Question

John West plc used cars has always hired students from the local university to wash the cars on the lot. John West is considering the purchase of an automatic car wash that would be used in place of the students. The following information has been gathered by John West's accountant to help him make a decision on the purchase:

a) Payments to students for washing cars total R15 000 per year at present.

b) The car wash would cost R21 000 installed, and it would have a 10 year useful life. John West uses straight line depreciation on all assets. The car wash would have a negligible salvage value in 10 years.

c) Annual out-of-pocket costs associated with the car wash would be: wages of students to operate the wash, keep the soap bin full and so forth, R6 300; utilites, R1 800; and insurance and maintenance , R900.

d) John West now earns a return of 20% on the funds invested in his inventory of used cars. He feels that he would have to earn an equivalent rate on the car wash for the purchase to be attractive.

Required:

1) Determine the annual savings that would be realized in cash operating costs if the car wash was purchased.

2) Calculate the simple rate of return promised by the car wash, (Hint: Note that this is a cost reduction project.) Will John West accept this project if he expects a 20% return?

3) Calculate the payback period on the car wash. John West (who has a reputation for being something of a penny-pincher) will not purchase any equipment unless it has a payback of four years or less. Will he purchase the car wash equipment?

4) Calculate ( to the nearest whole percent) the internal rate of return promised by the car wash. Based on this calculation, does it appear that the simple rate of return would normally be an accurate guide in investment decisions?

Answer 1

	1.)Net Incremental Cash Savings/(cost)
	Incremental Savings/(cost) every year after Installation of Car Wash:
	Incremental Saving for Payments to students				Rs. 15,000
	Incremental Depreciation				Rs. -2,100
	Other Costs:
	Wages				Rs. -6,300
	Utilities				Rs. -1,800
	Insurance and Maintenance				Rs.      -900
	Net Incremental Savings/(cost)				Rs.    3,900
	Add: Depreciation				Rs.    2,100
	Net Incremental Cash Savings/(cost)				Rs.    6,000
	2.)Simple Rate of Return
	Simple Rate of Return		= Savings/Cost of Purchase
			= 6000/21000
			28.57%
	Since the actual rate if return(28.57%) is higher than required rate of return(20%), hence the project would be accepted.
	3.)
	Payback Period		= Cost of Purchase/Savings
			= 21000/6000
			= 3 years
	Hence the project would be accepted since the payback period is less than 4 years.
	4)
	Internal Rate of Return:				13.19%
	This is calculated using equation, Inflow = Outflow.
	Hence, it would be more appropriate to use Simple Rate of Return than IRR.