Question

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 $230,000 per year to transient workers to pick the cherries.
2. The cherry picker would cost $670,000. 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, $93,000; insurance, $2,000; fuel, $10,000; and a maintenance contract, $13,000.

Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor using tables

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

1
Present cost of transient workers		230000
Less: Out of pocket fixed costs
Cost of an operator and assistant	93000
Insurance	2000
Fuel	10000
Maintenance contract	13000	118000
Annual savings in cash operating costs		112000
2
Annual savings in cash operating costs	112000
Less: Depreciation expense	67000	=670000/10
Annual incremental net operating income	45000
Annual incremental net operating income	45000
Divide by Investment cost	670000
Simple rate of return	6.72%
2b
NO, as simple rate of return is less than 11%
3a
Investment cost	670000
Divide by Annual savings in cash operating costs	112000
Payback period	5.98	years
3b
Yes, as payback period is less than 6 years
4a
Investment cost	670000
Divide by Annual savings in cash operating costs	112000
PV factor for internal rate of return	5.982
The PV factor 5.982 cor 10 years is closest to 11%
Internal rate of return = 11%
4b
No, simple rate of return is not an accurate guide in investment decisions.