A company is trying to decide which of two new product lines to introduce in the coming year. The company requires a 12% return on investment. The predicted revenue and cost data for each product line follows: ? Product A Product BUnit sales25,00020,000Unit sales price$ 30$ 30Direct materials$15,000$8,000Direct labor$120,000$80,000Other cash operating expenses$30,000$25,000New equipment costs$2,500,000$1,500,000Estimated useful life (no salvage)5 years5 yearsThe company has a 30% tax rate and it uses the straight-line depreciation method. The present value of an annuity of 1 for 5 years at 12% is 3.6048. Compute the net present value for each piece of equipment under each of the two product lines. Which, if either of these two investments is acceptable?
What will be an ideal response?
| ? | Product A ? | Product B | ||
| Sales | ? | $750,000 | ? | $600,000 |
| Estimated costs: | ? | ? | ? | ? |
| Direct materials | $ 15,000 | ? | $ 8,000 | ? |
| Direct labor | 120,000 | ? | 80,000 | ? |
| Other cash operating expenses | 30,000 | ? | 25,000 | ? |
| Depreciation* | 500,000 | 665,000 | 300,000 | 413,000 |
| Income before taxes | ? | $ 85,000 | ? | $187,000 |
| Income taxes (30%) | ? | 25,500 | ? | 56,100 |
| Net income | ? | $ 59,500 | ? | $130,900 |
*Annual depreciation: A $2,500,000/5 yrs. = $500,000; B $1,500,000/5 yrs. = $300,000
| ? | Product A | Product B |
| Annual net cash flows** | $559,500 | $430,900 |
| Present value factors @12% | x3.6048 | x3.6048 |
| Present value of net cash flows | $2,016,885 | $1,553,308 |
| Investment | (2,500,000) | (1,500,000) |
| Net present value | $ (483,115) | $53,308 |
**Product A: $59,500 + $500,000 = $559,500; Product B: $130,900 + $300,000 = $430,900
Product A is not acceptable since its NPV is less than zero. Product B is acceptable since its NPV is greater than zero.
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