Question

John Patrus is an accounting major at an eastern university located approximately 60 miles from a major city. Many of the students attending the university are from the metropolitan area and visit their homes regularly on the weekends. John, an entrepreneur at heart, realizes that few good commuting alternatives are available for students doing weekend travel. He believes that a weekend commuting service could be organized and run profitably from several suburban and downtown shopping mall locations.

John has gathered the following investment information.

1. Five used vans would cost a total of $90,000 to purchase and would have a 3-year useful life with negligible salvage value. John plans to use straight-line depreciation.

2. Ten drivers would have to be employed at a total payroll expense of $43,000.

3. Other annual out-of-pocket expenses associated with running the commuter service would include Gasoline $26,000, Maintenance $4,000, Repairs $5,300, Insurance $4,500, Advertising $2,200.

4. John desires to earn a return of 15% on his investment. 5. John expects each van to make ten round trips weekly and carry an average of six students each trip. The service is expected to operate 32 weeks each year, and each student will be charged $15 for a round-trip ticket.

Instructions

a) Determine the annual (1) net income and (2) net annual cash flows for the commuter service.

b) Compute (1) the cash payback period and (2) the annual rate of return. (Round to two decimals.)

c) Compute the net present value of the commuter service. (Round to the nearest dollar.)

d) What should John conclude from these computations?

Answer 1

a.
1.
Revenue = Price per student * No. of Students * Rounds per week * No. of Week * No. of Vans
= $15 * 6 Students * 10 rounds per week * 32 Weeks * 5 Vans
Revenue = $144000
Net Income
Revenue	$ 144,000.00
Costs:
Payroll Expense	$   43,000.00
Gasoline	$   26,000.00
Maintenance	$     4,000.00
Depreciation ($90,000 / 3 Years)	$   30,000.00
Repairs	$     5,300.00
Insurance	$     4,500.00
Advertising	$     2,200.00
Total Cost	$ 115,000.00
Net Income	$   29,000.00
2.
Net Annual Cash flow = Net Income + Non Cash Expenditure
=29000+30000
Net Annual Cash flow = $59000

b.

1.

Payback period = Initial Investment / Annual Cash Inflow per year

= Cost of Vans / Annual Cash Inflow per year

=90000/59000

Payback period = 1.53 Years

2.

Annual Return = (Net Income / Cost of Vans) * 100

= ($29,000 / 90,000) * 100

Annual Return = 32.22%

c.

Cost of Capital = 15%

PVAF @15% for 3 Years = 2.283

NPV = Present Value of Cash Inflows – Initial Investment (Cost of Vans)

= (Annual Cash Inflow * PVAF @15% for 3 Years) – Cost of Vans

= ($59000 * 2.283) – 90,000

NPV = $44697

d.

John concludes that investment option is profitable since it has positive net present value.

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