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 $210,000 per year to transient workers to pick the cherries.
2. The cherry picker would cost $600,000. 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, $86,000; insurance, $5,000; fuel, $13,000; and a maintenance contract, $16,000.

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 seven 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

1	Annual savings in Net operating costs	=	$           90,000
2 - a.	Simple rate of return	=	5%
2 - b.	No
	As, ROI is more than Simple rate of return
3 - a.	Payback period	=	6.67	years
3 - b.	Yes	=
	As, Payback period is less than 7 years
4 - a.	IRR	=	8.14%
4 - b.	No
	Workings:
1	Cash proceed per year	=	$       2,10,000
Less:	Cost incurred per year:
	Cost of an operator and an assistant	=	$         -86,000
	Insurance	=	$           -5,000
	Fuel	=	$         -13,000
	Maintenance Contract	=	$         -16,000
	Annual savings in Net operating costs	=	$           90,000
2	Computation of Simple rate of return:
	Simple rate of return	=	Net Profit / Investment
		=	$30000 / $600000
		=	5.00%
	Net Profit
	Annual savings in Net operating costs	=	$           90,000
Less:	Annual Depreciation expense [($600000 - 0) / 10 years]	=	$         -60,000
	Net Profit	=	$           30,000
3	Payback period	=	Initial investment / Annual net cash flows
		=	$600000/ $90000
		=	6.67	years
4	Computation of IRR
		Year	Value Flows
		0	$     -6,00,000
		1	$           90,000
		2	$           90,000
		3	$           90,000
		4	$           90,000
		5	$           90,000
		6	$           90,000
		7	$           90,000
		8	$           90,000
		9	$           90,000
		10	$           90,000
	IRR	=	8.14%