Lou Barlow, a divisional manager for Sage Company, has an opportunity to manufac
ID: 2582647 • 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 11B-1 and Exhibit 11B-2, to determine the appropriate discount factor(s) using tables.
Calculate the net present value for each product. (Use the appropriate table to determine the discount factor(s).)
Calculate the project profitability index for each product. (Use the appropriate table to determine the discount factor(s). 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% and use the appropriate table to determine the discount factor(s).)
For each measure, identify whether Product A or Product B is preferred.
Based on the simple rate of return, Lou Barlow would likely:
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:
Explanation / Answer
Answer:
2. Calculate the net present value for each product.
Product A
Product B
Sales revenues
390,000
470,000
Variable expenses
-178,000
-210,000
Fixed out-of-pocket operating costs
-87,000
-67,000
Annual net cash inflows
125,000
193,000
Product A:
Now
1
2
3
4
5
Purchase of equipment
($350,000)
Cah inflow of each year
125,000
125,000
125,000
125,000
125,000
Total cash flows (a)
($350,000)
$125,000
$125,000
$125,000
$125,000
$125,000
Discount factor (b) at 20%
1
0.8333333
0.69444444
0.578704
0.482253
0.4018776
Present value (a)×(b)
($350,000)
$104,167
$86,806
$72,338
$60,282
$50,235
Net present value
$23,827
Product B:
Now
1
2
3
4
5
Purchase of equipment
($550,000)
Cah inflow of each year
193,000
193,000
193,000
193,000
193,000
Total cash flows (a)
($550,000)
$193,000
$193,000
$193,000
$193,000
$193,000
Discount factor (b) at 20%
1
0.8333333
0.69444444
0.578704
0.482253
0.4018776
Present value (a)×(b)
($550,000)
$160,833
$134,028
$111,690
$93,075
$77,562
Net present value
$27,188
NPV
Project-A
$23,827
Project-B
$27,188
____________________________________________________________--
3. Calculate the internal rate of return for each product.
Product A
Product B
Investment required (a)
$350,000
$550,000
Annual net cash inflow (b)
$125,000
$193,000
Factor of the internal rate of return (a) ÷ (b)
$2.80
$2.85
Looking in table of Factor along the 5-period line, a factor of 2.80 falls right between 23% and 24%, so we’ll estimate an internal rate of return for Product A of 23.06%.
A factor of 2.85 is closest to 22%, so we’ll estimate an internal rate of return for Product B of 22.23%.
___________________________________________________________
4. Calculate the project profitability index for each product.
Product A
Product B
Net present value (a)
$23,827
$27,188
Investment required (b)
350,000
$550,000
Project profitability index (a) ÷ (b)
0.0681
0.0494
____________________________________________________
5. Calculate the simple rate of return for each product.
Product A
Product B
Annual net cash inflow
$125,000
$193,000
Depreciation expense
70,000
110,000
Annual incremental net operating income
$55,000
$83,000
Product A
Product B
Annual incremental net operating income (a)
$55,000
$83,000
Initial investment (b)
$350,000
$550,000
Simple rate of return (a) ÷ (b)
15.71%
15.09%
_________________________________________________________
6. Which of the two products should Lou’s division pursue? Why?
The net present value calculations suggest that Product B is preferable to Product A. However, the project profitability index reveals that Product A is the preferred choice.. However, it bears emphasizing that Lou Barlow may be inclined to reject both products because the simple rate of return for each product is lower than his division’s historical return on investment of 22%
Product A
Product B
Sales revenues
390,000
470,000
Variable expenses
-178,000
-210,000
Fixed out-of-pocket operating costs
-87,000
-67,000
Annual net cash inflows
125,000
193,000
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