Lou Barlow, a divisional manager for Sage Company, has an opportunity to manufac
ID: 2587802 • 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 25% 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) $ 340,000 $ 525,000 Annual revenues and costs: Sales revenues $ 380,000 $ 480,000 Variable expenses $ 172,000 $ 225,000 Depreciation expense $ 68,000 $ 105,000 Fixed out-of-pocket operating costs $ 83,000 $ 66,000 The company’s discount rate is 17%. 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:
req 1. Calculate the payback period for each product.
req2. Calculate the net present value for each product.
req 3. Calculate the internal rate of return for each product.
req4. Calculate the project profitability index for each product
req5. Calculate the simple rate of return for each product. (Round your answers to 1 decimal place i.e. 0.123 should be considered as 12.3%.)
req 6A For each measure, identify whether Product A or Product B is preferred.
Req 6B Based on the simple rate of return, Lou Barlow would likely: A accept product A b. accept product B c. reject both products.
Explanation / Answer
1. Payback period
Product A
Annual Cash flow = Annual revenues - Annual cash costs
= 380,000 - (172,000 + 83,000)
= $125,000
(Note: Depreciation is not added while calculating the annual costs as it is a non-cash expense)
Payback Period = Initial investment / Annual Cash flow = 340,000 / 125,000 = 2.72 years
Product B
Annual Cash flow = Annual revenues - Annual cash costs
= 480,000 - (225,000 + 66,000)
= $189,000
(Note: Depreciation is not added while calculating the annual costs as it is a non-cash expense)
Payback Period = Initial investment / Annual Cash flow = 525,000 / 189,000 = 2.78 years
2. Net Present Value (NPV)
Product A
NPV = Present value of Annual cash flows - Initial investment
Present value of annual cash flows = Annual cash flows x Cumulative discount factor for 5 years @17%
= 125,000 x 3.19935 = $399,919
Net Present Value (NPV) = 399,919 - 340,000 = $59,919
Product B
NPV = Present value of Annual cash flows - Initial investment
Present value of annual cash flows = Annual cash flows x Cumulative discount factor for 5 years @17%
= 189,000 x 3.19935 = $604,677
Net Present Value (NPV) = 604,677 - 525,000 = $79,677
3. Internal rate of return (IRR)
IRR is the rate of return at which NPV of the project is 0 (zero).
Product A
Since, NPV @17% is positive, the internal rate of return must be more than 17%. Let us assume it to be 20% and calculate NPV @20%.
NPV @20% = 125.000 x 2.99061 - 340,000 = $33,826
Since, NPV @20% is also positive, the internal rate of return must be more than 20%. Let us assume it to be 25% and calculate NPV @25%.
NPV @25% = 125.000 x 2.68928 - 340,000 = $(3,840)
NPV @25% is negative. So, IRR is somewhere between 20% and 25%.
The difference between NPVs @20% and 25% = 33826 - (-3840) = 37,666
On interpolating, we get IRR = 25 - (5 x 3,840 / 37,666) = 24.5%
Product B
Since, NPV @17% is positive, the internal rate of return must be more than 17%. Let us assume it to be 20% and calculate NPV @20%.
NPV @20% = 189.000 x 2.99061 - 525,000 = $40,226
Since, NPV @20% is also positive, the internal rate of return must be more than 20%. Let us assume it to be 25% and calculate NPV @25%.
NPV @25% = 189.000 x 2.68928 - 340,000 = $(16,276)
NPV @25% is negative. So, IRR is somewhere between 20% and 25%.
The difference between NPVs @20% and 25% = 40226 - (-16276) = 56,502
On interpolating, we get IRR = 25 - (5 x 16,276 / 56,502) = 23.5%
4. Project Profitability Index
Profitability Index = Present value of annual cash flows / Initial Investment
Product A
Profitability Index = 399,919 / 340,000 = 1.18
Product B
Profitability Index = 604,677 / 525,000 = 1.15
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