Yummy Brands is considering the purchase of a new machine that dispenses yogurt.

Question

Yummy Brands is considering the purchase of a new machine that dispenses yogurt. The machine cost $500,000. Annual revenues and expenses associated with the new machine follow: You have been hired as Yummy Brands chief financial officer and you need to advise the company CEO if the company should invest in this machine. Show your analysis/calculations in good form for all your recommendations: In your meeting with the CEO you find out that the company usually does not like to invest unless if a project promises a payback period of 4 years or less. Should the company invest in this machine? Show your calculations in good form and explain the pros and cons of this method to make this decision. Another approach that the CEO encouraged you to explore is the simple rate or return. Assuming that Yummy Brands requires a 15 percent on all equipment purchases, compute the simple rate of return promised by the new machine. Ignore income taxes. The CEO said he would be interested to find out about any other methods that should be used in this analysis. In the recent Yogurt Journal he had read something about using the internal rate of return of a particular investment in making an investment decision. As a recent graduate of managerial accounting you are expected to be familiar with this analysis and you should do the calculations and make a recommendation based on this method. This is your first assignment to make a recommendation about a significant financial investment and you want to be assured that you are making the correct recommendation. You are also trying to impress your boss with your knowledge of managerial accounting. 1. Are there any other methods that you would consider using in this particular situation? Explain the method(s) and show your calculations/analysis. Explain the pros and cons of all the methods that you have been asked to consider or that you recommend.

Explanation / Answer

Yummy Brands All Amounts in $ A. The Net Income associated with the new machine per year will be as under : Sales 325000 Less : Operating Expenses Advertising 30000 Operator Salaries 60000 Ingredients Cost 32000 Maintenance Contract 20000 Depreciation 40000 182000 Net Income per year 143000 The machine cost is $ 500,000 The recovery period (payback period) is supposed to be 4 years or less Recovery per year will be Year Recovery 1 143000 2 143000 3 143000 3 years 4 71000 5.958042 months Thus, the total recovery period will bre 3 years 5.96 months. Hence, the Company can invest in this machine, with the recovery period falling within the stipulated time limit. However, the payback period does not consider the discounted present values of the inflows, and hence cannot be considered as a full proof method of investment decision making. B. The simple rate of return on the investment made is equal to the Net Income divided by Investment made = $ 143,000 / $ 500,000 = 28.6% C. Since the rate of return on all equipment purchases is 15%, and the inflows and outflow are as given in Part A above, the Internal Rate of Return or IRR is considered to be a method where the Net Present Value of Cash Inflows less Outflows is equal to zero. It is a trial-and-error based method to be applied. Using the information given above, the IRR of the project works out to 5.61% (Period of usage is assumed as 4 years) D. We can consider the Net Present Value method for evaluating the project Based on a rate of return of 15%, the Net Present Value works out to - 79,772.26 The Net Present Value and Internal Rate of Return are considered to be more practical methods of project evaluation, since they consider the discounted present values of both cash inflows and outflows. In fact, the IRR considers the least possible point of return where the inflows and outflows match, or the difference therein is close to zero. The only problem with these two methods is that for any change in the interest rate, the factorial cannot be changed. The more detailed working for a change in the interest factor is the Modified Internal Rate method or MIRR. The simple rate of return is a basic accounting rate of return on the investment made, and like the payback period, does not consider the discounted value of cash inflows and outflows. Hence, it cannot be used in the long run, for projects having multiple cash inflow periods, and several cash outflows.

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