The Elberta Fruit Farm of Ontario always has hired transient workers to pick its
ID: 2559839 • Letter: T
Question
The Elberta Fruit Farm of Ontario always has hired transient workers to pick its annual cherry crop. Janessa Wright, the farm manager, just received information on a cherry picking machine that is being purchased by many fruit farms. The machine is a motorized device that shakes the cherry tree, causing the cherries to fall onto plastic tarps that funnel the cherries into bins. Ms. Wright has gathered the following information to decide whether a cherry picker would be a profitable investment for the Elberta Fruit Farm:
Currently, the farm is paying an average of $220,000 per year to transient workers to pick the cherries.
The cherry picker would cost $320,000, and it would have an estimated 8-year useful life. The farm uses straight-line depreciation on all assets and considers salvage value in computing depreciation expense. The estimated salvage value of the cherry picker is $85,000.
Annual out-of-pocket costs associated with the cherry picker would be: cost of an operator and an assistant, $97,000; insurance, $5,000; fuel, $18,000; and a maintenance contract, $20,000.
Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor using tables.
Required:
1. Determine the annual savings in cash operating costs that would be realized if the cherry picker were purchased.
2a. Compute the simple rate of return expected from the cherry picker.
2b. Would the cherry picker be purchased if Elberta Fruit Farm’s required rate of return is 17%?
3a. Compute the payback period on the cherry picker.
3b. The Elberta Fruit Farm will not purchase equipment unless it has a payback period of three years or less. Would the cherry picker be purchased?
4a. Compute the internal rate of return promised by the cherry picker.
4b. Based on this computation, does it appear that the simple rate of return is an accurate guide in investment decisions?
Explanation / Answer
(1) Calculation of annual saving in operating cost
Present cost of transient workers - Out of pocket expenses to operate cherry picker - cost of an operator and an assistant - Insurance - Fuel - Maintenance contract
= $220,000 -$97,000 -$5,000 - $18000 - $20,000 = $80,000
Annual Saving in operating Cost $80,000
(2a) Calculation of Simple rate of return
Annual Saving in operating cost $80,000
Less: Annual Depreciation [($320,000 - $85,000)/8] ($29,375)
Annual Incremental operating Income $50,625
therefore, simple rate of return = [Annual incremental net operating income]/Intial Investment
= $50,625/$320,000
= 15.82%
(2b) No, the cherry picker will not be purchased at the required rate of return of 17% because of the expected rate of return i.e., 15.82% is less than the required rate of return.
(3a) Calculation of payback period of cherry picker
Payback period = [Investment required]/[Annual cash flows]
= 320,000/80,000
= 4years
(3b) No, the Elberta Fruit Farm will not purchase the cherry picker machine because the payback period of 4years is more than the required payback period of 3years or less.
(4a) Calculation of Internal rate of return
NPV at 10% = $80,000 * PVAF(10%, 8years) + $85,000 * PVF(10%, 8year) - $320,000
= $146,447
NPV at 20% = $80,000 * PVAF(20%, 8years) + $85,000 * PVF(20%, 8year) - $320,000
= $6,741
By approximation we get IRR = 20.5%
(4b) No, simple rate of interest is not an accurate guide in investment decisions as it ignores the time value of money.
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