John West’s Used Cars plc has always hired students from thelocal university to wash the cars on the lot. John West isconsidering the purchase of an automatic car wash that would beused in place of the students. The following information has beengathered by John West’s accountant to help him make a decision onthe purchase:
a) Payments to students for washing cars total R15 000 per year atpresent.
b) The car wash would cost R21 000 installed, and it would have a10-year useful life. John West uses straight-line depreciation onall assets. The car wash would have a negligible salvage value in10 years.
c) Annual out-of-pocket costs associated with the car wash wouldbe: wages of students to operate the wash, keep the soap bin fulland so forth, R6 300; utilities, R1 800; and insurance andmaintenance, R900.
d) John West now earns a return of 20% on the funds invested in hisinventory of used cars. He feels that he would have to earn anequivalent rate on the car wash for the purchase to beattractive.
Required
1 ) Determine the annual savings that would be realised in cashoperating costs if the car wash was purchased.
2) Calculate the simple rate of return promised by the car wash.(Hint: Note that this is a cost reduction project.) Will John Westaccept this project if he expects a 20% return?
3) Calculate the payback period on the car wash. John West (who hasa reputation for being something of a penny-pincher) will notpurchase any equipment unless it has a payback of four years orless. Will he purchase the car wash equipment?
4) Calculate (to the nearest whole per cent) the internal rate ofreturn promised by the car wash. Based on this calculation, does itappear that the simple rate of return would normally be an accurateguide in investment decisions?