Simple Rate of Return; Payback [LO5, LO6]

Lugano’s Pizza Parlor is considering the purchase of a large oven and related equipment for mixing and baking “crazy bread.” The oven and equipment would cost $120,000 delivered and installed.

It would be usable for about 15 years, after which it would have a 10% scrap value. The following additional information is available:

a. Mr. Lugano estimates that purchase of the oven and equipment would allow the pizza parlor to bake and sell 72,000 loaves of crazy bread each year. The bread sells for $1.25 per loaf.

b. The cost of the ingredients in a loaf of bread is 40% of the selling price. Mr. Lugano estimates that other costs each year associated with the bread would be as follows: salaries, $18,000;

utilities, $9,000; and insurance, $3,000.

c. The pizza parlor uses straight-line depreciation on all assets, deducting salvage value from original c ost.

Required:

(Ignore income taxes.)

1. Prepare a contribution format income statement showing the net operating income each year from production and sale of the crazy bread.

2. Compute the simple rate of return for the new oven and equipment. If a simple rate of return above 12% is acceptable to Mr. Lugano, will he purchase the oven and equipment?

3. Compute the payback period on the oven and equipment. If Mr. Lugano purchases any equipment with less than a six-year payback, will he purchase this equipment?