Question

Ben Paul is an accounting major at a western university located approximately 60 miles from a major city. Many of the students attending the university are from the metropolitan area and visit their homes regularly on the weekends. Ben, an entrepreneur at heart, realizes that few good commuting alternatives are available for students doing weekend travel. He believes that a weekend commuting service could be organized and run profitably from several suburban and downtown shopping mall locations. Ben has gathered the following investment information.

1.         Five used vans would cost a total of $90,000 to purchase and would have a 3-year useful life

    with negligible salvage value. Ben plans to use straight-line depreciation.

2.         Ten drivers would have to be employed at a total payroll expense of $43,000.

3.         Other annual out-of-pocket expenses associated with running the commuter service would  

    include Gasoline $26,000, Maintenance $4,000, Repairs $5,300, Insurance $4,500,

    Advertising $2,200.

4.         Ben desires to earn a return of 15% on his investment.

5.         Ben expects each van to make ten round trips weekly and carry an average of six students

    each trip. The service is expected to operate 32 weeks each year, and each student will be

    charged $15 for a round-trip ticket.

Instructions

(a)         Determine the annual:

                                                           (1) net income and

           (2) net annual cash flows for the commuter service.

(b)       Compute the:

           (1) cash payback period and

           (2) annual rate of return. (Round to two decimals.)

(c)         Compute the net present value of the commuter service. (Round to nearest dollar.)

(d)         What should Ben conclude from these computations?

Answer 1

Solution:-

(a)

(1):-

Net income:-

Particulars	Amount
Revenue (10 round trip * 6 students * 32 weeks * $15 * 5 van) (total a)	144,000
Less expenses:-
Depreciation (90,000 / 3)	30,000
Payroll expenses	43,000
Out of pocket expenses (26,000 + 4,000 + 5,300 + 4,500 + 2,200)	42,000
Total expenses (total b)	115,000
Net income (a - b)	26,000

(2) Net annual cash flows for the commuter service:-

Particulars	Amount
Net income	26,000
Add: Depreciation	30,000
Net cash flows	56,000

(b)

(1) Cash payback period:-

(2) Annual rate of return:-

= 28.89%

(c) Compute the net present value of the commuter service:-

Particulars	Amount
Net cash inflow 56,000 * PVIF (3 years,15%) = 56,000 * 2.2832)	127,860
Less Initial investment	(90,000)
Net present value	37,860

(d) What should Ben conclude from these computations:-

Ben should this accept option due to positive NPV of 37,860 and also his actual return i.e. 28.89% is greater than his required rate of return i.e. 15%)