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Lou Barlow, a divisional manager for Sage Company, has an opportunity to manufac

ID: 2472337 • 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 22% each of the last three years. He has computed the cost and revenue estimates for each product as follows:

  

  

  

Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor using tables.

  

Calculate the payback period for each product. (Round your answers to 2 decimal places.)

     

Calculate the net present value for each product. (Round discount factor(s) to 3 decimal places.)

     

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.)

         

Calculate the project profitability index for each product. (Round discount factor(s) to 3 decimal places. Round your answers to 2 decimal places.)

     

Calculate the simple rate of return for each product. (Round percentage answer to 1 decimal place. i.e. 0.1234 should be considered as 12.3%.)

     

For each measure, identify whether Product A or Product B is preferred.

     

Based on the simple rate of return, Lou Barlow would likely:

Product A Product B   Initial investment:   Cost of equipment (zero salvage value) $ 350,000 $ 550,000   Annual revenues and costs:   Sales revenues $ 390,000 $ 470,000   Variable expenses $ 178,000 $ 210,000   Depreciation expense $ 51,000 $ 93,000   Fixed out-of-pocket operating costs $ 87,000 $ 67,000

Explanation / Answer

1. Depreciation is a non cash item hence ignored.

Payback period = Initial Investment/ Annual Cash Flows

Product A = 350000 / (390000 - 178000 - 87000) = 350000 / 125000 = 2.8 years

Product B = 550000 / (470000 - 210000 -67000) = 550000 / 193000 = 2.85 years

2. NPV = PV of cash inflows - PV of cash outflows

Product A : 125000/(1.20) + 125000/(1.20)^2 + 125000/(1.20)^3 + 125000/(1.20)^4 + 125000/(1.20)^5 - 350000 = $23826.52

Product B : 193000/(1.20) + 193000/(1.20)^2 + 193000/(1.20)^3 + 193000/(1.20)^4 + 193000/(1.20)^5 - 550000 = $27188.14

3. IRR is the rate at which PV of Cash Inflows = PV of cash Outflows

Product A : 125000/(1+r) + 125000/(1+r)^2 + 125000/(1+r)^3 + 125000/(1+r)^4 + 125000/(1+r)^5 = 350000

r = 23.059% (approx)

Product B : 193000/(1+r) + 193000/(1+r)^2 + 193000/(1+r)^3 + 193000/(1+r)^4 + 193000/(1+r)^5 = 550000

r = 22.225% (aprox)

4. Profitability Index = PV of Cash Inflows/ Initial Investment

Product A = 373826.62 / 350000 = 1.068

Product B = 577188.14 / 550000 = 1.049

5. Simple rate of return = Annual Cash Flow/ Initial Investment * 100

Product A = 125000 / 350000 * 100 = 35.714%

Product B = 193000 / 550000 * 100 = 35.091%

6.a. Payback Period : Product A

       NPV : Product B

       IRR : product A

       Profitability Index : Product A

       Simple Rate of return : Product A

6 b Accept Product A