PROBLEM 8-23 Comprehensive Problem [LO 8-1, LO 8-2, LO 8-3, LO 8-5, LO 8-61 Lou

Question

PROBLEM 8-23 Comprehensive Problem [LO 8-1, LO 8-2, LO 8-3, LO 8-5, LO 8-61 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 divi- sion's return on investment (ROI), which has exceeded 18% 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 $170,000 $380,000 $250,000 $120,000 $350,000 $170,000 $34.000 $5,00 Depreciation expense . Fixed out-of-pocket operating costs $76,000 $70,000 The company's discount rate is 16%. 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. 6. Which of the two products should Lou's division pursue? Why?

Explanation / Answer

Solution 1:

Payback period = Initital Investment / Annual cash inflows

Product A = $170,000 / $60,000 = 2.833 years

Product B = $380,000/$130,000 = 2.923 years

Solution 2:

Solution 3:

At IRR present value of cash inflows will be equal to present value of cash outflows

Let IRR for product A is i and Product B is r

Product A:

$60,000 * cumulative PV factor at i for 5 periods = $170,000

Cumulative PV factor at i for 5 periods = 2.833333

This PV factor falls between IRR rate of 22% and 23%

Cumulative PV Factor at 22% = 2.86364

Cumulative PV Factor at 23% = 2.80347

IRR = 22% + (2.86364 - 2.83333) / (2.86364 - 2.80347) = 22.50%

Hence IRR for Product A is 22.50%

Product B:

$130,000 * cumulative PV factor at r for 5 periods = $380,000

Cumulative PV factor at r for 5 periods = 2.92307

This PV factor falls between IRR rate of 21% and 22%

Cumulative PV Factor at 21% = 2.92598

Cumulative PV Factor at 22% = 2.86364

IRR = 21% + (2.92598 - 2.92307) / (2.92598 - 2.86364) = 21.05%

Hence IRR for Product B is 21.05%

Solution 4:

Profitability Index = Present Value of Cash Inflows / PV of cash outflows

Product A = $196457.62/$170,000 = 1.156

Product B = $425,658.17 / $380,000 = 1.120

Computation of Annual cash Flows Particulars Product A Product B Sales Revenue $250,000.00 $350,000.00 Less: Variable expenses $120,000.00 $170,000.00 Less: Fixed out of pocket operating cost $70,000.00 $50,000.00 Annual Cash Inflows $60,000.00 $130,000.00

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