\"Louis Gallo owns a small retail ice cream parlor. He is considering expanding
ID: 2362164 • Letter: #
Question
"Louis Gallo owns a small retail ice cream parlor. He is considering expanding the business and has identified two attractive alternatives. One involves purchasing a machine that would enable Mr. Gallo to offer frozen yogurt to customers. The machine would cost $8,100 and has an ex- pected useful life of three years with no salvage value. Additional annual cash revenues and cash operating expenses associated with selling yogurt are expected to be $5,940 and $900, respectively. Alternatively, Mr. Gallo could purchase for $10,080 the equipment necessary to serve cap- puccino. That equipment has an expected useful life of four years and no salvage value. Addi- tional annual cash revenues and cash operating expenses associated with selling cappuccino are expected to be $8,280 and $2,430, respectively. Income before taxes earned by the ice cream parlor is taxed at an effective rate of 20 percent. Required a. Determine the payback period and unadjusted rate of return (use average investment) for each alternative. b. Indicate which investment alternative you would recommend. Explain your choice."Explanation / Answer
Machine #1. Calc the incremental cash flows... (Revenues - expenses - depreciation) * (1 - tax rate) + depreciation where depreciation = (cost - salvage)/useful life depreciation = (8100 - 0)/3 = 2,700 per year = [(5940 - 900 - 2,700) * .80] + 2,700 = 4,572 Calc the payback period... investment (i.e. cost of equipment) / Cash Flow = 8100 / 4572 = 1.77 years Not sure what s/he means by "unadjusted" rate of return... each year is CF/cost = 4572/8100 = 0.5644 or 56.44% for all three yrs...(4572 * 3) / 8100 = 13,716 / 8100 = 1.69333 or 169.33% (either method is weird because the cash flows should be discounted..maybe that's what s/he means by unadjusted) Now you do the same for Machine#2...note that this one has a FOUR year useful life.
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