The management of Douglass Corporation is considering the purchase of a new mach

Question

The management of Douglass Corporation is considering the purchase of a new machine costing $750,000. The company's desired rate of return is 6%. The present value factor for an annuity of $1 at interest of 6% for 5 years is 4.212. In addition to the this information, use the following data in determining the acceptability in this situation:

Income from Net Cash

Year Operations Flow

1 $37,700 $187,500

2 37,700 187,500

3 37,700 187,500

4 37,700 187,500 5 37,700 187,500

The average rate of return for this investment is

a. 5%. b. 10%. c. 25%. d. 15%.

Explanation / Answer

Answer:

Average Rate of Return, ARR = Average Accounting Profit / Initial Investment

ARR = $ 37,700 / $ 750,000 = 5.0267% or 5%

Correct answer is option a. 5%

If we form an opinion on the basis of ARR, then the project shall be rejected because its ARR is less than the Company's desired rate of return.

But, we know that ARR is a method of analysis that ignores time value of money and considers non cash expenses or historic expenses for calculating income from operations and therefore, it should not be made the only basis for decision making.

In the given question the NPV of the project is;

NPV = $ 187,500 x 4.212 - $ 750,000 = $ 789,750 - $ 750,000 = $ 39,750

Since, the NPV of the project is possitive which means that the project is earning absolute cash profits of more than Company's desired rate of return. Therefore, the project must be accepted.

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