Question

John West’s Used Cars plc has always hired students from the local university to wash the cars on the lot. John West is considering the purchase of an automatic car wash that would be used in place of the students. The following information has been gathered by John West’s accountant to help him make a decision on the purchase:
a) Payments to students for washing cars total R15 000 per year at present.
b) The car wash would cost R21 000 installed, and it would have a 10-year useful life. John West uses straight-line depreciation on all assets. The car wash would have a negligible salvage value in 10 years.
c) Annual out-of-pocket costs associated with the car wash would be: wages of students to operate the wash, keep the soap bin full and so forth, R6 300; utilities, R1 800; and insurance and maintenance, R900.
d) John West now earns a return of 20% on the funds invested in his inventory of used cars. He feels that he would have to earn an equivalent rate on the car wash for the purchase to be attractive.
Required
1 ) Determine the annual savings that would be realised in cash operating costs if the car wash was purchased.
2) Calculate the simple rate of return promised by the car wash. (Hint: Note that this is a cost reduction project.) Will John West accept this project if he expects a 20% return?
3) Calculate the payback period on the car wash. John West (who has a reputation for being something of a penny-pincher) will not purchase any equipment unless it has a payback of four years or less. Will he purchase the car wash equipment?
4) Calculate (to the nearest whole per cent) the internal rate of return promised by the car wash. Based on this calculation, does it appear that the simple rate of return would normally be an accurate guide in investment decisions?

Answer 1

1)

Annual Savings

Cost at present

15,000

After installation of Car Wash

Wages to students

6300

Utilities

1,800

Insurance & maintenance

900

Total annual cost

9,000

Savings in cash operating cost

6,000

2)

Simple rate of return:

A

Investment

21,000

B

Depreciation Cost per year

2,100

(21000/10)

C

Annual Savings in costs

3,900

(6000-2100)

D=C/A

Simple rate of return:

19%

Return is less than 20%

Hence it will NOT be accepted

3)

Payback Period

A

Investment

21,000

B

Annual Cash Savings

6,000

C=A/B

Payback Period in years

3.50

Payback is Less than 4 years

He will purchase the car wash equipment

4)

Internal Rate Of Return

Pv

Initial Investment

21,000

Pmt

Annual Cash Savings

6,000

(NOTE:Depreciation is not a cash expense)

Nper

Number of years of savings

10

RATE

Internal Rate of Return

26%

(Using RATE function of excel with Nper=10, Pmt=6000, Pv=-21000)

Excel Command: RATE(10,6000,-21000)

IRR should be accurate guide

Simple return does not consider cash flow.It also does not consider time value of money