Problem 10-20A Using the payback period and unadjusted rate of return to evaluat

Question

Problem 10-20A Using the payback period and unadjusted rate of return to evaluate alternative investment opportunities LO 10-4 Seth Fitch 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. Fitch to offer frozen yogurt to customers. The machine would cost $7.530 and has an expected 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 $6,090 and $870, respectively. Alternatively, Mr. Fitch could purchase for $9.440 the equipment necessary to serve cappuccino. That equipment has an expected useful life of four years and no salvage value. Additional annual cash revenues and cash operating expenses associated with selling cappuccino are expected to be $8.480 and $2,300, 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. (Round your answers to 2 decimal places.) Unad rch 40e@

Explanation / Answer

Computation of Cash flow from two alternatives -

Payback period = Completed Year + Remaining Amt./ Available Amt.

For option 1= 1 + (-2852/(-2852-1826))*12

= 1 year and 7.31 months

and For option 2 -

= 1 + (-4024/(-4024-1392))*12

= 1 year and 8.91 months

2. Unadusted rate of return = Average annual profit after taxes / Average Investment

average annual profit after taxes = 2168*3/3 = 2168

Average Investment = (Initial Investment + Salvage value )/2

= (7530+0)/2

= 3765

Rate of return = 2168/3765

= 57.58%

same as for alternative 2

Average profit after tax = 3056 / (9440-0)/2

= 3056/4720

= 64.74%

Please comment in case of any query/clarification.

Option 1 Year 0 1 2 3 Initial investment 7530 Annual cash revenues 6090 6090 6090 less Cash operating expense 870 870 870 less Depriciation(assuming SL method) 2510 2510 2510 EBIT 2710 2710 2710 less Tax @ 20% 542 542 542 EAT (EBIT -Tax) 2168 2168 2168 add Depriciation 2510 2510 2510 Cash flow -7530 4678 4678 4678 Cum. Cash flow -7530 -2852 1826 Option 2 Year 0 1 2 3 4 Initial investment 9440 Annual cash revenues 8480 8480 8480 8480 less Cash operating expense 2300 2300 2300 2300 less Depriciation(assuming SL method) 2360 2360 2360 2360 EBIT 3820 3820 3820 3820 less Tax @ 20% 764 764 764 764 EAT (EBIT -Tax) 3056 3056 3056 3056 add Depriciation 2360 2360 2360 2360 Cash flow -9440 5416 5416 5416 5416 Cum. Cash flow -9440 -4024 1392

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