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: 6.66 points Product AProduct 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 300,000 500,000 eBook 350, 000 450,000 $ 160, 000 210,000 $ 60,000 100,000 $ 80,000 61,000 Print References The company's discount rate is 16%. Click here to view Exhibit 13B-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

1) Product A Product B Annual revenues and costs: Sales revenues $350,000 $450,000 Variable expenses $160,000 $210,000 Fixed out-of-pocket operating costs $80,000 $61,000 Annual net cash inflows $110,000 $179,000 Initial Investment $300,000 $500,000 Payback period = Initial Investment/ Annual net cash inflows 2.73 2.79 years 2) Product A Product B Product A Product B Net present Value Year cash flows cash flows PV discount @16% Present Value Present Value 0 -$300,000 -$500,000 1 -$300,000 -$500,000 1 $110,000 $179,000 0.862068966 $94,827.59 $154,310.34 2 $110,000 $179,000 0.743162901 $81,747.92 $133,026.16 3 $110,000 $179,000 0.640657674 $70,472.34 $114,677.72 4 $110,000 $179,000 0.552291098 $60,752.02 $98,860.11 5 $110,000 $179,000 0.476113015 $52,372.43 $85,224.23 NPV $60,172.3 $86,098.56 3) IRR Product A 24.32% Product B 23.17% IRR calculated in excel. 4) profitability index = (NPV + Initial investment) ÷ Initial Investment Product A= ($60172.3+300000)/300000 1.20 Product B = (86098.56+500000)/500000 1.17 5) simple rate of return Product A Product B Annual net cash inflow $110,000 $179,000 Depreciation expense -60000 -100000 Annual incremental net operating income $50,000 $79,000 Simple rate of return = Annual incremental net operating income /Initial investment 16.67% 15.80% 6)a. Product A Product B Preferred Payback period 2.73 2.79 years Project A NPV $60,172.3 $86,098.56 Project B IRR 24.32% 23.17% Project A Profitability Index 1.201 1.172 Project A Simple rate of retun 16.67% 15.80% Both Rejected 6b Reject both the project as the simple rate of return for each product is lower than his division’s historical return on investment of 23%.

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