Lou Barlow, a divisional manager for Sage Company, has an opportunity to manufac
ID: 2532589 • 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 23% 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) $290,000 $490,006 Annual revenues and costs: Sales revenues Variable expenses Depreciation expense Fixed out-of-pocket operating costs $ 79,000 $ 59,000 $340,000 $440,000 $154,000 $206,000 $ 58,000 $ 98,000 The company's discount rate is 15%. Click here to view Exhibit 13B-1 and Exhibit 13B-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. 6a. For each measure, identify whether Product A or Product B is preferred. 6b. Based on the simple rate of return, Lou Barlow would likely:Explanation / Answer
First, the annual net cash inflows are calculated as follows:
Particular
Product A
Product B
Sales
340000
440000
Less : Variable Cost
154000
206000
Less :Fixed out-of-pocket operating costs
79000
59000
Annual Cash Flow
107000
175000
Now we will Calculate Payback Period
Particular
Product A
Product B
290000
490000
107000
175000
2.71 Years
2.8 Years
Particular
Year
Discounting Factor
A
B
Product A
Present value
Product B
Present Value
Purchase Of Machine
0
1.00
(290000)
(490000)
(290000)
(490000)
Annual Cash Inflow
0.8695
107000
175000
93036.5
152162.5
2
0.7561
107000
175000
80902.7
132317.5
3.
0.6575
107000
175000
70352.5
115062.5
4
0.5717
107000
175000
61171.9
100047.5
5
0.4971
107000
175000
53189.7
86992.5
NPV
68653.3
96582.5
Particular
Product A
Product B
290000
490000
107000
175000
2.7102
2.80
Particular
Product A
Product B
68653.3
96582.5
290000
490000
0.236
0.197
Particular
Product A
Product B
Net Cash flow (Annual)
107000
175000
Less Depreciation
58000
98000
Operating Income (a)
49000
77000
Initial Investment (b)
290000
490000
Simple Rate of Investment (a * 100)/ b
16.89%
15.71%
1
Net Present Value
Product B
2
Profitability Index
Product A
3
Payback Period
Product A
4
Internal Rate of Return
Product A
Lou Barlow required to reject both products because the simple rate of return for each product is lower than his division’s preceding return on investment of 23 %
Particular
Product A
Product B
Sales
340000
440000
Less : Variable Cost
154000
206000
Less :Fixed out-of-pocket operating costs
79000
59000
Annual Cash Flow
107000
175000
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