Smile Photo, Inc., is a nationally franchised company with over DO outlets locke

Question

Smile Photo, Inc., is a nationally franchised company with over DO outlets locked in the southern states. Part of the franchise agreement promises n centralized photo developing process with overnight delivery to the outlets Because of the tremendous increase in demand for its photo processing, Emma DuBarry, the corporation's president, is considering the Purchas: of a new, deluxe photo processing machine by the end of this month. DuBarry wants you to formulate a memo showing your evaluation of this purchase. Your memo will be presented at the board of directors' meeting next week. According to your research, the new machine will cost $320,000. It will function for an estimated five years and should have a $32,000 residual value All capital investments are expected to produce a 20 percent minimum rate of return, and the investment should be recovered in three years or less. All fixed assets are depreciated using the straight-line method. The forecasted increases in operating results for the new machine arc as follows. I In preparation for writing your memo, answer the following questions What kinds of information do you need to prepare this memo? Why is the information relevant? Where would you find the information? When would you want to obtain the information? Analyze the purchase of the machine and decide if the company should purchase it. Use (a) the net present value method, (b) the accounting rate- of-rectum method, and (c) the payback period method. What is the profitability index of the project? What lid the IRR of the project?

Explanation / Answer

Soln :

1)

a) To prepare this memo , it is required to have information of the yearly revenues and the yearly expenses .

b) This information is relevant because by knowing the cash cash inflows and cash outflows , it is possible to know the viability of the project .

c) The information about the cash flows can be found in the income statement of the firm .

d) The information can be obtained when the firm prepares the estimated cash flows for the duration of the project .

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2)

To calculate the Net present value the firm  

NPV = -$320,000 + $ 100,000/(1+0.20)1 + 105,000/(1.20)2 + $110,000/1.203 + $90,000/1.204 + 80,000/1.205 + $ 32,000/1.205

NPV = - $11,679.53

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To find accounting rate of return

Accounting rate of return = Average income / Average investment

Accounting rate of return = 1/5 X $308,320.47 / 1/5 X 320,000

Accounting rate of return = 61,664.09 / 64,000

Accounting rate of return = 96.33 %

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To find payback period

Payback period = 3 + 5000 / 90,000

Payback period   = 3.05 years .

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Profitability Index

Profitability Index = $929,951.13 - $ 320,000 / $ 320,000

Profitability Index = 0.8935

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Internal rate of return

The payback period is 3.05

From the present value of annuity table , for n = 5 years the value closest to 3.05 years = 19%

We start with a discount rate of 19%

At 19% , the NPV = -$4729.62

At 18% , the NPV = $ 2481.75

IRR = 18 % + $322,481.75 - $ 320,000 / $322,481.75 - $ 315,270.38

IRR = 18 % + $ 2481.75 / 7211.37

IRR = 18.34 %

Year Cash Inflows Cash outflows Depreciation per year Net cash flows = ( Revenue - expenses - depreciation ) + depreciation 0 ($320,000) 1 $310,000 $210,000 $64,000 $100,000 2 $325,000 $220,000 $64,000 $105,000 3 $340,000 $230,000 $64,000 $110,000 4 $300,000 $210,000 $64,000 $90,000 5 $260,000 $180,000 $64,000 $80,000

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