Question

The Elberta Fruit Farm of Ontario always has hired transient workers to pick its annual cherry crop. Janessa Wright, the farm manager, just received information on a cherry picking machine that is being purchased by many fruit farms. The machine is a motorized device that shakes the cherry tree, causing the cherries to fall onto plastic tarps that funnel the cherries into bins. Ms. Wright has gathered the following information to decide whether a cherry picker would be a profitable investment for the Elberta Fruit Farm:

Currently, the farm is paying an average of $160,000 per year to transient workers to pick the cherries.

The cherry picker would cost $152,000. It would be depreciated using the straight-line method and it would have no salvage value at the end of its 10-year useful life.

Annual out-of-pocket costs associated with the cherry picker would be: cost of an operator and an assistant, $92,000; insurance, $4,000; fuel, $11,000; and a maintenance contract, $14,000.

Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor using tables.

Required:

1. Determine the annual savings in cash operating costs that would be realized if the cherry picker were purchased.

2a. Compute the simple rate of return expected from the cherry picker.

2b. Would the cherry picker be purchased if Elberta Fruit Farm’s required rate of return is 21%?

3a. Compute the payback period on the cherry picker.

3b. The Elberta Fruit Farm will not purchase equipment unless it has a payback period of four years or less. Would the cherry picker be purchased?

4a. Compute the internal rate of return promised by the cherry picker.

4b. Based on this computation, does it appear that the simple rate of return is an accurate guide in investment decisions?

Answer 1

Solution 1:

Computation of annual savings in cash operating cost - Elberta Fruit farm
Particulars	Amount
Cost saving of payment made to Transient workers	$160,000.00
Annual cost of cherry picker:
Cost of operator and assistant	$92,000.00
Insurance	$4,000.00
Fuel	$11,000.00
Maintenance cost	$14,000.00
Total annual saving cash operating cost if Cherry picker purchased	$39,000.00

Solution 2a:

Annual increase in income from cherry picker = Cash savings - Depreciation = $39,000 - $152,000*10%

= $23,800

Investment in cherry picker = $152,000

Simple rate of return = $23,800 / $152,000 = 15.66%

Solution 2b:

A simple rate of return from cherry picker is 15.66% which is lesser than required rate of return of 21%, therefore Cherry picker should not be purchased.

Solution 3a:

Payback period = Initial investment / Annual savings in cash operating cost = $152,000 / $39,000 = 3.90 years

Solution 3b:

As payback period is less than 4 years, therefore Elberta fruit farm should purchase the cherry picker.

Solution 4a:

Let internal rate of return is i.

Now

$39,000 * Cumulative PV Factor at i for 10 periods = $152,000

Cumulative PV Factor at i for 10 periods = 3.89743

This PV factors falls between i at 22% and 23%

Cumulative PV Factor at 22% = 3.923184

Cumulative PV Factor at 23% = 3.79927

IRR = 22% + (3.923184 - 3.89743) / (3.923184 - 3.79927)

= 22.20%

Solution 4b:

As internal rate of return in 22.20% and simple rate of return is 15.65%, It clearly states that simple rate of return is not an accurate guide in investment decision as internal return offered by investment is higher than 21% i.e. minimum required return.