Chapter 12, Problem 19P

Simple Rate of Return; Payback Period
Paul Swanson has an opportunity to acquire a franchise from The Yogurt Place, be, 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 $300 per month.
b. Remodeling and necessary equipment would cost $270,000. The equipment would have a 15-year life and an S 18,000 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 S300.000 per year. Ingredients would cost 20% of sales.
d. Operating costs would include $70,000 per year for salaries, $3,500 per year for insurance, and $27,000 per year for utilities. In addition, Mr. Swanson would have to pay a commission to The Yogurt Place, Inc., of 12.5% of sales.
Required:
1. Prepare a contribution format income statement that shows the expected net operating income each year from the franchise outlet.
2. Compute the simple rate of return promised by the outlet. If Mr. Swanson requires a simple rate of return of at least 12%, should be acquire the franchise?
3. Compute the payback period on the outlet If Mr. Swanson want payback of four wars or less, will be acquire the franchise?

To determine

To determine:-:

Here, in the given problem we have to determine whether the decision of Paul Swanson to acquire a franchise from The Yogurt Place inc. is beneficial for the organisation or not by two capital budgeting techniques namely Simple Rate of return and Payback period. Also there is a need to prepare a contribution format income statement showing net operating income each year from the franchise.

Given:-

$Rent of the location=\$3500 per month$

$Equipment cost=\$270000, Salvage Value=\$18000, Straight Line Depriciation to be used$

$Sales=\$300000, Ingredients cost=20\% of sales$

$Salaries=\$70000, Insurance=\$3500, Utilities=\$27000, Commission 12.5\% of sales$

Answer to Problem 19P

Solution:-

Payback period and simple rate of return are the two techniques of capital budgeting which helps an organisation in decision making process whether to enter a project or not. Firstly, we will determine the payback period of the equipment and then the simple rate of return. One major difference between the two methods is that where Payback period method uses net cash flows Simple rate of return uses annual operating income which includes non cash items also such as depreciation etc.

Therefore, the simple rate of return calculated below is 16%. The payback period shows recovery period of 4.5Years.

Explanation of Solution

Explanation:-

For Contribution Format income statement

Sales	300000
Less Salaries	70000
Less Insurance	3500
Less Utilities	27000
Less Ingredients cost (300000 x 20%)	60000
Less Rent of the Location (3500 x 12)	42000
Less Depreciation (270000-18000) / 15	16800
Net Operating income	$43, 200 Per year

For Simple Rate of return:-

$Simple rate of return=Annual net operating income÷Initial Investment$

$=43200÷270000$

$=16\%$

Now, here Swanson expected simple rate of return is 12% and what he would get is 16%. Therefore, Swanson should acquire the Franchise.

For Payback period:-

$Payback period=Initial Investment÷Net cash flows per year$

Here, net cash flows are operating income add depreciation amount i.e.

$=43200+16800$

$=\$60000$

Now, payback period is,

$=270000÷60000$

$=4.5 Years$

Now, here Swanson expected payback period is 4 years or less and the calculation shows payback period of 4.5 Years. Therefore, according to the payback period Swanson should not acquire the franchise.

Conclusion

Conclusion:-

Swanson can acquire the franchise as per Simple rate of return method. Swanson should not acquire the franchise as per Payback period.