Using the payback period and unadjusted rate of return to evaluate alternative investment opportunities
Louis Gallo owns a small retail ice cream parlor. He is considering expanding the business and has identified two attractive alternatives. One involves purchasing a machine that would enable Mr. Gallo to offer frozen yogurt to customers. The machine would cost $8,100 and has an expected useful life of three years with no salvage value. Additional annual cash revenues and cash operating expenses associated with selling yogurt are expected to be $5,940 and $900, respectively.
Alternatively, Mr. Gallo could purchase for $10,080 the equipment necessary to serve captional annual cash revenues and cash operating expenses associated with selling cappuccino are expected to be $8,280 and $2,430, respectively. Income before taxes earned by the ice cream parlor is taxed at an effective rate of 20 percent.
a. Determine the payback period and unadjusted rate or return (use average investment) for each alternative.
b. Indicate which investment alternative you would recommend. Explain your choice.