PROBLEM 823 Comprehensive Problem LO 81 LO 82 LO 83 LO 85 LO

PROBLEM 8-23 Comprehensive Problem [LO 8-1, LO 8-2, LO 8-3, LO 8-5, LO 8-6) 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 divi- sion\'s return on investment (ROI), which has exceeded 18% 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)--F . . Annual revenues and costs: $170,000 $380,000 Varlable expenses . Depreciation expense Fixed out-of-pocket operating costs $250,000 $120,000 $34,000 $70,000 $350,000 $170,000 $76,000 $50,000 The company\'s discount rate is 16%. 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. 5. Calculate the simple rate of return for each product. 6. Which of the two products should Lou\'s division pursue? Why?

Solution

Project A:

Initial Investment = $170,000

Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $250,000 - $120,000 - $34,000 - $70,000
Annual Net Income = $26,000

Annual Net Cash flows = Annual Net Income + Depreciation
Annual Net Cash flows = $26,000 + $34,000
Annual Net Cash flows = $60,000

Project B:

Initial Investment = $380,000

Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $350,000 - $170,000 - $76,000 - $50,000
Annual Net Income = $54,000

Annual Net Cash flows = Annual Net Income + Depreciation
Annual Net Cash flows = $54,000 + $76,000
Annual Net Cash flows = $130,000

Answer 1.

Project A:

Payback Period = Initial Investment / Annual Net Cash flows
Payback Period = $170,000 / $60,000
Payback Period = 2.83 years

Project B:

Payback Period = Initial Investment / Annual Net Cash flows
Payback Period = $380,000 / $130,000
Payback Period = 2.92 years

Answer 2.

Project A:

Net Present Value = -$170,000 + $60,000 * PVA of $1 (16%, 5)
Net Present Value = -$170,000 + $60,000 * 3.2743
Net Present Value = $26,458

Project B:

Net Present Value = -$380,000 + $130,000 * PVA of $1 (16%, 5)
Net Present Value = -$380,000 + $130,000 * 3.2743
Net Present Value = $45,659

Answer 3.

Project A:

Let IRR be i%

$170,000 = $60,000 * PVA of $1 (i%, 5)
PVA of $1 (i%, 5) = 2.833
Using table values, i = 22.5%

So, IRR is 22.5%

Project B:

Let IRR be i%

$380,000 = $130,000 * PVA of $1 (i%, 5)
PVA of $1 (i%, 5) = 2.923
Using table values, i =21.1 %

So, IRR is 21.1%

Answer 4.

Product A:

Profitability Index = Net Present Value / Initial Investment
Profitability Index = $26,458 / $170,000
Profitability Index = 0.16

Product B:

Profitability Index = Net Present Value / Initial Investment
Profitability Index = $45,659 / $380,000
Profitability Index = 0.12

Answer 5.

Project A:

Simple Rate of Return = Annual Net Income / Initial Investment
Simple Rate of Return = $26,000 / $130,000
Simple Rate of Return = 20.0%

Project B:

Simple Rate of Return = Annual Net Income / Initial Investment
Simple Rate of Return = $54,000 / $380,000
Simple Rate of Return = 14.2%

Answer 6-a.

Net Present Value = Project B
Profitability Index = Project A
Payback Period = Project A
Internal Rate of Return = Project A