Accounting 225 Quiz Section #17

Chapter 13-2 Class Exercises Solution

1. Fremont CPA Tax Services is considering investing in two different types of tax
software that will result in cost savings for their business. The investment outflows
associated with their investment options are:
Software Option 1:
Year
Investment Cash Inflow
1
40000
2000
2
5000
4000
3
6000
4
8000
5
10000
6
10000
7
8000
8
8000
9
6000
10
6000

Software Option 2:
Year
Investment Cash Inflow
1
25000
2000
2
2000
3
4000
4
5000
5
6000
6
6000
7
5000
8
3000
9
3000
10
3000

a) Calculate the payback period for each of these options. Based on payback period,
which tax software should Fremont select?
Software Option 1:
Year
Investment Cash Inflow Unrecovered
1
40000
2000
38000
2
5000
4000
39000
3
6000
33000
4
8000
25000
5
10000
15000
6
10000
5000
7
8000
0
8
8000
0
9
6000
0
10
6000
0

Software Option 2:
Year
Investment Cash Inflow Unrecovered
1
25000
2000
23000
2
2000
21000
3
4000
17000
4
5000
12000
5
6000
6000
6
6000
0
7
5000
0
8
3000
0
9
3000
0
10
3000
0

Payback Period:
6.625 years
(6 years + 5000/8000 in Y7)

Payback Period:

6 years

Based on payback period they would select software option 2.

b) What other considerations should Fremont make and which option would you
recommend?
Option 1:
Total Cash Inflow
Investment
Net Cash Inflow

68000
45000
23000

Option 2:
Total Cash Inflow
Investment
Net Cash Inflow

39000
25000
14000

Accounting 225 Quiz Section #17

Chapter 13-2 Class Exercises Solution
1. Wallingford MicroBrew is considering the purchase of an automated bottling machine for
$80,000.
The machine would
replace an
piece of equipment
that costs
per yearbottling
to
2. Wallingford
MicroBrew
is old
considering
the purchase
of $33,000
an automated
machine
operate. The new machine would cost $10,000 per year to operate. The old machine could be
for $80,000. The machine would replace an old piece of equipment that costs $33,000
sold for a scrap value of $5,000. The new machine would have a useful life of 10 years (straight
per year to operate. The new machine would cost $10,000 per year to operate. The old
line depreciation) and has no salvage value.
machine could be sold for a scrap value of $5,000. The new machine would have a
a. Compute the simple (accounting) rate of return on the new bottling machine
useful life of 10 years (straight line depreciation) and has no salvage value. Compute the
The annual incremental net operating income is determined by comparing the operating
simple (accounting) rate of return on the new bottling machine
cost of the old machine to the operating cost of the new machine and the depreciation that
would be taken on the new machine:
Operating cost of old machine
$33,000
Less operating cost of new machine
($10,000)
Less annual depreciation on the new machine ($80,000 10 years) ($8,000)
Annual incremental net operating income
$15,000
Cost of the new machine
Less scrap value of old machine
Initial investment

$80,000
($5,000)
$75,000

Simple rate = Annual incremental net operating income

of return
Initial investment
=

$15,000
= 20%
$75,000

3. Blue Ridge Furniture is considering the purchase of two different items of equipment:
Machine A: New machine on the market that compresses sawdust into various shelving
products. Currently sawdust is disposed of as a waste product. Information on this
machine is as follows:
a. The machine costs $780,000 and would have a 25% salvage value at the end of its 10year useful life (straight line depreciation).
b. The shelving products produced by the machine would generate revenues of $350,000
per year. Variable manufacturing costs would be 20% of sales revenue.
c. Fixed annual expenses with the new shelving products would be: advertising $42,000;
salaries $86,000; utilities $9,000; insurance $13,000.
Machine B: This is a new machine that would automate a sanding process that is
primarily done by hand. The following information is available about this machine is:
a. The machine costs $220,000 and would have no salvage value at the end of its 10year useful life (straight line depreciation).
b. Several old pieces of sanding equipment that are fully depreciated would be disposed
of at a scrap value of $7,200.
c. The new machine would provide substantial annual savings in cash operating costs.
It would require an operator at an annual salary of $26,000 and $3,000 of annual

Accounting 225 Quiz Section #17

Chapter 13-2 Class Exercises Solution
maintenance expense. The current, hand operated sanding procedure costs the
company $85,000 per year.
Blue Ridge Furniture requires a simple rate of return of 16% on all equipment purchases.
Also, the company will not purchase equipment unless the equipment has a payback
period of four years or less.
For machine A:
a) Prepare and income statement showing the expected Net Operating Income each year
for the new shelving products (use contribution margin format).
1.

1.

1.

a. Sales revenue .............................................................................

$350,000

Variable production expenses (@ 20%)..................................

70,000

Contribution margin ................................................................

