Question

Problem 12-26 Simple Rate of Return; Payback [LO12-1, LO12-6]

Sharkey’s Fun Center contains a number of electronic games as well as a miniature golf course and various rides located outside the building. Paul Sharkey, the owner, would like to construct a water slide on one portion of his property. Mr. Sharkey gathered the following information about the slide:

1. Water slide equipment could be purchased and installed at a cost of $540,000. According to the manufacturer, the slide would be usable for 12 years after which it would have no salvage value.
2. Mr. Sharkey would use straight-line depreciation on the slide equipment.
3. To make room for the water slide, several rides would be dismantled and sold. These rides are fully depreciated, but they could be sold for $85,000 to an amusement park in a nearby city.
4. Mr. Sharkey concluded that about 50,000 more people would use the water slide each year than have been using the rides. The admission price would be $5.10 per person (the same price the Fun Center has been charging for the old rides).
5. Based on experience at other water slides, Mr. Sharkey estimates that annual incremental operating expenses for the slide would be: salaries, $96,000; insurance, $5,900; utilities, $14,700; and maintenance, $11,500.

Required:

1. Prepare an income statement showing the expected net operating income each year from the water slide.

2-a. Compute the simple rate of return expected from the water slide.

2-b. Based on the above computation, would the water slide be constructed if Mr. Sharkey requires a simple rate of return of at least 14% on all investments?

3. If Mr. Sharkey accepts any project with a payback period of five years or less, would the water slide be constructed?

Answer 1

1.Income statement

Incremental Revenue		$255,000(50,000*$5.10)
Less: Operating expenses
Salaries	$96,000
Insurance	$5,900
Utilities	$14,700
Maintenance	$11,500
Depreciation [$540,000/12]	$45,000	$173,100
Net operating Income		$81,900[$255,000-173,100]

2-a. Simple rate of return = Net operating Income/Initial investment]*100

=$81,900/$540,000 *100

=15.17%

2-b. water slide has simple rate of return 15.17% which is more than Mr. Sharkey's required simple rate of return of at least 14% on all investments.

3 Payback period = Initial investment/ cash flow per year

Cash flow = Net income+ depreciation (Non cash expense)

=$81,900+$45,000

=$126,900

Payback period = $540,000/126,900

=4.26 years

yes, water slide be constructed as the payback period is lesser than 5 years

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