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:

  

	Product A			Product B
Initial investment:
Cost of equipment (zero salvage value)	$	380,000		$	575,000
Annual revenues and costs:
Sales revenues	$	410,000		$	490,000
Variable expenses	$	186,000		$	218,000
Depreciation expense	$	76,000		$	115,000
Fixed out-of-pocket operating costs	$	89,000		$	69,000

The company’s discount rate is 20%.

Click here to view Exhibit 8B-1 and Exhibit 8B-2, to determine the appropriate discount factor using tables.  

  Required:

1. Calculate the payback period for each product. (Round your answers to 2 decimal places.)

2. Calculate the net present value for each product. (Round discount factor(s) to 3 decimal places.)

3. Calculate the internal rate of return for each product. (Round percentage answers to 1 decimal place. i.e. 0.1234 should be considered as 12.3% and round discount factor(s) to 3 decimal places.)

4. Calculate the project profitability index for each product. (Round discount factor(s) to 3 decimal places. Round your answers to 2 decimal places.)

5. Calculate the simple rate of return for each product. (Round percentage answers to 1 decimal place. i.e. 0.1234 should be considered as 12.3%.)

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:

	Accept Product A
	Accept Product B
	Reject both products

Answer 1

Discounted cash inflows are as below:

Net present value is as below:

3. The internal rate of return cannot be found for this project because even by using the factor as 1 for each of the five years, both the products are running into losses.

4.

Both the products should be rejected because:

1) NPV is negative

2) Payback period is more than the life of the product and both the payback periods are almost the same

3) Internal rate of return is negative for both the products

4) PI is almost the same for both the products and is below 1, which means that the discounted cash flows are not enough to even cover the initial investment.