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: A suitable location in a large shopping mall can be rented for $3,400 per month. 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. Based on similar outlets elsewhere, Mr. Swanson estimates that sales would total $370,000 per year. Ingredients would cost 20% of sales. 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

SOLUTION

1. Contribution format income statement

Particulars	Amount ($)	Amount ($)
Sales		370,000
Variable expenses:
Cost of ingredients (370,000*20%)	74,000
Commissions (370,000*11%)	40,700	114,700
Contribution margin		255,300
Selling and administrative expenses:
Salaries	77,000
Rent (3,400*12)	40,800
Depreciation*	14,820
Insurance	4,200
Utilities	34,000	170,820
Net opearting income		84,480

Depreciation = (312,000-15,600) / 20 years = 14,820

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

= 84,480 / 312,000 = 27.08%

Yes, the franchise would be acquired because it promises a rate of return in excess of 22%.

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

= 3120,000 / (84,480+14,820)

= 3120,000 / 99,300 = 3.14 years

3B. According to payback computation, the franchise would not acquired. The 3.14 years is greater than the maximum 3 years allowed.