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 $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

1
Present cost of transient workers		260000
Less: Out of pocket fixed costs
Cost of an operator and assistant	81000
Insurance	5000
Fuel	13000
Maintenance contract	16000	115000
Annual savings in cash operating costs		145000
2
Annual savings in cash operating costs	145000
Less: Depreciation expense	60000	=600000/10
Annual incremental net operating income	85000
Annual incremental net operating income	85000
Divide by Investment cost	600000
Simple rate of return	14.17%
2b
NO, as simple rate of return is less than 17%
3a
Investment cost	600000
Divide by Annual savings in cash operating costs	145000
Payback period	4.14	years
3b
No, as payback period is more than 4 years
4a
Investment cost	600000
Divide by Annual savings in cash operating costs	145000
PV factor for internal rate of return	4.138
The PV factor 4.138 for 10 years is closest to 20%
Internal rate of return = 20%
4b
No, simple rate of return is not an accurate guide in investment decisions.