Question

Lizzy, a strategic planner at Wild Products, is trying to decide which product to make and sell over the next 5 years. Lizzy gets a raise based on her company’s Return on Investment which has been more that 18% in the last 3 years. Wild Products uses a discount rate of 16%. Below are the cost and revenue projections for each product:

Gadgets Widgets

Initial Investment:

Cost of Equipment (zero salvage value) $170,000 $380,000

Annual revenues and costs:

Sales Revenue $250,000 $350,000

Variable Expenses $120,000 $170,000

Depreciation Expense $34,000 $76,000

Fixed out-of-pocket operating costs $70,000 $50,000

Requirements

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
6. Indicate which product is preferable based on each of the above metrics
7. Which, if any, product should Lizzy pursue and why?

Answer 1

1)

Net cash inflow of Gadgets = Sales revenue - Variable expense - Fixed cost
= $250,000 - $120,000 - $70,000
= $60,000

Payback period of Gadgets = Original cost of Asset / Cash inflow
= $170,000 / $60,000
= 2.83

Net cash inflow of Widgets = Sales revenue - Variable expense - Fixed cost
= $350,000 - $170,000 - $50,000
= $130,000

Payback period of Widgets = Original cost of Asset / Cash inflow
= $380,000 / $130,000
= 2.92

2)

NPV of Gadgets = Net cash flow / (1+Discount rate)t
= $60,000 / (1+0.16)5
=28,571.42

NPV of Widgets = Net cash flow / (1+Discount rate)t
= $130,000 / (1+0.16)5
=61,904.76