Question

Problem 13-24 (REV) Simple Rate of Return; Payback Period; Internal Rate of Return [LO13-1, LO13-3, LO13-6]

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 $190,000 per year to transient workers to pick the cherries.
2. The cherry picker would cost $490,000. 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, $3,000; fuel, $11,000; and a maintenance contract, $17,000.

Click here to view Exhibit 13B-1 and Exhibit 13B-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 9%?

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?

rev: 06_20_2017_QC_CS-91671, 03_16_2018_QC_CS-121342

Garrison 16e Rechecks 2017-05-22, Garrison 16e Rechecks 2017-11-15

Answer 1

Answer 1.
	Elberta Fruit Farm Statement of Annual Savings in Cash Operating Costs
	Particulars	Amount (in $)	Amount (in $)
	Cost Savings in payment made to the Transient Workers		190000
	Annual Cost of Cherry Picker
	Cost of Operator and Assistant	86000
	Insurance	3000
	Fuel	11000
	Maintenance Cost	17000	117000
	Annual Cost Savings in Operating Cash if Cherry Picker is purchased	73000
Answer 2a.
	Net income from the cherry picker machine
	=Savings in Operating Cost - Depreciation
	=73000 - (490000/10)
	$                                                               24,000.00
	Simple Rate of return expected
	=Net income/Initial Investment
	=24000/490000
	0.048979592
	4.90%
Answer 2b.
	Required Rate of Return	9%
	Return from the machine	4.90%
	Since the actual return is lower than the required rate of return
	the Cherry Picker machine should not be purchased
Answer 3a.
	Payback Period
	= Initial Investment/Annual Inflows of Cash
	=490000/73000
	6.712328767
	6.71	years
Answer 3b.
	Required Payback period	7 Years or less
	Actual Payback Period	6.71 years
	Since, the actual payback period is less than 7 years ie 6.71 years
	the cherry picker should be purchased
Answer 4a.
	At IRR,
	Initial Investment = PV of Annual Cash Inflows
	490000=73000xPVIFA(x,10)
	PVIFA(x,10) = 490000/73000
	PVIFA(x,10) =	6.71
	Uding Trial and Error
	At 8%
	PVIFA(8,10)	6.71
	At 8.5%
	PVIFA(12,10)	6.56
	IRR is 8%
Answer 4b.	Simple rate of return is not an accurate guide in making investment decisions.