P10–14 Simple rate of return; payback; internal rate of return Time allowed: 30 minutes Honest John’s Used Cars plc has always hired students from the local university to wash the cars on the lot. Honest John is considering the purchase of an automatic car wash that would be used in place of the students. The following information has been gathered by Honest John’s accountant to help Honest John make a decision on the purchase:

1 Payments to students for washing cars total £15,000 per year at present.

2 The car wash would cost £21,000 installed, and it would have a 10-year useful life. Honest John uses straight-line depreciation on all assets. The car wash would have a negligible salvage value in 10 years.

3 Annual out-of-pocket costs associated with the car wash would be: wages of students to operate the wash, keep the soap bin full and so forth, £6,300;

utilities, £1,800; and insurance and maintenance, £900.

4 Honest John now earns a return of 20% on the funds invested in his stock of used cars. He feels that he would have to earn an equivalent rate on the Required (ignore taxes)
1 Determine the annual savings that would be realized in cash operating costs if the car wash were purchased.
2 Compute the simple rate of return promised by the car wash. (Hint: Note that this is a cost reduction project.) Will Honest John accept this project if he expects a 20% return?
3 Compute the payback period on the car wash. Honest John (who has a reputation for being something of a penny-pincher) will not purchase any equipment unless it has a payback of four years or less. Will he purchase the car wash equipment?
4 Compute (to the nearest whole %) the internal rate of return promised by the car wash. Based on this computation, does it appear that the simple rate of return would normally be an accurate guide in investment decisions?