Question

Problem 13-24 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 $260,000 per year to transient workers to pick the cherries.
2. The cherry picker would cost $600,000. 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, $81,000; insurance, $5,000; fuel, $13,000; and a maintenance contract, $16,000.

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 17%?

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 four 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

Solution 1) Savings in Cash operating Costs:
Current Cost	260000
Less: Operator & Assistant	81000
Less: Insurance	5000
Less: Fuel	13000
Less: Main. Contract	16000
Cash Operating Savings	145000
Solution 2a) Simple Rate of Return:
Savings	145000
Less: Dep	60000
(600000/10)
Net Savings	85000
Return=(Net Savings/Initial Cost)
=(85000/600000)
14.17%
Solution 2b & 4a) Calculation of NPV & IRR
Cash flows	Period	Amount	P.V.F @ 17%	N.P.V @ 17%	P.V.F @ 25%	N.P.V @ 25%
Initial Cost	0	-600000	1.0000	-6,00,000	1.0000	-6,00,000
Cash Operating Savings	1-10	145000	4.6586	6,75,497	3.5705	5,17,723
			Total	75,497	Total	-82,278
IRR= Lower Discount Rate + [ Lower Rate NPV / ( Lower Rate NPV - Higher Rate NPV )]*(Higher Discount Rate-Lower Discount Rate)
So By putting figure into this formula IRR is		20.39%
Solution 3a) Cash Payback period:
=Initial Costs/annual cash savings
=600000/145000
4.14
Solution 3a) It should not be purchased, since pay back period is more than 4 as required.
Solution 4b) Simple rate of return is not accurate guide as its does not take into account the effect of discount factor.
We should look for NPV for best decision making.