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 $8,100 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 $6,080 and $850, respectively.

Alternatively, Mr. Fitch could purchase for $9,920 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 $8,320 and $2,380, respectively.

Income before taxes earned by the ice cream parlor is taxed at an effective rate of 20 percent.

   

Required

1. Determine the payback period and unadjusted rate of return (use average investment) for each alternative. (Round your answers to 2 decimal places.)

Answer 1

Particulars Alternative-1 Alternative-2 Revenues 6,080 8,320 Less: Cash operating expenses 850 2,380 Less: Depreciation expenses [$8,100/3] & [9,920/4] 2,700 2,480 Income before taxes 2,530 3,460 Less: Income taxes at 20% 506 692 Net Income 2,024 2,768 Add: Depreciation expenses 2,700 2,480 Annual cash flow 4,724 5,248 Payback Period for Alternative-1 = Initial investment / Annual cash flow = $8,100 / $4,724 = 1.71 Years Payback Period for Alternative-2 = Initial investment / Annual cash flow = $9,920 / $5,248 = 1.89 Years Unadjusted rate of return for Alternative-1 = Net Income / Average investment = $2,024 / [$8,100 / 2] = $2,024 / $4,050 = 0.4998 = 49.98% Unadjusted rate of return for Alternative-2 = Net Income / Average investment = $2,768 / [$9,920 / 2] = $2,768 / $4,960 = 0.5581 = 55.81%