DCF, accounting rate of return, working capital, evaluation of performance

Bhimani, Horngren, Datar and Rajan, Management and Cost Accounting, 5
th
Edition, Instructor’s Manual
© Pearson Education Limited 2012
1b
Use atrial and error approach. First, try a 16% discount rate
€25,000
× 4.344
€108,600

(€30,000 + €8,000)
× 0.305 11,590
Gross present value
120,190
Deduct net initial investment
(118,000)
Net present value
€2,190 Second, try an 18% discount rate
€25,000
× 4.078
€101,950

(€30,000 + €8,000)
× 0.266 10,108
Gross present value
112,058
Deduct net initial investment
(118,000)
Net present value
€(5,942)
By interpolation Internal rate of return
=
2,190 16%
(2%)
2,190 5, 942
+
+







= 16% + (.269) (2%) = 16.54%
2
The accounting rate of return based on net initial investment Net initial investment
= €110,000 + €8,000
=
€118,000 Annual depreciation
(€110,000 − €30,000) ÷ 8 years
= €10,000 Accounting rate of return
=
25, 000 10, 000 118, 000
−
€
€
€
= 12.71%
3
If your decision is based on the DCF model, the purchase would be made because the net present value is positive and the 16.54% internal rate of return exceeds the
14% required rate of return. However, you may believe that your performance may actually be measured using accrual accounting. This approach would show a
12.71% return on the initial investment, which is below the required rate. Your reluctance to make a buy decision would be quite natural unless you are assured of reasonable consistency between the decision model and the performance evaluation method.

Bhimani, Horngren, Datar and Rajan, Management and Cost Accounting, 5
th
Edition, Instructor’s Manual
© Pearson Education Limited 2012

Download 1.72 Mb.

Share with your friends: