Problem 24-2A Lon Timur is an accounting major at a midwestern state university

Question

Problem 24-2A

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.

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(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 $75,200 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 $47,990. 3. Other annual out-of-pocket expenses associated with running the commuter service would include Gasoline $16,000, Maintenance $3,300, Repairs $4,010, Insurance $4,210, and Advertising $2,510. 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 $11.95 for a round-trip ticket.

Explanation / Answer

a) 1) Annual Revenue from Service = (6 students*10 trips*$11.95 per trip)*30 weeks*5 vans

= $107,550

Depreciation = Purchase cost/Useful life = $75,200/3 = $25,067

Total Expenses including dep. = Payroll Exp.+Gasoline+Maintenance+Repairs+Insurance+Advertising+Depreciation

= $47,990+$16,000+$3,300+$4,010+$4,210+$2,510+$25,067 = $103,087

Net Income = Annual revenue - Total Expenses

= $107,550 - $103,087 = $4,463

2) Net Annual Cash Flows = Net Income+Depreciation

= $4,463+$25,067 = $29,530

b) 1) Cash payback period = Total Investment/Annual Cash Inflows

= $75,200/$29,530 = 2.55 years

2) Annual rate of return = Net Income/Average Investment

Average Investment = ($0+$75,200)/2 = $37,600

Annual rate of return = $4,463/$37,600 = 11.87%

c) Calculation of Net Present Value

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

= $29,530*2.28323 = $67,424

Net Present Value = PV of Cash inflows - Investment

= $67,424 - $75,200 = ($7,776)

Thus there will be a negative net present value of $7,776.

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