Lou Barlow, a divisional manager for Sage Company, has an opportunity to manufac
ID: 2466409 • 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 20% 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) $ 260,000 $ 470,000 Annual revenues and costs: Sales revenues $ 310,000 $ 410,000 Variable expenses $ 144,000 $ 194,000 Depreciation expense $ 52,000 $ 94,000 Fixed out-of-pocket operating costs $ 76,000 $ 56,000 The company’s discount rate is 18%.
3. Calculate the internal rate of return for each product. (Round percentage answer to 1 decimal place. i.e. 0.1234 should be considered as 12.3% and Round discount factor(s) to 3 decimal places.)
4. Calculate the project profitability index for each product. (Round discount factor(s) to 3 decimal places. Round your answers to 2 decimal places.)
Explanation / Answer
1
Calculation of internal rate of return (IRR) for each product:
Product A
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Sales Revenue
$ 310,000
$ 310,000
$ 310,000
$ 310,000
$ 310,000
Less: Variable Expenses
$ (144,000)
$ (144,000)
$ (144,000)
$ (144,000)
$ (144,000)
Less: Fixed out-of-pocket operating costs
$ (76,000)
$ (76,000)
$ (76,000)
$ (76,000)
$ (76,000)
Initial investment
$ (260,000)
Net Cash Flows
$ (260,000)
$ 90,000
$ 90,000
$ 90,000
$ 90,000
$ 90,000
IRR=
21.59%
Using Excel formula = IRR()
Product B
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Sales Revenue
$ 410,000
$ 410,000
$ 410,000
$ 410,000
$ 410,000
Less: Variable Expenses
$ (194,000)
$ (194,000)
$ (194,000)
$ (194,000)
$ (194,000)
Less: Fixed out-of-pocket operating costs
$ (56,000)
$ (56,000)
$ (56,000)
$ (56,000)
$ (56,000)
Initial investment
$ (470,000)
Net Cash Flows
$ (470,000)
$ 160,000
$ 160,000
$ 160,000
$ 160,000
$ 160,000
IRR=
20.82%
Using Excel formula = IRR()
2
Calculation of project profitability index for each product:
Product A
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Sales Revenue
$ 310,000
$ 310,000
$ 310,000
$ 310,000
$ 310,000
Less: Variable Expenses
$ (144,000)
$ (144,000)
$ (144,000)
$ (144,000)
$ (144,000)
Less: Fixed out-of-pocket operating costs
$ (76,000)
$ (76,000)
$ (76,000)
$ (76,000)
$ (76,000)
Net Cash Flows (CF)
$ -
$ 90,000
$ 90,000
$ 90,000
$ 90,000
$ 90,000
PVF (18%)
1.00000
0.84746
0.71818
0.60863
0.51579
0.43711
PV = CF*PVF
$ -
$ 76,271.19
$ 64,636.60
$54,776.78
$46,421.00
$39,339.83
Present value of cash Inflows = Sum (A)
$281,445.39
Initial investment (B)
$260,000.00
Profitability index = A/B =
1.08
Calculation of project profitability index for each product:
Product B
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Sales Revenue
$ 410,000
$ 410,000
$ 410,000
$ 410,000
$ 410,000
Less: Variable Expenses
$ (194,000)
$ (194,000)
$ (194,000)
$ (194,000)
$ (194,000)
Less: Fixed out-of-pocket operating costs
$ (56,000)
$ (56,000)
$ (56,000)
$ (56,000)
$ (56,000)
Net Cash Flows (CF)
$ -
$ 160,000
$ 160,000
$ 160,000
$ 160,000
$ 160,000
PVF (18%)
1.00000
0.84746
0.71818
0.60863
0.51579
0.43711
PV = CF*PVF
$ -
$135,593.22
$114,909.51
$97,380.94
$82,526.22
$69,937.47
Present value of cash Inflows = Sum (A)
$500,347.36
Initial investment (B)
$470,000.00
Profitability index = A/B =
1.06
1
Calculation of internal rate of return (IRR) for each product:
Product A
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Sales Revenue
$ 310,000
$ 310,000
$ 310,000
$ 310,000
$ 310,000
Less: Variable Expenses
$ (144,000)
$ (144,000)
$ (144,000)
$ (144,000)
$ (144,000)
Less: Fixed out-of-pocket operating costs
$ (76,000)
$ (76,000)
$ (76,000)
$ (76,000)
$ (76,000)
Initial investment
$ (260,000)
Net Cash Flows
$ (260,000)
$ 90,000
$ 90,000
$ 90,000
$ 90,000
$ 90,000
IRR=
21.59%
Using Excel formula = IRR()
Product B
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Sales Revenue
$ 410,000
$ 410,000
$ 410,000
$ 410,000
$ 410,000
Less: Variable Expenses
$ (194,000)
$ (194,000)
$ (194,000)
$ (194,000)
$ (194,000)
Less: Fixed out-of-pocket operating costs
$ (56,000)
$ (56,000)
$ (56,000)
$ (56,000)
$ (56,000)
Initial investment
$ (470,000)
Net Cash Flows
$ (470,000)
$ 160,000
$ 160,000
$ 160,000
$ 160,000
$ 160,000
IRR=
20.82%
Using Excel formula = IRR()
2
Calculation of project profitability index for each product:
Product A
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Sales Revenue
$ 310,000
$ 310,000
$ 310,000
$ 310,000
$ 310,000
Less: Variable Expenses
$ (144,000)
$ (144,000)
$ (144,000)
$ (144,000)
$ (144,000)
Less: Fixed out-of-pocket operating costs
$ (76,000)
$ (76,000)
$ (76,000)
$ (76,000)
$ (76,000)
Net Cash Flows (CF)
$ -
$ 90,000
$ 90,000
$ 90,000
$ 90,000
$ 90,000
PVF (18%)
1.00000
0.84746
0.71818
0.60863
0.51579
0.43711
PV = CF*PVF
$ -
$ 76,271.19
$ 64,636.60
$54,776.78
$46,421.00
$39,339.83
Present value of cash Inflows = Sum (A)
$281,445.39
Initial investment (B)
$260,000.00
Profitability index = A/B =
1.08
Calculation of project profitability index for each product:
Product B
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Sales Revenue
$ 410,000
$ 410,000
$ 410,000
$ 410,000
$ 410,000
Less: Variable Expenses
$ (194,000)
$ (194,000)
$ (194,000)
$ (194,000)
$ (194,000)
Less: Fixed out-of-pocket operating costs
$ (56,000)
$ (56,000)
$ (56,000)
$ (56,000)
$ (56,000)
Net Cash Flows (CF)
$ -
$ 160,000
$ 160,000
$ 160,000
$ 160,000
$ 160,000
PVF (18%)
1.00000
0.84746
0.71818
0.60863
0.51579
0.43711
PV = CF*PVF
$ -
$135,593.22
$114,909.51
$97,380.94
$82,526.22
$69,937.47
Present value of cash Inflows = Sum (A)
$500,347.36
Initial investment (B)
$470,000.00
Profitability index = A/B =
1.06
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