Seth Fitch owns a small retail ice cream parlor. He is considering expanding the

Question

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 $8,100 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 $6,010 and $830, 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 $8,460 and $2,370, respectively.

Income before taxes earned by the ice cream parlor is taxed at an effective rate of 20 percent.

   

Required

Determine the payback period and unadjusted rate of return (use average investment) for each alternative. (Round your answers to 2 decimal places.)

Alternative 1 Alternative 2 Payback period years years Unadjusted rate of return % %

Explanation / Answer

Alternative 1 :-

Calculation of pay back period

Initial investment of machine = $8100

Calculation of net revenue from the project =

(Annual cash revenue – cash operating expense )

= $6010 - $830= $5180

Calculation of payback period = Investment required

Net annual cashflow

Therefore,$ 8100/$5180

= Payback period will be 1.56 years.

( Note : As depreciation is a non cash expense, hence it will be ignored while calculating pay back period.)

Calculation of Unadjusted rate of return.

Step 1 : calculation of depreciation of the asset.

Machine cost : $ 8100

Life of the machine = 3 years

Salvage value = Nil

Depreciation per annum = ($ 8100/3 years) = $ 2700

Step 2 : Calculation of net income

Additional cash revenue = $ 6010

Less : Depreciation= ($ 2700)

Less : Operating expense = ($ 830)

____________________________

Net total income= $ 2480

Less : Tax @ 20 % =$ 496

____________________________

After tax income= $ 1984

Step 3 : Calculation of Unadjusted rate of return

= Net total income/ Initial investment

= $ 1984/ $ 8100

= 24.49 %

Alternative 2 :-

Calculation of pay back period

Initial investment of machine = $ 9440

Calculation of net revenue from the project =

(Annual cash revenue – cash operating expense )

= $ 8460 - $ 2370= $ 6090

Calculation of payback period = Investment required

Net annual cashflow

Therefore,$ 9440/ $ 6090

= Payback period will be 1.55 years.

( Note : As depreciation is a non cash expense, hence it will be ignored while calculating pay back period.)

Calculation of Unadjusted rate of return.

Step 1 : calculation of depreciation of the asset.

Machine cost : $ 9440

Life of the machine = 4 years

Salvage value = Nil

Depreciation per annum = ($ 9440/4 years) = $ 2360

Step 2 : Calculation of net income

Additional cash revenue = $ 8460

Less : Depreciation= ($ 2360)

Less : Operating expense = ($ 2370)

____________________________

Net total income= $ 3730

Less : Tax @ 20 % =$ 746

____________________________

After tax income= $ 2984

Step 3 : Calculation of Unadjusted rate of return

= Net total income/ Initial investment

= $ 2984/ $ 9440

= 31.61 %

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