Question

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Nick’s Novelties, Inc., is considering the purchase of new electronic games to place in its amusement houses. The games would cost a total of $175,000, have a fifteen-year useful life, and have a total salvage value of $17,500. The company estimates that annual revenues and expenses associated with the games would be as follows:

Revenues				$	200,000
Less operating expenses:
Commissions to amusement houses	$	80,000
Insurance		25,000
Depreciation		10,500
Maintenance		60,000			175,500
Net operating income				$	24,500

2a. Compute the simple rate of return promised by the games.

2b. If the company requires a simple rate of return of at least 11%, will the games be purchased?

Answer 1

Answer-

2a. Simple rate of return =

(Incremental net operating income/Initial investment)*100

Incremental net operating income=incremental revenues less incremental expenses including depreciation.

So according to formula

=(24500/175000)*100

= 14%

2b.If company requires simple rate of return at least 11% then games should be purchased if it covers at least fixed costs that are depreciation and insurance of operating expenses that will remain same in each year amounts to $35500 and 11% means $19250(175000*11%) that is not covering even fixed cost so games should not be purchased.

Assuming insurance expense to be same in each year as generally it's a fixed cost.