Question

Seth Fitch owns a small retail ice cream parlor. He is considering expanding the business and has identified two attractive alternatives. One involves purchasing a machine that would enable Mr. Fitch to offer frozen yogurt to customers. The machine would cost $7,710 and has an expected useful life of three years with no salvage value. Additional annual cash revenues and cash operating expenses associated with selling yogurt are expected to be $6,030 and $890, respectively.

Alternatively, Mr. Fitch could purchase for $9,480 the equipment necessary to serve cappuccino. That equipment has an expected useful life of four years and no salvage value. Additional annual cash revenues and cash operating expenses associated with selling cappuccino are expected to be $8,390 and $2,310, respectively.

Income before taxes earned by the ice cream parlor is taxed at an effective rate of 20 percent.

   

Required

Determine the payback period and unadjusted rate of return (use average investment) for each alternative. (Round your answers to 2 decimal places.)

Answer 1

Ans- Calculation of payback period of Each Alternative:-

	Alternative 1	Alternative 2
Annual Cash Revenues	$6,030	$8,390
Cash Operating Expenses	890	2,310
Depreciation	2,570 ($7,710/3 years)	2,370 $9,480/ 4 years)
Income before tax	2,570	3,710
Income tax expenses (20%)	514	742
Annual Income	2,056	2,968
Add: Depreciation	2,570	2,370
Annual Cash Inflow	4,626	5,338
Initial Investment	$7,710	$9,480
Payback Period (Initial Investment / Annual Cash Inflow)	1.67 years ($7,710/$4,626)	1.78 years ($9,480/ $5,338)

Unadjusted Rate of Return

	Alternative 1	Alternative 2
Average Investment	3,885 ($7,710/2)	4,740 ($9,480/2)
Annual Income	2,056	2,968
Unadjusted Rate of Return (Annual Income / Average Investment)	53.33%	62.62%

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