Question

The Elberta Fruit Farm of Ontario has always hired transient workers to pick its annual cherry crop. Francie Wright, the farm manager, has 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: a. Currently, the farm is paying an average of $230,000 per year to transient workers to pick the cherries. b. The cherry picker would cost $520,000, and it would have an estimated 5-year useful life. The farm uses straight-line depreciation on all assets and considers salvage value in computing depreciation deductions. The estimated salvage value of the cherry picker is $90,000. c. Annual out-of-pocket costs associated with the cherry picker would be: cost of an operator and an assistant, $78,000; insurance, $2,000; fuel, $10,000; and a maintenance contract, $13,000. Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor using tables. 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 12%? Yes No 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 five years or less. Would the cherry picker be purchased? No Yes 4a. Compute the internal rate of return promised by the cherry picker. (Round you answer to nearest whole percentage place. i.e. 0.1234 should be considered as 12%.) 4b. Based on this computation, does it appear that the simple rate of return is an accurate guide in investment decisions? No Yes

Answer 1

For detailed understanding of calculation please refer the excel screenshots attached at the end with and without formula. Please check them while going through the answers for quick understanding. We would refer transient workers as Man Method and Cherry picker as Machine Method.

1. Total Cost for Man would be $230,000 and total cost for Machine would be $103,000. The depreciation is considered as non cash cost so will not be considered over here. Hence total saving in cash operating cost saved would be $127,000 (230k-103k)

2a. The SIMPLE rate of return is 39.42%. Please note at the end of 5th year, we would receive the salvage value of $90,000 which is added in the excel.

2b. Yes. since the rate of return is 39.42% more than the expected rate of return of 12%

3a. At 5th year we need $12000, the per month saving would be $10583 (127000/12) so the payback period would be 4years and 1.5 months approx.

3b. Yes, since the payback period is less than 5 years i.e. 4 years and 1.5 months

4a. Internal rate of return is 11.20%

4b. No, simple rate of return is not appropriate since the inflows are evenly distributed over the life of asset. Internal rate of returns should be the appropriate method to make the investment decision.

.