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 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 $160,000 per year to transient workers to pick the cherries.
2. The cherry picker would cost $152,000. 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, $92,000; insurance, $4,000; fuel, $11,000; and a maintenance contract, $14,000.

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 21%?

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 four 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?

Explanation

1.

Present cost of transient workers			$	160,000
Less out-of-pocket costs to operate the cherry picker:
Cost of an operator and assistant	$	92,000
Insurance		4,000
Fuel		11,000
Maintenance contract		14,000		121,000
Annual savings in cash operating costs			$	39,000

2.

a.

The first step is to determine the annual incremental net operating income:

  

Annual savings in cash operating costs	$	39,000
Less annual depreciation [$152,000 ÷ 10 years]		15,200
Annual incremental net operating income	$	23,800

Simple rate of return	=	Annual incremental net operating income
		Initial investment
	=	$23,800	= 15.66% (rounded)
		$152,000

b.

No, the cherry picker would not be purchased. The expected return is less than the 21% return required by the farm.

3

a.

The formula for the payback period is:

Payback period	=	Investment required
		Annual net cash inflow
	=	$152,000	= 3.90 years
		$39,000*

*In this case, the cash inflow is measured by the annual savings in cash operating costs.

b.

Yes, the cherry picker would be purchased. The payback period is less than 4 years. Note that this answer conflicts with the answer in Part 2a.

4.

a.

The formula for the internal rate of return is:

Factor of the internal rate of return	=	Investment required
		Annual net cash inflow
	=	$152,000	= 3.897
		$39,000

Looking in Exhibit 13B-2 and scanning along the 10-period line, we can see that the factor computed above, 3.897, is closest to 3.923, the factor for the 22% rate of return. Therefore, to the nearest whole percent, the internal rate of return is 22%.

b.

No, the simple rate of return is not an accurate guide in investment decisions. It ignores the time value of money.

Thanks