Question: Using the payback and accounting rate of return methods to make capital investment decisions

Consider how Hunter Valley Snow Park Lodge could use capital budgeting to decide whether the \(11,000,000 Snow Park Lodge expansion would be a good investment. Assume Hunter Valley’s managers developed the following estimates concerning the expansion:

Number of additional skiers per day 121 skiers Average number of days per year that weather conditions allow skiing at Hunter Valley 142 days Useful life of expansion (in years) 7 years Average cash spent by each skier per day \) 241 Average variable cost of serving each skier per day 83 Cost of expansion 11,000,000 Discount rate 10%

Assume that Hunter Valley uses the straight-line depreciation method and expects the lodge expansion to have a residual value of $600,000 at the end of its seven-year life.

Requirements

1. Compute the average annual net cash inflow from the expansion.
2. Compute the average annual operating income from the expansion.

Step by step solution

01

Meaning of Payback

A capital budgeting technique used by the business to calculate how much time it takes the business can recover the amount that is initially invested is known as the payback period.

02

(1) Computation of average annual cash inflows from the expansion

Particulars	Amount ($)
Average cash received from each skier per day	241
Less: Average variable cost of serving each skier per day	83
Average net cash inflow per skier per day	158
Multiply: Number of additional skiers per day	121
Average net cash inflow per day	19,118
Multiply: Number of ski days per year	142
Average annual net cash inflows per year	2,714,756

03

(2) Computation of the average annual operating income from the expansion

$$\begin{gathered} \text{Average}\text{annual}\text{operating} \text{income}=\text{Average}\text{annual}\text{net}\text{cash}\text{inflow}-\text{Depreciation} \\ =\$2,714,756-\$1,485,714 \\ =\$1,229,042 \end{gathered}$$

Working note:

Given,

Cost of Snow park lodge	$11,000,000
Residual value	$600,000
Year	7

Calculation of depreciation by straight-line method

$$\begin{gathered} \text{Depreciation}=\frac{\text{Cost}-\text{Rsidual}\text{value}}{\text{Year}} \\ =\frac{\$11,000,000-\$600,000}{7} \\ =\$1,485,714 \end{gathered}$$

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