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Seth Fitch owns a small retail ice cream parlor
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 $7,920 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 $6,120 and $850, respectively.
Alternatively, Mr. Fitch could purchase for $9,400 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 $8,470 and $2,270, 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.)
Expert Solution
| Calculation of payback period of Each Alternative:- | ||
| Alternative 1 | Alternative 2 | |
| Annual Cash Revenues | $6,120 | $8,470 |
| Cash Operating Expenses | 850 | 2,270 |
| Depreciation | 2640 | 2,350 |
| ($7,920/3 years) | $9,400/ 4 years) | |
| Income before tax | 2,630 | 3,850 |
| Income tax expenses (20%) | 526 | 770 |
| Annual Income | 2,104 | 3,080 |
| Add: Depreciation | 2640 | 2,350 |
| Annual Cash Inflow | 4,744 | 5,430 |
| Initial Investment | $7,920 | $9,400 |
| Payback Period (Initial Investment / Annual Cash Inflow) | 1.67 | 1.73 |
| ($7,920/$4744) | ($9,400/ $5,430) | |
| Calculation of Unadjusted Rate of Return: | ||
| Alternative 1 | Alternative 2 | |
| Average Investment | 3,960 | 4,700 |
| ($7,920/2) | ($9,400/2) | |
| Annual Income | 2104 | 3,080 |
| Unadjusted Rate of Return (Annual Income / Average Investment) | 53.13% | 65.53% |
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