Question

Seth Fitch owns a small retail ice cream parlor. He is considering expanding the business and has identified two attractive alternatives. One involves purchasing a machine that would enable Mr. Fitch to offer frozen yogurt to customers. The machine would cost $7,950 and has an expected useful life of three years with no salvage value. Additional annual cash revenues and cash operating expenses associated with selling yogurt are expected to be $6,020 and $830, respectively.

Alternatively, Mr. Fitch could purchase for $9,720 the equipment necessary to serve cappuccino. That equipment has an expected useful life of four years and no salvage value. Additional annual cash revenues and cash operating expenses associated with selling cappuccino are expected to be $8,320 and $2,300, respectively.

Income before taxes earned by the ice cream parlor is taxed at an effective rate of 20 percent.

Required

Determine the payback period and unadjusted rate of return (use average investment) for each alternative. (Round your answers to 2 decimal places.)

Answer 1

	Yogurt	Cappuccino
Value of Machine	$ 7,950.00	$ 9,720.00
Salvage Value	$0	$0
Years	3	4
Depriciation per year	$ 2,650.00 (7950/3)	$ 2,430.00 (9720/4)
Sales	$ 6,020.00	$8,320
less:Operating Expenses	$ 830	$2,300
Operating Income	$5,190	$6,020
Less:Depriciation	$2,650	$2,430
Earnings Before Tax	$2,540	$3,590
Tax @ 20%	$508	$718
Earnings After Tax	$2,032	$2,872
Add:Depriciation	$2,650	$2,430
Cash Flow Each Year	$4,682	$5,302
Payback Period (years)	1.70($7950/$4682)	1.83($9720/$5302)
Average Investment (opening investment+closing investment)/2	$3,975($7950/2)	$4,860($9720/2)
Unadjusted Rate Of return(Earning After Tax / Average Investment)	51.12%($2,032/$3,975)	59.09%($2,872/$4,860)