Lou Barlow, a divisional manager for sage company, has an opportunity to manufac
ID: 2790964 • 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, which has exceeded 18% each of the last three years . He has computed the cost and revenue estimates for each product as follows: 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, which has exceeded 18% each of the last three years . He has computed the cost and revenue estimates for each product as follows: The company’s discount rate is 16% Product A Product B Initial investment: Cost of equipment (zero salvage value) $170,000 $380,000 Annual revenues and costs: Sales revenues $250,000 $350,000 Fixed out-of-pocket operating costs....$ $34,000 $70,000 $50,000Explanation / Answer
LOU BARLOW-SAGE COMPANY: PRODUCT A PRODUCT B Investment 170000 380000 Sales revenues 250000 350000 Variable expenses 120000 170000 Fixed costs 70000 50000 Depreciation expense 34000 76000 Net operating profit 26000 54000 Add: Depreciation 34000 76000 OCF 60000 130000 1) Payback period in years: Product A = 170000/60000 = 2.83 Product B = 380000/130000 = 2.92 2) NPV: Product A = 60000*PVIFA(16,5)-170000 = 60000*3.2743 -170000= 26458 Product B = 130000*PVIFA(16,5)-380000 = 130000*3.2743 - 380000 = 45659 3) IRR: Product A: IRR is that discount rate for which NPV = 0 or PV of cash inflows = Initial investment. Hence, 170000=60000*PVIFA(IRR,5) 2.8333 = PVIFA(IRR,5) 22% 23% IRR lies between 22% and 23%. 2.8636 2.8035 IRR, using simple interpolation = 22+(2.8636-2.8333)/(2.8636-2.8035) = 22.50% Product B: Similary, 380000 = 130000*PVIFA(IRR,5) 2.9231 = PVIFA(IRR,5) 21% 22% IRR lies between 21% and 22%. 2.926 2.8636 IRR = 21+(2.926-2.9231)/(2.926-2.8636) = 21.05% 4) Profitability index = PV of cash inflows/Initial cost Product A = 196458/170000 = 1.16 Product B = 425659/380000 = 1.12 5) Simple rate of return = Annual net income/Investment Product A = 26000/170000 = 15.29% Product B = 54000/380000 = 14.21% 6) The results of the evaluation under the different methods are tabulated below: Product A Product B Payback period in years 2.83 2.92 NPV [$] 26458 45659 IRR [%] 22.50% 21.05% PI 1.16 1.12 SRR 15.29% 14.21% Product A would be preferred under the methods--Payback (lower payback), IRR (higher rate), PI (higher ratio) and SRR (higher return). NPV would prefer Product B. As Mr. Barlow would be rewarded only for the return in excess of 18%, he is likely to reject both the products, their simple return being less than 18%.
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