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 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) $ 310,000 $ 510,000 annual revenues and costs: sales revenues $ 360,000 $ 460,000 variable expenses $ 164,000 $ 214,000 depreciation expense $ 62,000 $ 102,000 fixed out-of-pocket operating costs $ 81,000 $ 65,000 the company's discount rate is 18%.

Answer 1

In order to compute the return on investment we will first need to compute the cash flows for 5 years for both the products to find which one of the product will provide the company with returns of more than 18% which is the minimum return the company expects.

In order to find the discounted cash inflows @18% we first need to find profit for both the products as below:

Product A

Sales 360000

Less Variable Expenses 164000

Less Fixed Costs 81000

Net Income 115000

Cash Flow for 5 Years discounted @18% 3.24

Total Cash Inflow for Product A $372685

Product B

Sales 460000

Less Variable Overheads (214000)

Less Fixed Expense (65000)

Net Income 181000

Cash Flow for 5 Years discounted @18% 3.24

Cash Inflow for Product B $586573

Net Cash Flow for A and B

A B

Net Inflows for 5 years $372685 $586574

Net Outflow $310000 $510000

Net Cash Flow $62685 $76574

Note: We will ignore depreciation wile calculating the above cash flows as depreciation is not a cash expense also depreciation needs to be considered only if tax information is given, which is absent in this question.

Discounted Factor has been found using attached formula, where r is rate of discount and n is period of time.

As can be observed in the above calculation we can see that product B gives a better result thus it should be considered.