Question

Paul Swanson has an opportunity to acquire a franchise from The Yogurt Place, Inc., to dispense frozen yogurt products under The Yogurt Place name. Mr. Swanson has assembled the following information relating to the franchise:

1. A suitable location in a large shopping mall can be rented for $3,400 per month.
2. Remodeling and necessary equipment would cost $312,000. The equipment would have a 20-year life and a $15,600 salvage value. Straight-line depreciation would be used, and the salvage value would be considered in computing depreciation.
3. Based on similar outlets elsewhere, Mr. Swanson estimates that sales would total $370,000 per year. Ingredients would cost 20% of sales.
4. Operating costs would include $77,000 per year for salaries, $4,200 per year for insurance, and $34,000 per year for utilities. In addition, Mr. Swanson would have to pay a commission to The Yogurt Place, Inc., of 11.0% of sales.

Required:

1. Prepare a contribution format income statement that shows the expected net operating income each year from the franchise outlet.

2-a. Compute the simple rate of return promised by the outlet.

2-b. If Mr. Swanson requires a simple rate of return of at least 22%, should he acquire the franchise?

3-a. Compute the payback period on the outlet.

3-b. If Mr. Swanson wants a payback of three years or less, will he acquire the franchise?

Answer 1

Answer and explanation:

1.

Cost of ingredients and sales commission is based on sales volume. Hence, it is variable cost.

Depreciation on equipment:

Straight line method
Annual depreciation expense = ($312,000 - $15,600) / 20 = $14,820

2.a.
Simple rate of return = Annual incremental net operating income / Initial investment

Annual incremental net operating income = $84,480
Initial investment = $312,000

Simple rate of return = $84,480/ $312,000 = 27.08%

2.b.
He should acquire the franchise because, the simple rate of return required for Mr. Swanson is atleast 22% and in this case, the return is 27.08%.

3.a.
Payback period = Investment required / Annual net cash inflow

Investment required = $312,000
Annual net cash inflow = Net income + Depreciation = $84,480 + $14,820 = $99,300

Payback period = $312,000/ $99,300 = 3.1 years

3.b.
Mr. Swanson will not acquire the franchise because, it has a payback period of 3.1, which is more than his requirement of 3 years or less.