Question

Problem 13-24 Simple Rate of Return; Payback Period; Internal Rate of Return [LO13-1, LO13-3, LO13-6]

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 $170,000 per year to transient workers to pick the cherries.

The cherry picker would cost $270,000. It would be depreciated using the straight-line method and it would have no salvage value at the end of its 8-year useful life.

Annual out-of-pocket costs associated with the cherry picker would be: cost of an operator and an assistant, $80,000; insurance, $3,000; fuel, $13,000; and a maintenance contract, $18,000.

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 15%?

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 five 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?

Answer 1

Answer

1.

We will not consider Depreciation Cost as Depreciation Cost is Non-Cash and we need to calculate Annual Cash Saving

	$
Salary of Transient Workers (A)	170,000.00
Cost of Operating Machine
Operator and Assistant Salary	80,000.00
Insurance	3,000.00
Fuel	13,000.00
Maintenance	18,000.00
Annual Cost of Operating Machine (B)	114,000.00
Net Cash Saving in Annual Cost (A - B)	56,000.00

2.

a.

Simple Rate of Return = Annual Net operating Income / Initial Investment

= (Net Cash saving in Annual Cost – Depreciation) / Initial Investment

= {$56,000 – ($270,000 / 8 Years) / $270,000}

Simple Rate of Return = 8.24%

b.

No, as Simple Rate of Return is less than 15%

3.

a.

Payback period = Initial Investment / Annual Cash Inflow

= $270,000 / $56,000 per year

Payback period = 4.82 Years

b.

Yes, as Payback period is less than 5 years.

4.

IRR
Year 1	Project
0	(270,000)
1	56,000
2	56,000
3	56,000
4	56,000
5	56,000
6	56,000
7	56,000
8	56,000
IRR	12.863%
Formula	IRR(B3:B11)

b.

Simple Rate of Return doesn’t take into account Time Value of Money, which is a Important factor in Investment Decision.

So, it is not an accurate guide in Investment Decision.

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