Quentin owns a small retail ice cream parlor. He is considering expanding the business and has two alternatives.
Question 1. Involves purchasing a machine that would enable him to offer frozen yogurt to customers. The machine would cost $4,050 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 $2,970 and $450, respectively.
Question 2. Alternatively, he could purchase for $5,040 the equipment necessary to serve cappuccino. That equipment has an expected useful life of four years and no salvage value. Additional annual cash revenues and cash operating expenses associated with selling cappuccino are expected to be $4,140 and $1,215, respectively. Income before taxes earned by the ice cream parlor is taxed at an effective rate of 20%.
a. Determine the payback period and unadjusted rate of return (use average investment) for each alternative.
b. Indicate which investment alternative you would recommend. Explain your choice.