Question

Century Lab plans to purchase a new centrifuge machine for its New Hampshire New Hampshire facility. The machine costs $567,000 and is expected to have a useful life of 8 ​years, with a terminal disposal value of $54,000. Savings in cash operating costs are expected to be $108,000 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 $38,000 needs to be maintained at all​ times, but this investment is fully recoverable​ (will be​ "cashed in") at the end of the useful life. Century Lab Century Lab​'s required rate of return is 8​%.Ignore income taxes in your analysis. Assume all cash flows occur at​ year-end except for initial investment amounts. Century LabCentury Lab uses​ straight-line depreciation for its machines.

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

5. If the decision is based on the DCF model, the purchase would be made since the net present value is positive, and the 9.53% internal rate of return exceeds the 8% required rate.However if Accounting rate of return method is used, the return of 7.25% is below the required return of 8% thus creating a doubt as to the use of DCF model.