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 20% 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)	$	260,000		$	470,000
Annual revenues and costs:
Sales revenues	$	310,000		$	410,000
Variable expenses	$	144,000		$	194,000
Depreciation expense	$	52,000		$	94,000
Fixed out-of-pocket operating costs	$	76,000		$	56,000

  

The company’s discount rate is 18%.

  

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

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

	Product A		Product B
Payback period	2.89	years		years

Product B?

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

	Product A	Product B
Net present value

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.)

	Product A		Product B
Internal rate of return		%		%

Answer 1

Product A
Cash Flow Estimation and Analysis
Year	0	1	2	3	4	5
Capex (Rs)	-260,000
Revenues (Rs)		310,000	310,000	310,000	310,000	310,000
Operating cost (Rs)		220,000	220,000	220,000	220,000	220,000
Depreciation (Rs)		52,000	52,000	52,000	52,000	52,000
Total Cost (Rs)		272,000	272,000	272,000	272,000	272,000
Operating Income (Rs)		38,000	38,000	38,000	38,000	38,000
Add back: Depreciation (Rs)		52000	52000	52000	52000	52000
Net Cash flow (Rs)	-260,000	90,000	90,000	90,000	90,000	90,000

Present value with WACC ===>	18%
Year	Capex (Rs)-Outflow	Net cash inflow (Rs)	Present Value in Rs.
0	-260,000
1		90,000	76271.2
2		90,000	64636.6
3		90,000	54776.8
4		90,000	46421.0
5		90,000	39339.8
Total (Rs)	-260,000	450,000	281,445

Cash flow and DCF with WACC ==>	18%
Year	Net Cash Flow (Rs.)	Cummilative Cash Flow (Rs.)	Discounted Cash Flow (DCF) (Rs.)	Cummilative DCF (Rs.)
0	-260,000	-260000	(260,000)	-260000
1	90,000	-170000	76,271	-183729
2	90,000	-80000	64,637	-119092
3	90,000	10000	54,777	-64315
4	90,000	100000	46,421	-17894
5	90,000	190000	39,340	21445

Therefore for Product A

Net Present Value (NPV) ==> Rs.	21,445
Internal Rate Of Return (IRR) ==>	21.6%
Pay Back Period==> Years	2.89

Product B

Cash Flow Estimation and Analysis
Year	0	1	2	3	4	5
Capex (Rs)	-470,000
Revenues (Rs)		410,000	410,000	410,000	410,000	410,000
Operating cost (Rs)		250,000	250,000	250,000	250,000	250,000
Depreciation (Rs)		94,000	94,000	94,000	94,000	94,000
Total Cost (Rs)		344,000	344,000	344,000	344,000	344,000
Operating Income (Rs)		66,000	66,000	66,000	66,000	66,000
Add back: Depreciation (Rs)		94000	94000	94000	94000	94000
Net Cash flow (Rs)	-470,000	160,000	160,000	160,000	160,000	160,000

Present value with WACC ===>	18%
Year	Capex (Rs)-Outflow	Net cash inflow (Rs)	Present Value in Rs.
0	-470,000
1		160,000	135593.2
2		160,000	114909.5
3		160,000	97380.9
4		160,000	82526.2
5		160,000	69937.5
Total (Rs)	-470,000	800,000	500,347

Cash flow and DCF with WACC ==>	18%
Year	Net Cash Flow (Rs.)	Cummilative Cash Flow (Rs.)	Discounted Cash Flow (DCF) (Rs.)	Cummilative DCF (Rs.)
0	-470,000	-470000	(470,000)	-470000
1	160,000	-310000	135,593	-334407
2	160,000	-150000	114,910	-219497
3	160,000	10000	97,381	-122116
4	160,000	170000	82,526	-39590
5	160,000	330000	69,937	30347

Therefore for Product B

Net Present Value (NPV) =>	30,347
Internal Rate Of Return (IRR)==>	20.8%
Pay Back Period==> Years	2.94