Question

Problem 1

The Gabriel Co. is considering a 7-year project that would require a cash outlay of $140,000 for machinery and an additional $30,000 for working capital that would be released at the end of the project. The equipment would be depreciated evenly over the 7 years and have a salvage value of $ 7,000 at the end of 7 years. The project would generate before tax annual cash inflows of $41,500. The tax rate is 20% and the company's discount rate is 12%.

Homework Questions for Problem 1

1. What is the annual accounting income?
2. What is the annual after-tax cash flow?
3. What is the payback based upon the initial cash outflows?
4. What is the discounted payback based upon the initial cash outflows?
5. What is the simple rate of return based upon the initial cash outflows?
6. What is the net present value?
7. What is the internal rate of return?
8. Would you recommend this project or not? Why?

Problem 2

Joey's Pizza Parlor is considering the purchase of a large oven and related equipment for mixing and baking Joey's Favorite Bread. The oven and equipment would cost $150,000 delivered and installed. It would be usable for about 15 years, after which it would have a 10% scrap value.

The following additional information is available.

• Joey estimates that the purchase of the oven and equipment would allow the pizza parlor and restaurant to bake and sell 90,000 loaves of crazy bread each year. The sells for $1.85 per loaf.
• The cost of the ingredients in a loaf of bread is 45% of the selling price. Joey estimates that other costs each year associated with the bread would be as follows: salaries, $22,000; utilities, $10,000; and insurance, $4,000.
• The pizza parlor will use the straight-line depreciation on all assets, deducting salvage value from the original cost.

Homework Questions for Problem 2

1. Prepare a contribution format income statement showing the net operating income each year from the production and sale of Joey’s Favorite Bread.
2. Compute the simple rate of return for the new oven and equipment. If a simple rate of return above 12% is acceptable to Joey, will he purchase the oven and equipment?
3. Compute the payback period on the oven and equipment. If Joey purchases any equipment with less than a 6-year payback, will he purchase this equipment?

Answer 1

Problem 1.

Annual Accounting Income

Particular	Amount
Before tax annual cash inflows	$41,500
Less: Depreciation [(140,000-7,000)/7]	($19,000)
Earnings before tax	$22,500
Less: Tax expense (22,500 X 20%)	($4,500)
Earnings after tax / Accounting Income	$18,000

Annual after tax cash flow

Particular	Amount($)
Earnings after tax	18,000
Add: depreciation	19,000
After tax cash flow	37,000

Payback based on initial cash outflow

Initial Investment Payback Period = Annual Cash Inflows $140,000 $37,000 = 3.78 years

Discounted Payback based on initial cash outflow

Year	Annual after tax cash inflows	Discounted Cash flows	Commulative discounted cash flows
1	37,000	33,035.71 (37,000/1.12)	33,035.71
2.	37,000	29496.17 (37,000/1.12^2)	62,531.88
3.	37,000	26,335.87 (37,000/1.12^3)	88867.75
4.	37,000	23,514.17 (37,000/1.12^4)	112,381.92
5.	37,000	20,994.79 (37,000/1.12^5)	133,376.71
6.	37,000	18,745.35 (37,000/1.12^6)	152,122.06

Unrecovered Amount at start of period Discounted Payback Period = Years before Maturity + - Cash flows during the period $140,000 - $133, 376.71 $18, 745.35 = 5.35 years = 5+