Question

chapter 13 problem 2

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 $250,000 per year to transient workers to pick the cherries.

The cherry picker would cost $540,000, and it would have an estimated 5-year useful life. The farm uses straight-line depreciation on all assets and considers salvage value in computing depreciation expense. The estimated salvage value of the cherry picker is $50,000.

Annual out-of-pocket costs associated with the cherry picker would be: cost of an operator and an assistant, $80,000; insurance, $4,000; fuel, $12,000; and a maintenance contract, $15,000.

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 10%?

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

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1. the annual savings in cash operating costs
Cost to Transient Worker		250000
Less: Cost associated with Cherry Picker:
Operator		80000
Insurance		4000
Fuel		12000
Maintenance		15000
Net Cash Annual Saving in operating Cost		139000
2a. the simple rate of return
Net Cash Annual Saving in operating Cost		139000
Less: Annual Depreciation		98000
(540000-50000)/5
Net Incremental Income		41000
Investment		540000
Simple Rate of Return 41000/540000		7.59%
2b. No Since simplre rate of returns is less than required.
3a. Payback Period
Initial Investment/Annual Net Cash Flow (Saving)	540000/139000	3.88 Years
3b. No since PB is less than 4 Year
4. Internal Rate of Return
Factor for IRR=	Initial Investment/Annual Net Cash Flow (Saving)	540000/139000	3.88 Years
Looking in Exhibit 13B-2, factor of 3.88 represents an internal rate of return of approximately (Check Exhibit)
4b. No, the simple rate of return is not an accurate guide in investment decisions. It ignores the time value of money.