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 17% 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)	$	180,000		$	390,000
Annual revenues and costs:
Sales revenues	$	260,000		$	360,000
Variable expenses	$	124,000		$	174,000
Depreciation expense	$	36,000		$	78,000
Fixed out-of-pocket operating costs	$	71,000		$	51,000
The company’s discount rate is 15%.    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

Answer 1

	Product A	Product B
Sales revenues	260000	360000
Less:
Variable expenses	124000	174000
Fixed out-of-pocket operating costs	71000	51000
Annual net cash inflows	65000	135000
1
Payback period = Initial investment/Annual net cash inflows
Product A = 180000/65000= 2.77 years
Product B = 390000/135000= 2.89 years
2
	Product A	Product B
Annual net cash inflows	65000	135000
Present value factor	3.352	3.352
Present value of Annual net cash inflows	217880	452520
Less: Initial investment	180000	390000
Net present value	37880	62520
3
PV factor for Internal rate of return =Initial investment/ Annual net cash inflows
Product A Pv factor= 180000/65000= 2.769
Product A Internal rate of return = 24%
Product A PV factor= 390000/135000= 2.889
Product B Internal rate of return = 22%