Nick’s Novelties, Inc., is considering the purchase of new electronic games to place in its amusement houses.

Nick’s Novelties, Inc., is considering the purchase of new electronic games to place in its amusement houses. The games would cost a total of $425,000, have a fifteen-year useful life, and have a total salvage value of $42,500. The company estimates that annual revenues and expenses associated with the games would be as follows:

Revenues				$	220,000
Less operating expenses:
Commissions to amusement houses	$	70,000
Insurance		25,000
Depreciation		25,500
Maintenance		40,000			160,500
Net operating income				$	59,500

 Required:

1a. Compute the pay back period associated with the new electronic games.

1b. Assume that Nick’s Novelties, Inc., will not purchase new games unless they provide a payback period of five years or less. Would the company purchase the new games?

Explanation

1.

a.

Computation of the annual cash inflow associated with the new electronic games:

Net operating income	$	59,500
Add: Noncash deduction for depreciation		25,500
Annual net cash inflow	$	85,000

Payback period	=	Investment required
		Annual net cash inflow
	=	$425,000	= 5 years
		$85,000 per year

b.

Yes, the games would be purchased. The payback period is equal to the maximum 5 years required by the company.

2a. Compute the simple rate of return promised by the games.

2b. If the company requires a simple rate of return of at least 11%, will the games be purchased?

 

Explanation

2.

a.

The simple rate of return would be:

Simple rate of return	=	Annual incremental net operating income
		Initial investment

	=	$59,500	= 14.0%
		$425,000

b.

Yes, the games would be purchased. The 14.0% return exceeds 11%.

Thanks