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:

Currently, the farm is paying an average of $220,000 per year to transient workers to pick the cherries.

The cherry picker would cost $570,000. It would be depreciated using the straight-line method and it would have no salvage value at the end of its 6-year useful life.

Annual out-of-pocket costs associated with the cherry picker would be: cost of an operator and an assistant, $83,000; 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.

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 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

Answer:
Requirement 1	The annual saving in cash operating cost if the cherry picker is purchased is calculated as follows:
	Cost paid to transient workers		$             2,20,000
	Less: Annual out of pocket cost
	Cost of an operator and assistant	$               83,000
	Insurance	$                 2,000
	Fuel	$               10,000
	Maintenance contract	$               13,000	$             1,08,000	($83,000+2,000+10,000+13,000)
	Annual saving in cash operation		$             1,12,000	(220000-108,000)
Requirement 2a	The simple rate of return would be calculated as follows:
	Annual saving in cash operation	$            1,12,000
	Less: Depreciation	$               95,000	($570,000/6 years)
	Net operating income	$               17,000
	Cost of cherry picker	570000
	Simple rate of return	=Annual net operating income/Cost of cherry picker
		=$17,000/$570,000
		2.98%
Requirement 2b	Since the actual rate of return 2.98% that is less than the required rate of return the cherry picker should not be purchased
Requirement 3a.	The payback period on the cherry picker would be calculated as follows:
	Annual saving in cash operation	$            1,12,000
	Cost of cherry picker	$            5,70,000
	Payback period	=Cost of cherry picker/Annual saving in cash operation
		=$570,000/112,000
		5.09	years