Question

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:

1. Currently, the farm is paying an average of $190,000 per year to transient workers to pick the cherries.
2. The cherry picker would cost $490,000. It would be depreciated using the straight-line method and it would have no salvage value at the end of its 10-year useful life.
3. Annual out-of-pocket costs associated with the cherry picker would be: cost of an operator and an assistant, $86,000; insurance, $3,000; fuel, $11,000; and a maintenance contract, $17,000.

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 9%?

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 seven 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?

Req 1 Req 2A Reg 2B Req ЗА Req 3B Req 4A Req 4B Determine the annual savings in cash operating costs that would be realized if the cherry picker were purchased. Annual savings in cash operating costs

Answer 1

1)
Present cost of transient workers		$190,000
Less- Out of pocket expenses to operate the cherry picker
Cost of an operator and assistant	$86,000
Insurance	$3,000
Fuel	$11,000
Maintainence Contract	$17,000	$117,000
Annual savings in cash operating cost		$73,000
2)
The first step is to determine annual incremental net operating income
Annual savings in cash operating cost		$73,000
Less- Annual Depreciation (490,000/10)		-49000
Annual incremental net operating income		$24,000
Simple rate of return= Annual incremental net operating income/Initial investment
Simple rate of return= 24000/490000
Simple rate of return= 4.898%
No, Cherry picker should not be purchased as simple rate of return is leass than the expected rate that is 9%
3)
Calculation of payback period
Pay back period= Investment required/ Annual cash inflows
Pay back period= 4,90,000/73000
Pay back period = 6.7 years
Yes, the cheery picker would be purchased, as payback period is less than 7 years
4)
Factor of Internal rate of return= Investment required/ Annual cash inflow
Factor of Internal rate of return= 490,000/73,000
Factor of Internal rate of return= 6.7
A factor of 6.7 represents an internal rate of approx 15%
No, the simple rate of return is not an accurate guide in investment decisions. It ignores the time value of money