Question

Problem 7-19 (Algo) Simple Rate of Return; Payback Period (LO7-1, LO7-6] Paul Swanson has an opportunity to acquire a franchise from The Yogurt Place, Inc., to dispense frozen yogurt products under The Yogurt Place name. Mr. Swanson has assembled the following information relating to the franchise: a. A suitable location in a large shopping mall can be rented for $5,100 per month. b. Remodeling and necessary equipment would cost $414,000. The equipment would have a 15-year life and a $27,600 salvage value. Straight-line depreciation would be used, and the salvage value would be considered in computing depreciation. c. Based on similar outlets elsewhere, Mr. Swanson estimates that sales would total $540,000 per year. Ingredients would cost 20% of sales. d. Operating costs would include $94,000 per year for salaries, $5,900 per year for insurance, and $51,000 per year for utilities. In addition, Mr. Swanson would have to pay a commission to The Yogurt Place, Inc., of 16.0% of sales. Required: 1. Prepare a contribution format income statement that shows the expected net operating income each year from the franchise outlet. 2-a. Compute the simple rate of return promised by the outlet. 2-b. If Mr. Swanson requires a simple rate of return of at least 19%, should he acquire the franchise? 3-a. Compute the payback period on the outlet. 3-b. If Mr. Swanson wants a payback of two years or less, will he acquire the franchise?

Answer 1

SOLUTION

1. Contribution format income statement

Particulars	Amount ($)	Amount ($)
Sales		540,000
Variable expenses:
Cost of ingredients (20%*540,000)	108,000
Commissions (16%*540,000)	86,400	194,400
Contribution margin		345,600
Selling and administrative expenses:
Salaries	94,000
Rent (5,100*12)	61,200
Depreciation [(414,000-27,600)/15]	25,760
Insurance	5,900
Utilities	51,000	237,860
Net operating income		107,740

2A. Simple rate of return = Annual incremental net operating income / Initial investment

= 107,740 / 414,000 = 26.0%

2B. Yes, the franchise would be acquired because it promises a rate of return in excess of 19%.

3A. Payback period = Investment required / Annual net cash inflow

= 414,000 / 133,500 = 3.10 years

Annual net cash inflow = Net operating income + Depreciation

= 107,740+ 25,760 = 133,500

3B. The franchise should not be acquired as pay back period is more than 2.