DCF, accounting rate of return, working capital, evaluation of performance.
Meer has been offered a special-purpose metal-cutting machine for €110 000. The machine is expected to have a useful life of eight years with a terminal disposal value of €30 000. Savings in cash-operating costs are expected to be €25 000 per year. However, additional working capital is needed to keep the machine running efficiently and without stoppages. Working capital includes such items as filters, lubricants, bearings, abrasives, flexible exhaust pipes and belts. These items must continually be replaced so that an investment of
€8000 must be maintained in them at all times, but this investment is fully recoverable
(will be ‘cashed in’) at the end of the useful life. Meer’s required rate of return is 14%.
Required
1 a Calculate the net present value.
b Calculate the internal rate of return.
2 Calculate the accounting rate of return based on the net initial investment. Assume straight-line depreciation.
3 You have the authority to make the purchase decision. Why might you be reluctant to base your decision on the DCF model?
Solution:
| Cost 1 10 000 | |||||||||
| 8 years | |||||||||
| Salvage 30000 | |||||||||
| Depreciation 10000 | |||||||||
| Savings 25000 | |||||||||
| Working capital 8000 | |||||||||
| Kc 14 % | |||||||||
| NPV | Inflow – Outflow | ||||||||
| Inflow = 25000 * 4.64 (annuiy factor of 1 unit for 8 years @ 14 %) + 30000 * 0.350 | |||||||||
| Inflow = 126500 | |||||||||
| Outflow = 110000 + (working capital = 8000 – PV of working capital reinvested after 8 years = 8000 *0.350) | |||||||||
| Outlow = 110000 + ( 8000 – 2804.5 ) | |||||||||
| Outflow = 110000 + 5195.5 | |||||||||
| Outflow = 115195.5 | |||||||||
| NPV | 116000 – 115195.5 | ||||||||
| NPV | 11304.5 | ||||||||
| IRR | Outflow = Inflow | ||||||||
| IRR | 16.70% | ( by alot of trial and error approach / interpolation method ) | |||||||
| ARR | average accounting profit / net initial innvestment | ||||||||
| Average profit = 25000 – 10000 | |||||||||
| Average profit = 15000 | |||||||||
| Net initial investment = 115195.5 | |||||||||
| ARR = | 15000 / 115195.5 | ||||||||
| ARR = | 13% | ||||||||
| Comment | A decision maker would be reluctant in choosing the DCF model because the model and the inputs used are broadly based on assumptions . | ||||||||
| The figures and data used is wholly on assumptions and so a decision maker would be reluctant in using DCF model in such cases . | |||||||||
| DCF model even though broadly used has a lot of drawbacks that it is mainly based on assumptions . | |||||||||
| hence we can conclude that the DCF model even though broadly used cannot be depended on properly and at all times . | |||||||||
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