Question

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 $230,000 per year to transient workers to pick the cherries.

The cherry picker would cost $620,000. 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, $91,000; insurance, $5,000; fuel, $13,000; and a maintenance contract, $16,000.

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 11%?

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 six 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
Annual saving in labor cost	230000
Less: additional cost per year
Cost of an operator and an assistant	91000
Insurance	5000
Fuel	13000
Maintenance contract	16000
Total additional cost per year	125000
Annual net cost saving	105000
Answer 2
Annual net cost saving	105000
Less: depreciation expense (620000/8)	77500
Annual return	27500
Divided by: cost of cherry picker	620000
Simple rate of return on original investment	4.4355%

Year	Cash inflow(Outflow)	Discount factor @ 11%	Present value
0	(620,000)	1	(620,000.00)
1	105,000	0.900901	94,594.59
2	105,000	0.811622	85,220.36
3	105,000	0.731191	76,775.10
4	105,000	0.658731	69,166.75
5	105,000	0.593451	62,312.39
6	105,000	0.534641	56,137.29
7	105,000	0.481658	50,574.13
8	105,000	0.433926	45,562.28
Net present value			(79,657.11)
Cherry picker should not purchase because Net present value is Negative

Answer 3
Cost of cherry picker	620,000
Divided by : annual net cost saving	105,000
Payback period in years	5.90
Elberta Fruit Farm should purchase equipment because payback period is less than 6 years.
Answer 4
Year	Year
0	(620,000)
1	105,000
2	105,000
3	105,000
4	105,000
5	105,000
6	105,000
7	105,000
8	105,000
Internal rate of return promised	7.29%
Remark of formula	=IRR(E42:E50)
Where E42:E50 means cash flow inflow or outflow from Year 0 to Year 8
Internal rate of return is accurate guide compare to Simple rate of return.