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

Solution a:
Computation of annual income - Commuter service
Particulars	Amount
Sales Revenue (5*10*30*6*$12)	$108,000
Cost:
Gasoline	$16,100
Maintenance	$3,200
Repairs	$4,300
Insurance	$4,000
Advertising	$2,500
Payroll expense	$48,700
Depreciation ($75,920/3)	$25,307
Net Annual Income	$3,893
Computation of Cash Flows - Commuter service
Particulars	Amount
Net Annual Income	$3,893
Add: Depreciation	$25,307
Annual cash flows	$29,200

Solution b:

Cash payback period = Initial investment / Annual cash inflows = $75,920 / $29,200 = 2.60 years

Annual rate of return = Average annual income / Average investment

Average investment = (Cost + Salvage value) / 2 = $75,920/2 = $37,960

Annual rate of return = $3,893 / $37,960 = 10.26%

Solution c:
Computation of NPV - Commuter service
Particulars	Amount	Period	PV Factor	Present Value
Cash Outflows:
Cost of Investment	$75,920.00	0	1	$75,920
Present Value of Cash Outflows (A)				$75,920
Cash Inflows:
Annual cash inflows	$29,200.00	1-3	2.28323	$66,670
Present Value of Cash Inflows (B)				$66,670
Net Present Value (B-A)				-$9,250