Question

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Exercise 12-8 Payback Period and Simple Rate of Return [LO12-1, LO12-6]

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Nick’s Novelties, Inc., is considering the purchase of new electronic games to place in its amusement houses. The games would cost a total of $350,000, have a fifteen-year useful life, and have a total salvage value of $35,000. The company estimates that annual revenues and expenses associated with the games would be as follows:

Revenues				$	220,000
Less operating expenses:
Commissions to amusement houses	$	90,000
Insurance		20,000
Depreciation		21,000
Maintenance		40,000			171,000
Net operating income				$	49,000

Exercise 12-8 Part 2

2a. Compute the simple rate of return promised by the games.

2b. If the company requires a simple rate of return of at least 12%, will the games be purchased?

Answer 1

2a) Simple rate of return = Average net income / Average investment Initial investment Estimated salvage value Average investment Average net income Simple rate of return $350,000 $35,000 $192,500 [($350000 + $35000)/2] $49,000 25.45% ($490000 / $192500 = 0.2545 = 25.45%] 2b) If the company requires a simple rate of return of at least 12%, the games will be purchased because simple rate of return earned by this games investment is higher than company's required simple rate of return.