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)	$	360,000		$	530,000
Annual revenues and costs:
Sales revenues	$	400,000		$	510,000
Variable expenses	$	180,000		$	250,000
Depreciation expense	$	72,000		$	106,000
Fixed out-of-pocket operating costs	$	85,000		$	65,000

  

The company’s discount rate is 19%.

	Product A	Product B
Project profitability index

	Product A		Product B
Simple rate of return		%		%

Answer 1

	Product A	Product B
Project profitability index	1.31	1.28
Simple rate of return	17.50%	16.79%

Note: Answers rounded off to 2 decimal places.

Workings:

Year	Factor	Product A		Product B
	i=19%	Cash Flows	PV	Cash Flows	PV
0	0.84034	-360000	-302522.4	-530000	-445380.2
1 to 5	3.05763	400000	1223052	510000	1559391.3
1 to 5	3.05763	-265000	-810271.95	-315000	-963153.45
NPV			110257.65		150857.65

Profitability index = (Net Present Value + Initial investment)/Initial investment

Product A: ($110257.65 + 360000)/360000 = 1.31

Product B: ($150857.65 + 530000)/530000 = 1.28

Simple rate of return = Annual net income/Initial Investment

Product A: ($400000 - 180000 - 72000 - 85000)/$360000 = $63000/$360000 = 17.50%

Product B: ($510000 - 250000 - 106000 - 65000)/$530000 = $89000/$530000 = 16.79%