Question

Simple Rate of Return/Payback Period

Lugano’s Pizza Parlor is considering the purchase of a large oven and related equipment for mixing and baking “crazy bread.” The oven and equipment would cost $289,000 delivered and installed. It would be usable for about 15 years, after which it would have a 10% scrap value. The pizza parlor uses straight-line depreciation on all assets.

Annual incremental revenue and cash inflows for the “crazy bread” would be $144,000 and annual incremental costs and cash outflows would be $86,200.

a) What is the simple rate of return on the new pizza oven and equipment?

b) If a simple rate of return above 12% is acceptable to Mr. Lugano, will he purchase the oven and equipment?

c) What is the payback period of the pizza oven and equipment?

d) If Mr. Lugano purchases any equipment with less than a 6-year payback, will he purchase this equipment?

Answer 1

a) Simple rate of return = annual net income / initial investment

Depreciation = (Cost - Salvage value) / Estimated useful life = ($289,000 - $28,900) / 15 = $17,340.

Annual net income
Incremental revenue and cash inflows	$144,000
- Incremental costs and cash outflows	$86,200
- Depreciation	$17,340
Net income	$40,460

Simple rate of return = Annual net income / initial investment = $40,460 / $289,000 = 14%

b) Simple rate of return is 14% i.e. more than the minimum required of 12%, Mr. Lugano will purchase the oven and equipment

c) Payback period = Initial investment / annual cashflows = $289,000 / ($144,000 - $86,200) = 5 years

d) Payback period of 5 years - less than requirement of 6 years, so Mr. Lugano will purchase the equipment