Question

Problem 12-24 Simple Rate of Return; Payback Period; Internal Rate of Return [LO12-1, LO12-3, LO12-6]

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:

1. Currently, the farm is paying an average of $240,000 per year to transient workers to pick the cherries.
2. The cherry picker would cost $630,000. It would be depreciated using the straight-line method and it would have no salvage value at the end of its 10-year useful life.
3. Annual out-of-pocket costs associated with the cherry picker would be: cost of an operator and an assistant, $92,000; insurance, $5,000; fuel, $18,000; and a maintenance contract, $20,000.

Click here to view Exhibit 12B-1 and Exhibit 12B-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

Solution 1:

Computation of annual savings in cash operating cost - Elberta Fruit farm
Particulars	Amount
Cost saving of payment made to Transient workers	$240,000.00
Annual cost of cherry picker:
Cost of operator and assistant	$92,000.00
Insurance	$5,000.00
Fuel	$18,000.00
Maintenance cost	$20,000.00
Total annual saving cash operating cost if Cherry picker purchased	$105,000.00

Solution 2a:

Net income offered by cherry picking machine = Saving in cash operating cost - Depreciation = $105,000 - ($630,000/10) = $42,000

Simple rate of return = Net Income / Initial investment = $42,000/ $630,000 = 6.67%

Solution 2b:

Cherry picker should not be purchased as return offered is less than required rate of return.

Solution 3a:

Payback period = Initial investment / Annual cash inflows = $630,000 / $105,000 = 6 years

Solution 3b:

Yes, cherry pick should be purchased as payback period is equa to 6 years.

Solution 4a:

Present value of annuity of $1 for 10 periods at IRR = Initial investment / Annual cash inflows = $530,000 / $105,000 = 6.000

This factor falls nearest to IRR = 11%

Hence IRR = 11%

Solution 4b:

No, simple rate of return is not an accurate guide in investment decisions.