280,000

Fixed revenue
expenses:
a. Sales
.............................................................................
Advertising
............................................................................
Variable production
expenses (@ 20%)..................................
Salaries...................................................................................
Contribution
margin ................................................................
Utilities
...................................................................................
Fixed
expenses:
a. Sales revenue .............................................................................
Insurance ...............................................................................
Advertising
............................................................................
Variable
production
expenses (@ 20%)..................................
Depreciation* ........................................................................
Salaries...................................................................................
Contribution margin ................................................................
Total
fixed...................................................................................
expenses ..................................................................
Utilities
Fixed
expenses:
Net
operating
income ...............................................................
Insurance
...............................................................................
Advertising
............................................................................

Depreciation*
........................................................................
Salaries...................................................................................
*
[$780,000

(25%
$780,000)] 10 years = $58,500 per year
Total
fixed...................................................................................
expenses ..................................................................
Utilities
b. TheNet
formula
for the
simple
rate of return is:
operating
income
...............................................................
Insurance
...............................................................................

$350,000

$42,000

70,000

86,000

280,000

9,000
13,000
$42,000
58,500
86,000
9,000
13,000
$42,000
58,500
86,000

$350,000
70,000
280,000
208,500

$ 71,500

9,000

208,500

13,000

$ 71,500

b) Compute
simple
of return.
Annual
incremental net operating income
Depreciation*
........................................................................
58,500
Simple
rate rate
=
* of
[$780,000
(25%
$780,000)] 10 years = $58,500 per year
return
Initial investment
Total
fixed expenses ..................................................................
b. TheNet
formula
for
the
simple
rate
of
return
is:
operating income ...............................................................

$71,500
= Annual incremental
= 9.2% net operating income
Simple rate = $780,000
* of
[$780,000
10 years
= $58,500 per year
return (25% $780,000)]Initial
investment

208,500
$ 71,500

c. The formula for the payback period is:

b. The formula for the simple rate of return is:

$71,500
=
= 9.2%required
Investment
Annual
incremental
net operating income
Simple rate
Payback
period
=
= $780,000
Net annual
cash
inflow
of return
Initial investment
c. The formula for the payback period is:
$780,000
$71,500
= Investment
c) Compute payback=period.
= 9.2%required= 6.0 years
Payback period$780,000
= $130,000 per year*
Net annual cash inflow
*Net annual
inflowperiod
= Net is:
operating income + Depreciation
c. The formula
for thecash
payback
$780,000
=
$71,500
+
$58,500 = $130,000
=
= 6.0 years

Investment required
Payback period = $130,000 per year*
Net annual cash inflow

*Net annual cash inflow = Net operating income + Depreciation

$780,000
= $71,500
+ $58,500 = $130,000

$130,000 per year*

= 6.0 years

*Net annual cash inflow = Net operating income + Depreciation

= $71,500 + $58,500 = $130,000

Accounting 225 Quiz Section #17

Chapter 13-2 Class Exercises Solution
For machine B:
a) Compute simple rate of return.
2. a. A cost reduction project is involved here, so the formula for the simple rate of return would
be:

Cost savings - Depreciation

Simple
rate
of return
= so the formula for the simple rate of return would
2. a. A cost reduction
project
is involved
here,
Initial
- Salvage from
be:
investment old equipment
savings
- Depreciation
The Simple
reductionrate
in costs
with the=newCost
equipment
would
be:
of return
Initial

Salvage from

Annual costs, old equipment ..........................................

investment old equipment

Annual costs, new equipment:

The reduction
with the
new equipment would be:
Salaryinofcosts
operator
.......................................................
................................................................
AnnualMaintenance
costs, old equipment
..........................................
Annual
savings
in costs ..................................................
Annual
costs,
new equipment:
Salary of operator .......................................................
Thus,
the simple
rate of return would be:
Maintenance
................................................................
Annual savings
in costs
..................................................
$56,000
- $22,000*
$34,000

$220,000 - $7,200

$212,800

$85,000

$26,000
3,000 $85,000
29,000
$56,000
$26,000
3,000

29,000

= 16.0%

$56,000

Thus, the simple rate of return would be:

*$220,000 10 years = $22,000 per year
$56,000 - $22,000*
$34,000
b. The formula for the payback period
as in Part (1), except we must reduce
= remains the same
= 16.0%
$220,000
- $7,200
$212,800
the investment
required
by the salvage
from sale of the old equipment:

b) Compute payback period.

*$220,000 10 years = $22,000 per year

Investment
from
b. The formula for the payback
period remains
the same
as in Part (1), except we must reduce
- Salvage
required
old
equipment
the investment
by the salvage from sale of the old equipment:
Payback
periodrequired
=

Net annual cash inflow

Investment
Salvage from
$220,000 - $7,200
=required
= 3.8 years
old equipment
Payback period =
$56,000 per year*
Net annual cash inflow
=

$220,000 - $7,200
= 3.8 years
$56,000 per year*

According to the companys criteria, which machine should they purchase?

Simple Rate of Return
Payback Period

Machine A
9.2%
6 years

Machine B
16%
3.8 years

According to the companys criteria, machine A should not be purchased and machine B
should be purchased.