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Chapter 26: Problem 6

Family Care Products Company is considering an investment in one of two new product lines. The investment required for either product line is \(\$ 600,000\). The net cash flows associated with each product are as follows: \begin{tabular}{crr} Year & Liquid Soap & Cosmetics \\ \hline 1 & \(\$ 120,000\) & \(\$ 165,000\) \\ 2 & 120,000 & 155,000 \\ 3 & 120,000 & 140,000 \\ 4 & 120,000 & 140,000 \\ 5 & 120,000 & 110,000 \\ 6 & 120,000 & 90,000 \\ 7 & 120,000 & 80,000 \\ 8 & 120,000 & 80,000 \\ Total & \(\$ \$ 960,000\) & \(\$ 960,000\) \\ \hline \hline \end{tabular} a. Recommend a product offering to Family Care Products Company, based on the cash payback period for each product line. b. Why is one product line preferred over the other, even though they both have the same total net cash flows through eight periods?

Short Answer

Expert verified
Recommend the Cosmetics product line based on its shorter payback period of 4 years, providing quicker investment recovery.

Step by step solution

01

Understand the Cash Payback Period

The cash payback period is the time it takes for an investment to generate an amount of cash equal to the initial outlay. Family Care Products Company wants to know how long it will take for each product line to repay the initial investment of $600,000 through its cash flows.
02

Calculate Payback Period for Liquid Soap

Summing the annual cash flows for the Liquid Soap line: - Year 1: $120,000 - Year 2: $120,000 - Year 3: $120,000 - Year 4: $120,000 - Year 5: $120,000 Total up to Year 5: $600,000 Thus, the payback period for Liquid Soap is exactly 5 years.
03

Calculate Payback Period for Cosmetics

Summing the annual cash flows for the Cosmetics line: - Year 1: $165,000 - Year 2: $155,000 (Total = $320,000) - Year 3: $140,000 (Total = $460,000) - Year 4: $140,000 (Total = $600,000) Thus, the payback period for Cosmetics is 4 years.
04

Compare the Payback Periods

Liquid Soap has a payback period of 5 years, while Cosmetics has a payback period of 4 years. The Cosmetics line recoups the initial investment faster than the Liquid Soap line.
05

Provide the Recommendation and Explanation

Based on the cash payback periods, Cosmetics should be recommended because it recovers the initial $600,000 investment in just 4 years compared to 5 years for Liquid Soap. Despite having the same total cash flows, the faster recovery of the investment makes the Cosmetics line a preferred option.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Investment Analysis
Investment analysis is a fundamental process in assessing the viability of a proposed investment. It involves evaluating various financial metrics to decide whether a particular investment aligns with a company's strategic goals.
When Family Care Products Company considers investing in new product lines, it's crucial to analyze the potential returns and risks associated with each option. The cash payback period is one of several metrics used for this analysis.
This metric reveals how quickly an investment can pay back its initial outlay through generated cash flows. Therefore, it's critical to calculate the cash payback period for both product lines in order to compare them and make the most informed decision.
In this scenario, understanding which product line recoups the investment faster enables Family Care Products Company to make a sound investment choice, enhancing financial efficiency and aligning with strategic growth objectives.
Net Cash Flows
Net cash flows are the cash inflows and outflows resulting from an investment. Crucially, they are a key determinant of an investment's profitability and liquidity profile.
In Family Care's case, both the Liquid Soap and Cosmetics lines generate a total of $960,000 in net cash flows over an eight-year period. However, what's pivotal is not just the total amount but the timing of these flows.
The timing dictates how soon the initial investment is recouped; faster recovery enhances liquidity and frees up capital for other opportunities.
Comparing the yearly cash inflows of both product lines:
  • Liquid Soap shows steady inflows of $120,000 yearly.
  • Cosmetics starts with higher inflows, reaching $165,000 in the first year, swiftly reducing the principal balance owed by the investment.
This difference illustrates why merely looking at total figures without considering timing can lead to misleading conclusions.
Product Line Comparison
Product line comparison involves evaluating two or more potential projects to determine which option better suits a company鈥檚 strategic aims.
In the exercise provided, the comparison is between the Liquid Soap and Cosmetics lines, specifically using their cash payback periods as a metric.
  • Cosmetics: Has a quicker payback period of 4 years due to higher initial cash inflows.
  • Liquid Soap: A longer payback period of 5 years, given consistent but lower inflows over time.
Ultimately, the quicker recovery of costs through the Cosmetics line makes it more appealing under these conditions.
Even though both lines yield the same total net cash flows eventually, the speed at which they achieve payback significantly influences the decision-making process.
Choosing Cosmetics aligns with strategies that prioritize rapid fund recuperation, allowing for more agile financial management and the potential reprioritization of resources.

