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 $5,000 per month. b. Remodeling and necessary equipment would cost $408,000. The equipment would have a 20-year life and a $20,400 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 $530,000 per year. Ingredients would cost 20% of sales. d. Operating costs would include $93,000 per year for salaries, $5,800 per year for insurance, and $50,000 per year for utilities. In addition, Mr. Swanson would have to pay a commission to The Yogurt Place, Inc., of 15.5% 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 18%, 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

1. Contribution Format Income Statement

Sales		$ 530000
Variable Expenses
Cost of ingredients(See Note 1)	$ 106000
Commission(See Note 1)	$ 82150	$ 188150
Contribution Margin		$ 341850
Selling and Administrative Expenses
Salaries	$ 93000
Rent(See Note 1)	$ 60000
Depreciation (See Note 1)	$ 19380
Insurance	$   5800
Utilities	$ 50000	$ 228180
Net Operating Income		$ 113670

2. a Simple Rate of Return=27.86%( See Note 2)

b. If Mr Swanson requires a simple rate of return of at least 18% should he acquire the franchise: YES since the simple rate of return is greater than 18% i.e 27.86%

3. a. Payback period for the outlet=3.1 years( See Note 3)

b. If Mr Swanson wants a payback of two years or less

NO: Since the payback period is greater than 2 years(i.e 3.1 years)

Note:

1. Variable expenses:

Cost of ingredients (20% × $530,000) = $ 106,000

Commissions (15.5 % × $530,000) = $ 82150

Selling and administrative expenses:

Rent ($5,000 × 12) = $ 60,000

Depreciation:

$408,000 – $20,400 = $387,600

$387,600 ÷ 20 years = $19380 per year

2. The formula for the simple rate of return is as follows:

Simple Rate of Return= Annual incremental net operating income/ Initial Investment =$113670/$408000=27.86%

3. Payback Period=Initial Investment/Annual Net Cash Inflow

Annual Net Cash Inflow=Net Operating Income+ Depreciation

=$ 113670+$ 19380=$ 133050

Therefore Payback Period=$ 408000/$ 133050=3.07 years i.e 3.1 years