The Elberta Fruit Farm of Ontario has always hired transient workers to pick its annual cherry crop. Francie Wright, the farm manager, has just received information on a cherry picking machine that is being purchased by many fruit farms. The machine is a motorized device that shakes the cherry tree, causing the cherries to fall onto plastic tarps that funnel the cherries into bins. Ms. Wright has gathered the following information to decide whether a cherry picker would be a profitable investment for the Elberta Fruit Farm:
(a) Currently, the farm is paying an average of $40,000 per year to transient workers to pick the cherries.
(b) The cherry picker would cost $94,500, and it would have an estimated 12-year useful life. The farm uses straight-line depreciation on all assets and considers salvage value in computing depreciation deductions. The estimated salvage value of the cherry picker is $4,500.
(c) Annual out-of-pocket costs associated with the cherry picker would be: cost of an operator and an assistant, $14,000; insurance, $200; fuel, $1,800; and a maintenance contract, $3,000.
Required:
(Ignore income taxes.)
1. Determine the annual savings in cash operating costs that would be realized if the cherry picker were purchased.
2. Compute the simple rate of return expected from the cherry picker. Would the cherry picker be purchased if Elberta Fruit Farm’s required rate of return is 16%?
3. Compute the payback period on the cherry picker. The Elberta Fruit Farm will not purchase equipment unless it has a payback period of five years or less. Would the cherry picker be purchased?
4. Compute (to the nearest whole percent) the internal rate of return promised by the cherry picker. Based on this computation, does it appear that the simple rate of return is an accurate guide in investment decisions?