Question

Nick’s Novelties, Inc., is considering the purchase of new electronic games to place in its amusement houses. The games would cost a total of $592,000, have an fifteen-year useful life, and have a total salvage value of $59,200. The company estimates that annual revenues and expenses associated with the games would be as follows: Revenues $ 300,000 Less operating expenses: Commissions to amusement houses $ 70,000 Insurance 66,000 Depreciation 35,520 Maintenance 90,000 261,520 Net operating income $ 38,480
Required:
1a. Compute the pay back period associated with the new electronic games.
1b. Assume that Nick’s Novelties, Inc., will not purchase new games unless they provide a payback period of five years or less. Would the company purchase the new games?
No
Yes
2a. Compute the simple rate of return promised by the games. (Round your answer to 1 decimal place. i.e. 0.123 should be considered as 12.3%.)
2b. If the company requires a simple rate of return of at least 8%, will the games be purchased?
No
Yes

Answer 1

Answer and Explanation:

1a. The computation of the payback period is shown below:

Payback period = Initial investment ÷ Cash inflow

where,

Initial investment is $592,000

And, the cash flow is

= Depreciation expense + net operating income

= $35,520 + $38,480

= $74,000

So, the payback period is

= $592,000 ÷ $74,000

= 8 years

1b. As we can see that the payback period is of 8 years but the given payback period is 5 years so the company should not purchased the new games

2a. The computation of the simple rate of return is shown below:

Payback period =  Net operating income ÷ Initial investment

                           = $38,480 ÷  $592,000

                           = 6.5%

2b. As we can see that the simple rate of return is 6.5% but the given simple rate of return is minimum 8% so the company should not purchased the new games