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 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 Annual revenues and costs: Sales revenues Variable expenses Depreciation expense Fixed out-of-pocket operating costs $390,000 585,000 420,000 500,000 185,000 222,000 $ 78,000 117,000 $ 90,000 70,000 The company's discount rate is 21%. Click here to view Exhibit 138-1 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

Product A Cash Flow Estimation and Analysis Year 0 1 2 3 4 5 Capex (Rs) -390,000 Revenues (Rs) 420,000 420,000 420,000 420,000 420,000 Operating cost (Rs) 275,000 275,000 275,000 275,000 275,000 Depreciation (Rs) 78,000 78,000 78,000 78,000 78,000 Total Cost (Rs) 353,000 353,000 353,000 353,000 353,000 Operating Income (Rs) 67,000 67,000 67,000 67,000 67,000 Add back: Depreciation (Rs) 78000 78000 78000 78000 78000 Net Cash flow (Rs) -390,000 145,000 145,000 145,000 145,000 145,000 Present value with WACC ===> 21% Year Capex (Rs)-Outflow Net cash inflow (Rs) Present Value in Rs. 0 -390,000 1 145,000 119834.7 2 145,000 99037.0 3 145,000 81848.7 4 145,000 67643.6 5 145,000 55903.8 Total (Rs) -390,000 725,000 424,268 Cash flow and DCF with WACC ==> 21% Year Net Cash Flow (Rs.) Cummilative Cash Flow (Rs.) Discounted Cash Flow (DCF) (Rs.) Cummilative DCF (Rs.) 0 -390,000 -390000 (390,000) -390000 1 145,000 -245000      119,835 -270165 2 145,000 -100000        99,037 -171128 3 145,000 45000        81,849 -89280 4 145,000 190000        67,644 -21636 5 145,000 335000        55,904 34268 Net Present Value (NPV) ==> 34,268 Internal Rate Of Return (IRR) ==> % 25.0% PPI==> 1.0879 Pay Back Period==> Years 2.69 Product B Cash Flow Estimation and Analysis Year 0 1 2 3 4 5 Capex (Rs) -585,000 Revenues (Rs) 500,000 500,000 500,000 500,000 500,000 Operating cost (Rs) 292,000 292,000 292,000 292,000 292,000 Depreciation (Rs) 117,000 117,000 117,000 117,000 117,000 Total Cost (Rs) 409,000 409,000 409,000 409,000 409,000 Operating Income (Rs) 91,000 91,000 91,000 91,000 91,000 Add back: Depreciation (Rs) 117000 117000 117000 117000 117000 Net Cash flow (Rs) -585,000 208,000 208,000 208,000 208,000 208,000 Present value with WACC ===> 21% Year Capex (Rs)-Outflow Net cash inflow (Rs) Present Value in Rs. 0 -585,000 1 208,000 171900.8 2 208,000 142066.8 3 208,000 117410.6 4 208,000 97033.5 5 208,000 80193.0 Total (Rs) -585,000 1,040,000 608,605 Cash flow and DCF with WACC ==> 21% Year Net Cash Flow (Rs.) Cummilative Cash Flow (Rs.) Discounted Cash Flow (DCF) (Rs.) Cummilative DCF (Rs.) 0 -585,000 -585000 (585,000) -585000 1 208,000 -377000     171,901 -413099 2 208,000 -169000     142,067 -271032 3 208,000 39000     117,411 -153622 4 208,000 247000        97,034 -56588 5 208,000 455000        80,193 23605 Net Present Value (NPV) ==> 23,605 Internal Rate Of Return (IRR) ==> % 22.8% PPI==> 1.0403 Pay Back Period==> Years 2.81

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