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

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 23% 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) $290,000 $490,000
Annual revenues and costs:
Sales revenues $340,000 $440,000
Variable expenses $154,000 $206,000
Depreciation expense $58,000 $98,000
Fixed out-of-pocket
operating costs $79,000 $59,000
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.
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:
1. Accept Product A
2. Accept Product B
3. Reject both products

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  1. Answer:

    1. Calculate the payback period for each product.

    • A = 2.71 years, A is preferred
    • B = 2.8 years

    2. Calculate the net present value for each product.

    • A = $60,349
    • B = $83,001, B is preferred

    3. Calculate the internal rate of return for each product.

    • A = 25%, A is preferred
    • B = 23%

    4. Calculate the project profitability index for each product.

    • A = 121%, A is preferred
    • B = 117%

    5. Calculate the simple rate of return for each product.

    • A = 184%, A is ´preferred
    • B = 179%

    6B. Based on the simple rate of return, Lou Barlow would likely:

    • 1. Accept Product A, since its IRR is 25% which exceeds the company’s  minimum ROI (23%)

    Explanation:

                                           Product A               Product B

    Initial investment:

    Cost of equipment          $290,000              $490,000

    Annual revenues and costs:

    Sales revenues              $340,000               $440,000

    Variable expenses         $154,000               $206,000

    Depreciation expense    $58,000                 $98,000

    Fixed out-of-pocket

    operating costs               $79,000                 $59,000

    net cash flow                  $107,000                $175,000

    The company’s discount rate is 16%.

    payback period

    A = $290,000 / $107,000 = 2.71 years, A is preferred

    B = $490,000 / $175,000 = 2.8 years

    using an excel spreadsheet I calculated the NPV and IRR

    NPV

    A = $60,349

    B = $83,001, B is preferred

    IRR

    A = 25%, A is preferred

    B = 23%

    Project profitability

    A = $350,349 / $290,000 = 1.21

    B = $573,001 / $490,000 = 1.17

    Simple rate of return

    A = $535,000 / $290,000 = 184%, A is ´preferred

    B = $875,000 / $490,000 = 179%

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