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. 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)	$	210,000		$	420,000
Annual revenues and costs:
Sales revenues	$	290,000		$	390,000
Variable expenses	$	138,000		$	186,000
Depreciation expense	$	42,000		$	84,000
Fixed out-of-pocket operating costs	$	74,000		$	54,000

The company’s discount rate is 19%.

Ignore income taxes. Note that Excel or a financial calculator must be used to calculate items 2 - 4.

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.

6a. For each measure, identify whether Product A or Product B is preferred.

Answer 1

		Product A		Product B
	Cash Inflow from Investment	78000	(290000-138000-74000)	150000	(390000-186000-54000)
		Product A		Product B
1	Payback period	2.69 Years	(210000/78000)	2.8 years	(420000/150000)
2	Calculation of Present value	Product A		Product B
	Present value of Inflows (19%, 5)	238495.1	(78000*3.05763)	458644.5	(150000*3.05763)
	Initial Investment	210000		420000
	Net present value	28495.14		38644.5
3		Product A		Product B
	Internal rate of return
	Factor for IRR	2.692308	(210000/78000)	2.8	(420000/150000)
		25%		23%
4		Product A		Product B
	Project profitability index	1.135691		1.092011