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 $7,830 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 $6,070 and $880, respectively. Alternatively, Mr. Fitch could purchase for $9,400 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 $8,290 and $2,320, 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	%	%

Answer 1

Note :-

1. Depreciation = (Machine cost - Salvage value)/Life of the machine

2. Assuming Straight line depreciation applicable and depreciation per year can be calculated as per SLM.

3. Unadjusted rate of return = Increase in Future net income or net profit/Initial Investment

4.Unadjusted rate of return means the simple rate of return or accounting rate of return. It is calculated by dividing increase in future income by initial investment. The word unadjusted means that it does not take into consideration the time value of money.

5. Pay back period = Initial Investment/ Annnual net cash flows

Calculation of Payback period and unadjusted rate of return have been provided below along with workings :-

Calculation of Unadjusted rate of return:
Particulars	Alternative 1	Alternative 2
Step 1:Depreciation per year can be calculated as follows:
Machine Cost	7,830	9,400
Life of Machine	3	4
Salvage value	-	-
Depreciation per year	2,610	2,350
Step 2:Calculation of increase in future income
Increase in revenue	6,070	8,290
Depreciation per year	2,610	2,350
Operating Expense	880	2,320
Increase in taxable income	2,580	3,620
Tax expense(@20%)	516	724
Increase in Net Income	2,064	2,896
Depreciation Add back	2,610	2,350
Net Annual Cash Flows	4,674	5,246
Step 3:Calculation of unadjusted rate of return
1. Increase in future net income	2,064	2,896
2. Average Investment	(7,830+0)/2= 3915	(9,400+0)/2=4,700
3. Unadjusted rate of return (1/2)	50.72%	61.62%
Step 4: Calculation of Payback period
1.Net Annual Cash Flows	4,674	5,246
2. Initial investment	7,830	9,400
3. Payback period (1/2) (In Years)	1.68 Years	1.79 Years

Best alternative is Alternative 2.