PROBLEM 8-23 Comprehensive Problem ILO 8-1, LO 8-2, LO 8-3, LO 8-5, LO 8-6 Lou B
ID: 2539015 • Letter: P
Question
PROBLEM 8-23 Comprehensive Problem ILO 8-1, LO 8-2, LO 8-3, LO 8-5, LO 8-6 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 . . . . . . Depreciation expense . Fixed out-of-pocket operating costs $250,000 $120,000 $34,000 $70,000 $350,000 $170,000 $76,000 $50,000 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
First, lets calculate cash inflow for future years Product A Product B Sales $ 250,000 $ 350,000 Less: Variable expenses $ 120,000 $ 170,000 Fixed out of pocket operating cost $ 70,000 $ 50,000 Cash inflow per year $ 60,000 $ 130,000 Less: depreciation $ 34,000 $ 76,000 Income $ 26,000 $ 54,000 1 Payback period 2.83 2.92 (Investment/cash inflow per year) 2. NPV $26,457.62 $45,658.17 PV(rate,period,-cash inflow)-Investment 3 IRR 22.50% 21.04% 4. Project Profitability index 1.16 1.12 (PV of cash inflows/investment) 5. Simple rate of return 15.29% 14.21% (Income/investment) 6. Product B is better with higher NPV.
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