Question

Sharkey’s Fun Center contains a number of electronic games as well as a miniature golf course and various rides located outside the building. Paul Sharkey, the owner, would like to construct a water slide on one portion of his property. Mr. Sharkey gathered the following information about the slide:

1. Water slide equipment could be purchased and installed at a cost of $405,000. According to the manufacturer, the slide would be usable for 12 years after which it would have no salvage value.
2. Mr. Sharkey would use straight-line depreciation on the slide equipment.
3. To make room for the water slide, several rides would be dismantled and sold. These rides are fully depreciated, but they could be sold for $72,500 to an amusement park in a nearby city.
4. Mr. Sharkey concluded that about 50,000 more people would use the water slide each year than have been using the rides. The admission price would be $4.20 per person (the same price the Fun Center has been charging for the old rides).
5. Based on experience at other water slides, Mr. Sharkey estimates that annual incremental operating expenses for the slide would be: salaries, $87,000; insurance, $5,000; utilities, $13,800; and maintenance, $10,600.

Required:

1. Prepare an income statement showing the expected net operating income each year from the water slide.

	Sharkey’s Fun Center Income Statement Selling and administrative expenses: Total selling and administrative expenses

2-a. Compute the simple rate of return expected from the water slide.

2-b. Based on the above computation, would the water slide be constructed if Mr. Sharkey requires a simple rate of return of at least 14% on all investments?

3-a. Compute the payback period for the water slide.

3-b. If Mr. Sharkey accepts any project with a payback period of five years or less, would the water slide be constructed?

Answer 1

1	Incremental net opertaing income calculated on the following basis:
	Sharkey’s Fun Center
	Income Statement
	Ticket revenue (50,000 X $4.20)		$210,000
	Selling and administrative expenses:
	Salaries	$87,000
	Insurance	5,000
	Utilities	13,800
	Depreciation*	33,750
	Maintenance	10,600
	Total selling and administrative expenses		150,150
	Net operating income		59,850
	*$405,000 ÷ 12 years = $33,750 per year.
2	The simple rate of return is:
	simple rate of return =	Incremental net operating income annual basis
		Net Initial investment
	=	$59,850
		$405,000 - $72,500
	=	$59,850		=	18.00%
		$332,500
	Water slide would be constructed, since it has higher Rate of return than its hurdle rate of 14%
3	The payback period is:
	payback period =	Net Initial investment
		net cash inflow per year
	=	$405,000 - $72,500
		$93,600*
	=	$332,500		=	3.55	Years(rounded)
		$93,600*
	*Net operating income + Depreciation = Annual net cash flow
	$59,850 + $33,750 = $93,600.
	Water slide would be constructed since its payback period is 3.55 years that is less than maximum allowed pay back period of 5 years.