Question

Sharkey’s Fun Centre contains a number of electronic games, as well as a miniature golf course and various rides located outside the building. Paul Sharkey, the owner, would like to construct a water slide on one portion of his property. Paul has gathered the following information about the slide:

a.	Water slide equipment could be purchased and installed at a cost of $330,000. According to the manufacturer, the slide would be usable for 12 years, after which it would have no salvage value.
b.	Paul would use straight-line depreciation on the slide equipment.
c.	To make room for the water slide, several rides would be dismantled and sold. These rides are fully depreciated, but they could be sold for $60,000 to an amusement park in a nearby city.
d.	Paul has concluded that about 50,000 more people would use the water slide each year than have been using the rides. The admission price would be $3.60 per person (the same price that the Fun Centre has been charging for the rides).
e.	On the basis of experience at other water slides, Paul estimates that incremental operating expenses each year for the slide would be as follows: salaries, $85,000; insurance, $4,200; utilities, $13,000; maintenance, $9,800.

Required:

1.	Prepare an income statement showing the expected incremental net income each year from the water slide.

2-a.	Compute the SRR expected from the water slide.

          

2-b.	On the basis of this computation, would the water slide be constructed if Paul requires an SRR of at least 14% on all investments?
	Yes No

3-a.	Compute the payback period for the water slide. (Round your answer to 2 decimal places.)

         

3-b.	If Paul requires a payback period of five years or less, should the water slide be constructed?
	Yes No

Answer 1

incremental income statement will be constructed on the basis of incremental income and expenses.

we will have to calculate depreciation

= cost-salvage/useful life

=$330,000-0/12years

=$27,500

income statement showing expected incremental net income each year from the water slide.

Ticket revenue	[50000*$3.60]	$180,000
incremental expenses
depreciation	($27,500)
salaries	($85,000)
insurance	($4,200)
utilities	($13,000)
maintenance	($9,800)
Total expense		($139,500)
Net incremental operating income	[180000-139500]	$40,500

(2) simple rate of return is obtained by dividing total annual return on investment by initial investment

=$40,500/$330,000

=12.27%

(2b) if the simple rate of return required is 14%than water slide should not be accepted as it gives 12.27% simple rate of return which is lesser than required.

(3a) payback period

= initial investment / cash inflow per year

pay attention here simple rate of return uses incremental net income whereas payback period uses cash inflow here the cash inflow will be calculated by adding non cash expense(depreciation) to net income

=$40,500+$27,500

=$68,000

initial investment = cost of water slide-salvage of other assets sold

=$330,000-$60,000

=$270,000

payback period = $270,000/$68,000

=3.97years

(3b)

If Paul requires a payback period of five years or less, should the water slide be constructed?

Yes as the payback period 3.97 is lesser than 5years it would construct the waterslide.