Lon Timur is an accounting major at a midwestern state university located approx

Question

Lon Timur is an accounting major at a midwestern state 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. Lon, 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. Lon has gathered the following investment information.

(a)

Determine the annual (1) net income and (2) net annual cash flows for the commuter service. (Round answers to 0 decimal places, e.g. 125.)

(b)

Compute (1) the cash payback period and (2) the annual rate of return. (Round answers to 2 decimal places, e.g. 10.50.)

(c)

Compute the net present value of the commuter service. (Round answer to 0 decimal places, e.g. 125. If the net present value is negative, use either a negative sign preceding the number eg -45 or parentheses eg (45). For calculation purposes, use 5 decimal places as displayed in the factor table provided.)

1. Five used vans would cost a total of $75,000 to purchase and would have a 3-year useful life with negligible salvage value. Lon plans to use straight-line depreciation. 2. Ten drivers would have to be employed at a total payroll expense of $48,000. 3. Other annual out-of-pocket expenses associated with running the commuter service would include Gasoline $16,000, Maintenance $3,300, Repairs $4,000, Insurance $4,200, and Advertising $2,500. 4. Lon has visited several financial institutions to discuss funding. The best interest rate he has been able to negotiate is 15%. Use this rate for cost of capital. 5. Lon expects each van to make ten round trips weekly and carry an average of six students each trip. The service is expected to operate 30 weeks each year, and each student will be charged $12.00 for a round-trip ticket.

Explanation / Answer

a) Total Service Revenue per year = 5 vans*10 round trips*30 weeks*6 students*$12 per student

= $108,000

Depreciation expense = (Cost - Salvage Value)/Useful Life

= ($75,000 - $0)/3 yrs = $25,000

Total Cost = Payroll exp+Gasoline+Maintenance+Repairs+Insurance+Advertising+Depreciation exp

= $48,000+$16,000+$3,300+$4,000+$4,200+$2,500+$25,000 = $103,000

Net Income = Total Service Revenue - Total Cost

= $108,000 - $103,000 = $5,000

Net Annual Cash Flows = Net Income+Depreciation exp

= $5,000+$25,000 = $30,000

b) Cash payback period = Initial cost of vans/Net Annual Cash Inflows

= $75,000/$30,000 = 2.5 years

Annual rate of return = Net Income/Initial cost of vans

= $5,000/$75,000 = 0.0667 or 6.67%

c) Present Value of annual cash inflows = Net Annual cash inflows*PVAF(15%, 3 yrs)

= $30,000*2.28323 = $68,497

Net Present Value = PV of Annual Cash Inflows - Initial Cost of Vans

= $68,497 - $75,000 = ($6,503)

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