Question

Aikmen Lab plans to purchase a new centrifuge machine for its Georgia facility. The machine costs $279,000 and is expected to have a useful life of 7 ​years, with a terminal disposal value of $50,000. Savings in cash operating costs are expected to be $63,000 per year.​ However, additional working capital is needed to keep the machine running efficiently. The working capital must continually be​ replaced, so an investment of $30,000 needs to be maintained at all​ times, but this investment is fully recoverable​ (will be​ "cashed in") at the end of the useful life. Aikmen Lab​'s required rate of return is 10​%. Ignore income taxes in your analysis. Assume all cash flows occur at​ year-end except for initial investment amounts. Aikmen Lab uses​ straight-line depreciation for its machines.

Required:
1. Calculate net present value.
2. Calculate internal rate of return.
3. Calculate accrual accounting rate of return based on net initial investment.
4. Calculate accrual accounting rate of return based on average investment.
5. You have the authority to make the purchase decision. Why might you be reluctant to base your decision on the DCF​ methods?

Answer 1

initial outlay costs of the project = $279,000 (machine) + $30,000 (additional working capital) = $309,000

1. CF1 = $63,000
2. CF2 = $63,000
3. CF3 = $63,000
4. CF4 = $63,000
5. CF5 = $63,000
6. CF6 = $63,000
7. CF7 = $63,000 + $50,000 (salvage value) + $30,000 (working capital) = $143,000

discount rate = 10%

using an excel spreadsheet:

1) =NPV(10%,63000,63000,63000,63000,63000,63000,143000) = $347,763 - $309,000 = $38,763

2) =IRR(-309000,63000,63000,63000,63000,63000,63000,143000) = 13.34%

3) accounting rate of return based on net initial investment = average net profit / net initial investment

• average net profit = $63,000 - $32,714 (depreciation cost) = $30,286
• net initial investment = $309,000

accounting rate of return based on net initial investment = $30,286 / $309,000 = 9.8%

4) accounting rate of return based on average investment = average net profit / average investment

• average net profit = $63,000 - $32,714 (depreciation cost) = $30,286
• average investment = ($309,000 + $80,000) / 2 = $194,500

accounting rate of return based on average investment = $30,286 / $194,500 = 15.57%

5) Generally the discounted cash flow method is the most widely accepted way to determine whether a project should be accepted or not, and to be honest the NPV is positive and the IRR is higher than the required rate of return. The only rate that was lower was the accounting rate of return on net investment (9.8%) but it was really close.

If I was the manager that decided whether or not to carry out the project I would go for it.