Chapter 13, Problem 19P

Capital Budgeting is used by organisations to determine as to whether the project which they are undertaking is fruitful for the organisation or not. There are various techniques in capital budgeting which an organisation uses to decide on the investment proposal. Most popular ones are Net Present value, Internal Rate of return, Simple rate of return, Payback period etc.

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.