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Most popular questions from this chapter

International Fabricators Inc. is considering an investment in equipment that will replace direct labor. The equipment has a cost of \(\$ 85,000\), with a \(\$ 5,000\) residual value and a 10 -year life. The equipment will replace one employee who has an average wage of \(\$ 23,000\) per year. In addition, the equipment will have operating and energy costs of \(\$ 6,000\) per year. Determine the average rate of return on the equipment, giving effect to straight-line depreciation on the investment.

Integrated Technologies Inc. is considering the purchase of automated machinery that is expected to have a useful life of four years and no residual value. The average rate of return on the average investment has been computed to be \(25 \%\), and the cash payback period was computed to be \(4.5\) years. Do you see any reason to question the validity of the data presented? Explain.

Airwave Communications Inc. is considering an investment in new equipment that will be used to manufacture a PDA (personal data assistant). The PDA is expected to generate additional annual sales of 4,800 units at \(\$ 350\) per unit. The equipment has a cost of \(\$ 910,000\), residual value of \(\$ 50,000\), and a 10 -year life. The equipment can only be used to manufacture the PDA. The cost to manufacture the PDA is shown below. \(\begin{array}{lr}\text { Cost per unit: } & \$ 52.00 \\ \text { Direct labor } & 195.00 \\ \text { Direct materials } & 58.00 \\ \text { Factory overhead (including depreciation) } & \$ 305.00 \\ \text { Total cost per unit }\end{array}\) Determine the average rate of return on the equipment.

The following data are accumulated by Green Mountain Testing Services Inc. in evaluating two competing capital investment proposals: \begin{tabular}{lcc} & Testing Equipment & Centrifuge \\ \hline Amount of investment & \(\$ 34,000\) & \(\$ 40,000\) \\ Useful life & 6 years & 8 years \\ Estimated residual value & 0 & 0 \\ Estimated total income over the useful life & \(\$ 10,200\) & \(\$ 14,000\) \end{tabular} Determine the expected average rate of return for each proposal.

Carnival Corporation has recently placed into service some of the largest cruise ships in the world. One of these ships, the Carnival Glory, can hold up to 3,000 passengers and cost \(\$ 530\) million to build. Assume the following additional information: \- The average occupancy rate for the new ship is estimated to be \(85 \%\) of capacity. \- There will be 300 cruise days per year. \- The variable expenses per passenger are estimated to be \(\$ 80\) per cruise day. \- The revenue per passenger is expected to be \(\$ 310\) per cruise day. \- The fixed expenses for running the ship, other than depreciation, are estimated to be \(\$ 80,000,000\) per year. \- The ship has a service life of 10 years, with a salvage value of \(\$ 90,000,000\) at the end of 10 years. a. Determine the annual net cash flow from operating the cruise ship. b. Determine the net present value of this investment, assuming a \(12 \%\) minimum rate of return. Use the present value tables provided in the chapter in determining your answer. c. Assume that Carnival Corp. decided to increase its price so that the revenue increased to \(\$ 320\) per passenger per cruise day. Would this allow Carnival Corp. to earn a \(15 \%\) rate of return on the cruise ship investment, assuming no change in any of the other assumptions? Use the present value tables provided in the chapter in determining your answer.
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