $124,000 $174,00e The company's discount rate is 15% Click here to view Exhibit 13B-1 and Exhibit 138-2, to determine the appropriate discount factor using tables Required 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. 5. Calculate the simple rate of return for each product.

Explanation / Answer

Q1. Annual Cash inflows Product A Product B Sales 260000 360000 Less: Cash cost Variable expense 124000 174000 Fixed out of pocket expense 71000 50,000 Cash flows Annual 65000 136000 Initial Investment 180,000 390,000 Payback period 2.77 2.87 (Initial Investment/Annual cassh inflows) Q2. Annual Cash inflows Product A Product B Sales 260000 360000 Less: Cash cost Variable expense 124000 174000 Fixed out of pocket expense 71000 50,000 Cash flows Annual 65000 136000 Annuity factor for 5 yr at 15% 3.352 3.352 Present value of Investment 217880 455872 Less: Investment 180,000 390,000 NPV 37880 65872 Q3. IRR Product A Product B Sales 260000 360000 Less: Cash cost Variable expense 124000 174000 Fixed out of pocket expense 71000 50,000 Cash flows Annual 65000 136000 Annuity factor for 5 yr at 24% 2.745 2.745 Present value of Investment 178425 373320 Less: Investment 180,000 390,000 NPV -1,575 -16,680 IRR of Product A: Lower rate + NPVv at Lower rate /Diference in NPV * Difference in rates 15% + (37880 /39455)*9% = 23.64% IRR of Product B: Lower rate + NPVv at Lower rate /Diference in NPV * Difference in rates 15% + (65872 /825520*9% = 22.18% Q4. Profitability Index: Product A Product B Sales 260000 360000 Less: Cash cost Variable expense 124000 174000 Fixed out of pocket expense 71000 50,000 Cash flows Annual 65000 136000 Annuity factor for 5 yr at 15% 3.352 3.352 Present value of Investment 217880 455872 Investment 180,000 390,000 Profitability Index 1.21 1.17 (Present value of inflows/ Investmnet) Q5. Product A Product B Sales 260000 360000 Less: Cash cost Variable expense 124000 174000 Fixed out of pocket expense 71000 50,000 Cash flows Annual 65000 136000 Less: Depreciation 36000 78,000 Net Income 29000 58000 Average Investment 90000 195,000 Simple rate of return 32.22% 29.74% (Net income/ Average investment)

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