Problem 12-2A Lon Timur is an accounting major at a midwestern state university

Question

Problem 12-2A

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 $74,000 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 $15,990, Maintenance $3,290, Repairs $3,990, Insurance $4,190, and Advertising $2,490. 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

Answer a. Income Statement Revenue - 5 Vans X 10 Trips X 6 Students X 30 Weeks X $11.95    107,550 Less: Expenses Driver Salary        47,990 Gasoline Exp.        15,990 Maintenance           3,290 Repairs           3,990 Insurance           4,190 Advertising           2,490 Depreciation - $74,000 / 3 Years        24,667    102,607 Net Income         4,943 Net Income           4,943 Add: Non-Cash Expenses Depreciation        24,667 Net Annual Cash Inflow        29,610 Answer b. Cash Payback Period = $74,000 (Intial Investment) / $29,610 (Net Annual Cash inflow) Cash Payback Period = 2.499156 or say 2.50 Years (Approx.) Annual Rate of Return = Net Income / Average Intial Investment Average Intial Investments = $74,000 / 2 = $37,000 ARR = $4,943 / $37,000 ARR = 13.3595% or say 13.36% (Approx.) Answer c. Calculation of NPV Particulars Year 15% Factor Net Cash Flow Present value D C C X D Cash Inflow Annual Cash Inflow 1-3    2.28323            29,610       67,606 A. Total Cash Inflow - PV       67,606 Cash Outflow Cost of Vans 0    1.00000            74,000       74,000 B. Total Cash Outflow - PV       74,000 NPV (A - B)       (6,394)

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