Question

Yummy Brands is considering the purchase of a new machine that dispenses yogurt. The machine cost $300,000, useful life 5 years 0 salvage. Annual revenues and expenses associated with the new machine follow:Sales revenue$325,000Operating Expenses:Advertising$ 30,000Operator salaries 60,000 Ingredients cost 32,000 Maintenance contract 20,000Depreciation ? You have been hired as Yummy Brands chief financial officer and you need to advise the company CEO if the company should invest in this machine. Show your analysis/ calculations in good form for all your recommendations:A.In your meeting with the CEO you find out that the company usually does not like to invest unless if a project promises a payback period of 4 years or less. Should the company invest in this machine? Show your calculations in good form and explain the pros and cons of this method to make this decision.B.Another approach that the CEO encouraged you to explore is the simple rate or return. Assuming that Yummy Brands requires a 15 percent return on all equipment purchases, compute the simple rate of return promised by the new machine. Ignore income taxes. C.The CEO said he would be interested to find out about any other methods that should be used in this analysis. In the recent Yogurt Journal he had read something about using the internal rate of return of a particular investment in making an investment decision. As a recent graduate of managerial accounting you are expected to be familiar with this analysis and you should do the calculations and make a recommendation based on this method . D.This is your first assignment to make a recommendation about a significant financial investment and you want to be assured that you are making the correct recommendation. You are also trying to impress your boss (and your professor) with your knowledge of managerial accounting. Are there any other methods that you would consider using in this particular situation? Explain the method(s) and show your calculations/ analysis. Explain the pros and cons of all the methods that you have been asked to consider or that you recommend.

Answer 1

	Calculation of Annual Cashinflows
	Sales Revenue			325000
Less:	Advertisement			30000
	Operator Salaries			60000
	Ingredients Cost			32000
	Maintenance Contract			20000
	Net Annual Cashinflows			183000
	Payback Period		=	Intial Investment/Annual Cashinflow
			=	300000/183000
			=	1.639344	Years
	Since Payback period is Less than 4 Years Acceptable as Per Company Policy
	Pros:
1	This method is Simple to Understand and easy to operate
2	Surplus arises only after intial investment is recovered fully.Hence there is no payback period unless the payback period is Over
3	Promotes Liquidity by stressing on projects with earlier cash inflows
4	Payback period can be compared to a break-even point.
	Cons:
1	It Stresses on Capital Recovery rather than profitability
2	It Doesn’t Consider returns from the project after its payback period
3	Ignores Time value of Money
	Simple Rate of Return
		Net Profit		123000
	(Net Cashinflows-Depreciation)
		Capital Invested		300000
		Cost of Capital		15%
		Return		45000
		Residual Value		78000
	Since residual Value is Positive we can Accept the Proposal
	Internal Rate Of return
	At IRR Sum of the Discounted Cashinflows is Equal to Sum of Discounted Cashoutflows
		Sum of Discounted Cashinflows* Annuity Factor=Disounted Cashoutflows
			183000xAF	=	300000
			AF	=	1.639344
			The Discount Factor is 49%
			IRR for the project is 49%
		Since IRR IS More THAN REQUIRED RETURN THE PROJECT IS FEASIBLE
	Pros:
	1	All cashinflows of the project,arising at different points of time are considered
	2	Decisions are taken immediately by considering cost of capital
	3	It takes into Account time value of money
	Cons:
	1	It may conflict with NPV in case of inflow/outflow patterns are different in alternative proposals
	2	The presumption that all the future cash inflows of proposal are invested at a rate equal to the IRR may not be practically valid
	Calculation of Net Present Value
		Years	Cashflows	Pv factor@15%		DCF's
		0	-300000	1		-300000
		1	183000	0.87		159210
		2	183000	0.756		138348
		3	183000	0.658		120414
		4	183000	0.572		104676
		5	183000	0.497		90951
				NPV		313599
		Since NPV is Postive the Project is Feasible
		pros
		1	Consider time value of money
		2	All Cashflows are Considered
		3	It Provides for Comparision of Profits
		Cons
		1	It Involves Difficult Calculations
		2	It Ignores the difference in intial Outflows,Size of Different Proposals