Question

Lon Timur is an accounting major at a midwestern state university located approximately 60 miles from a major city. Many of the students attending the university are from the metropolitan area and visit their homes regularly on the weekends. Lon, an entrepreneur at heart, realizes that few good commuting alternatives are available for students doing weekend travel. He believes that a weekend commuting service could be organized and run profitably from several suburban and downtown shopping mall locations. Lon has gathered the following investment information.

1.Five used vans would cost a total of $75,920 to purchase and would have a 3-year useful life with negligible salvage value. Lon plans to use straight-line depreciation.

2.Ten drivers would have to be employed at a total payroll expense of $48,700.

3.Other annual out-of-pocket expenses associated with running the commuter service would include Gasoline $16,100, Maintenance $3,200, Repairs $4,300, Insurance $4,000, and Advertising $2,500.

4.Lon has visited several financial institutions to discuss funding. The best interest rate he has been able to negotiate is 15%. Use this rate for cost of capital.

5.Lon expects each van to make ten round trips weekly and carry an average of six students each trip. The service is expected to operate 30 weeks each year, and each student will be charged $12 for a round-trip ticket.

a. Determine the annual (1) net income and (2) net annual cash flows for the commuter service. (Round answers to 0 decimal places, e.g. 125.)

b. Compute (1) the cash payback period and (2) the annual rate of return. (Round answers to 2 decimal places, e.g. 10.50.)

c. Compute the net present value of the commuter service. (Round answer to 0 decimal places, e.g. 125.)

Answer 1

Workings-                                                           

Calculation of income from each bus per year                                                         

operational period- 30 weeks yearly

fare- 12 per student

carrying capacity per Van- 6 students per trip

trips that each van can make Weekly- 10 round trip, Yearly round trips per bus= (10*30) = 300  

Yearly revenue from 1 bus= (12*6*300)= $21600

Number of Van purchased= 5

Revenue from all van = 21600*5= $108000 per year

2. Calculation of depreciation and Capital Expenditure today -

Cash Outflow = 75920 ( Purchase of used van)

useful life= 3 years, method of depreciation- Straight line method, Salvage Value= nil

depreciation per year= (cost of asset - salvage value)/ useful life of asset

(75920-0)/3 = 25307

* As no tax rate is given in the question the calculation of depreciation is of no use as there will be no tax shield available on depreciation expense. Depreciation is a non-cash expense.

Statement showing cash flows-    (Amount in $)

Particulars                                                Year- 1                         Year 2                       Year 3

Revenue from the van (A)                        108000                         108000                        108000

Less- Operating Expenses-

Driver payroll                                             48700                           48700                          48700

Gasoline                                                    16100                           16100                          16100

Maintenance                                               3200                             3200                            3200

Repair                                                         4300                             4300                            4300

Insurance                                                    4000                             4000                            4000

Advertising                                                  2500                             2500                            2500

Total (B)                                                    78800                            78800                          78800

Net Income/Cash Flow (A-B)                   29200                           29200                            29200

Present value factor @ 15%                    .8695                            .7561                             .6575

Present value of annual cash flows         25389                           22078                            19199

Total of cash inflows                                    (25389+22078+19199) = 66666

Calculation of Net present value= Present value of cash inflows - cash outflows

                                                        66666- 75920= -9254

The project is not viable as net present value of the project is negative.

2. Calculation of cash payback period=

payback period= Initial investment/ Net annual cash inflows

Initial Investment= 75920

Net annual cash inflows= 66666 (25389+22078+19199)

Payback Period= 75920/66666 = 1.138 Years

3. Annual rate of return= (-9254/75920)*100 = -12.19%           (Net income available/ Initial Investment)*100