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 $7,980 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 $6,080 and $800, respectively. Alternatively, Mr. Fitch could purchase for $9,720 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 $8,300 and $2,260, 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.

* For the machine investment decision:

  + Payback period: 1.68 years

  + Unadjusted rate of return: 26.27%

* For the equipment investment decision:

  + Payback period: 1.83 years

  + Unadjusted rate of return: 29.71%

Explanation:

* For the machine investment decision:

Payback calculation:

+ Incremental  in yearly cashflow = ( Increase in revenue - Increase in operating expenses ) x ( 1 - tax rate) + Tax shield from increase in depreciation (which is Depreciation in one year x Tax rate) = (6080 - 800 ) * 0.8 + (7980/3)*0.2 = $4756

+ Payback period = Increase in yearly cashflow / Initial investment = 7980 /4756 = 1.68 years

Unadjusted rate of return:

+ Increamental profit in one-year= ( Increase in revenue - Increase in operating expenses - Increase in depreciation) x ( 1 - tax rate) = (6080 - 800 - 7980/3) * 0.8 = $2096

+ Unadjusted rate of return = Increamental profit in one-year / Initial investment = 2096 / 7980 = 26.27%

* For the equipment investment decision:

Payback calculation:

+ Incremental  in yearly cashflow = ( Increase in revenue - Increase in operating expenses ) x ( 1 - tax rate) + Tax shield from increase in depreciation (which is Depreciation in one year x Tax rate) = (8300 - 2260 ) * 0.8 + (9720/4)*0.2 = $5318

+ Payback period = Increase in yearly cashflow / Initial investment = 9720 /5318 = 1.83 years

Unadjusted rate of return:

+ Increamental profit in one-year= ( Increase in revenue - Increase in operating expenses - Increase in depreciation) x ( 1 - tax rate) = (8300 - 2260 - 9720/4) * 0.8 = $2888

+ Unadjusted rate of return = Increamental profit in one-year / Initial investment = 2888 / 9720 = 29.71%

Explanation:

                          Monthly Cash budget for January - March

Particulars                 January     February         March

Opening  balance     30,000       30,000         69,294

Cash received          525,000     400,000       450,000

Total                          555,000     430,000       519,294

Cash payment          (475,000)     (350,000)    (525,000)

Interest (60000*1%)   (600)    10600*1%(106)         0

                                  79,400        79,894            (5,706)

Loan repayment        (49,400)      (10,600)          35,706

Minimum cash balance of 30,000 required.

(79,400-30,000)  

(60,000-49,400)                    

Cash balance            30,000          69,294           30,000

Loan repayment.

January

Opening balance  60,000

Repayment            (49,400)

balance                   10,600

February

Opening balance     10,600

repayment(balance)  (10,600)

March

35,706