Problem 13-23 Comprehensive Problem [LO13-1, LO13-2, LO13-3, LO13-5, LO13-6] Lou
ID: 2658069 • Letter: P
Question
Problem 13-23 Comprehensive Problem [LO13-1, LO13-2, LO13-3, LO13-5, LO13-6]
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 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:
The company’s discount rate is 14%.
Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor using tables.
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:
Product A Product B Initial investment: Cost of equipment (zero salvage value) $ 220,000 $ 410,000 Annual revenues and costs: Sales revenues $ 280,000 $ 380,000 Variable expenses $ 130,000 $ 182,000 Depreciation expense $ 44,000 $ 82,000 Fixed out-of-pocket operating costs $ 73,000 $ 60,000Explanation / Answer
Product A:
Initial Investment = $220,000
Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $280,000 - $130,000 - $44,000 - $73,000
Annual Net Income = $33,000
Annual Net Cash flows = Annual Net Income + Depreciation
Annual Net Cash flows = $33,000 + $44,000
Annual Net Cash flows = $77,000
Product B:
Initial Investment = $410,000
Net Income = Sales Revenues - Variable Expenses - Depreciation Expenses - Fixed out-of-pocket Operating Costs
Annual Net Income = $380,000 - $182,000 - $82,000 - $60,000
Annual Net Income = $56,000
Annual Net Cash flows = Annual Net Income + Depreciation
Annual Net Cash flows = $56,000 + $82,000
Annual Net Cash flows = $138,000
Answer 1.
Product A:
Payback Period = Initial Investment / Annual Net Cash flows
Payback Period = $220,000 / $77,000
Payback Period = 2.86 years
Product B:
Payback Period = Initial Investment / Annual Net Cash flows
Payback Period = $410,000 / $138,000
Payback Period = 2.97 years
Answer 2.
Product A:
Net Present Value = -$220,000 + $77,000 * PVA of $1 (14%, 5)
Net Present Value = -$220,000 + $77,000 * 3.4331
Net Present Value = $44,348.70
Product B:
Net Present Value = -$410,000 + $138,000 * PVA of $1 (14%, 5)
Net Present Value = -$410,000 + $138,000 * 3.4331
Net Present Value = $63,767.80
Answer 3.
Product A:
Let IRR be i%
$220,000 = $77,000 * PVA of $1 (i%, 5)
PVA of $1 (i%, 5) = 2.8571
Using table values, i = 22.1%
So, IRR is 22.1%
Product B:
Let IRR be i%
$410,000 = $138,000 * PVA of $1 (i%, 5)
PVA of $1 (i%, 5) = 2.9710
Using table values, i =20.3%
So, IRR is 20.3%
Answer 4.
Product A:
Profitability Index = Net Present Value / Initial Investment
Profitability Index = $44,348.70 / $220,000
Profitability Index = 0.20
Product B:
Profitability Index = Net Present Value / Initial Investment
Profitability Index = $63,767.80 / $410,000
Profitability Index = 0.16
Answer 5.
Product A:
Simple Rate of Return = Annual Net Income / Initial Investment
Simple Rate of Return = $33,000 / $220,000
Simple Rate of Return = 15.0%
Product B:
Simple Rate of Return = Annual Net Income / Initial Investment
Simple Rate of Return = $56,000 / $410,000
Simple Rate of Return = 13.7%
Answer 6-a.
Net Present Value = Product B
Profitability Index = Product A
Payback Period = Product A
Internal Rate of Return = Product A
Simple Rate of Return = Product A
Answer 6-b.
Based on the simple rate of return, Lou Barlow would likely select Product A.