Accounting Rate of Return (ARR)
ARR provides a quick estimate of a project's worth over its useful life. ARR is derived by finding profits before taxes and interest. ARR is an accounting method used for purposes of comparison. The major drawbacks of ARR are that it uses profit rather than cash flows, and it does not account for the time value of money.

ARR is most often used internally when selecting projects. It can also be used to measure the performance of projects and subsidiaries within an organisation. Various proposals are ranked in order to rate of earnings on the investment in the projects concerned. The project which shows highest rate of return is selected and others are ruled out.

How to calculate ARR
The Accounting rate of Return is found out by dividing the average income after taxed by the average investment, i.e., average net value after depreciation. The accounting rate of return, thus, is an average rate and can be determined by the following equation.

Accounting Rate of Return (ARR) = Average income / Average investment Average rate of Return= Estimated average annual income
Average investment
Average investment is original investment divided by 2
Advantage of ARR
1) Easy to calculate
2) Fairly easy to construct (realistic) examples
Disadvantage of ARR
1) Cash flows are more important to investors, and ARR is based on numbers that include non-cash items. 2) ARR does not take into account the time value of money — the value of cash flows does not diminish with time as is the case with NPV and IRR. 3) It does not adjust for the greater risk to longer term forecasts. 4) There are better alternatives which are not significantly more difficult to calculate.

Project A:
Average annual net income = ($225,000 + $225,000 + $225,000)/3 = $225,000
Average investment = ($600,000 + $0)/2
= $300,000
Average accounting return = $225,000/$300,000...

...Internal Rate of Return
Meaning of Capital Budgeting
Capital budgeting can be defined as the process
of analyzing, evaluating, and deciding whether
resources should be allocated to a project or
not.
Capital budgeting addresses the issue of
strategic long-term investment decisions.
Process of capital budgeting ensure optimal
allocation of resources and helps management
work towards the goal of shareholder wealth
maximization.
Why Capital Budgeting is so Important?
Involve massive investment of resources
Are not easily reversible
Have long-term implications for the firm
Involve uncertainty and risk for the firm
Capital Budget Techniques
Net PresentValue
Discounted
BenefitCost/Profitability
Index Ratio
IRR
Capital Budget
Techniques
AccountingRate
of Return
Non Discounted
Payback
Period
Internal Rate of Return
The rate at which the net present value of cash
flows of a project is zero, I.e., the rate at which
the present value of cash inflows equals initial
investment
Project’s promised rate of return given initial
investment and cash flows.
Consistent with wealth maximization
Accept a project if IRR ≥ Cost of Capital
Question
The management is considering to acquire an
equipment costing $1,00,000 . It is expected that
the...

...Accountingrate of return
The accountingrate of return (ARR) is a way of comparing the profits you expect to make from an investment to the amount you need to invest.
The ARR is normally calculated as the average annual profit you expect over the life of an investment project, compared with the average amount of capital invested. For example, if a project requires an average investment of £100,000 and is expected to produce an average annual profit of £15,000, the ARR would be 15 per cent.
The higher the ARR, the more attractive the investment is. You can compare the ARR to your own target rate of return, and to the ARR on other potential investments.
The ARR is widely used to provide a rough guide to how attractive an investment is. The main advantage is that it is easy to understand.
Disadvantages
Unlike other methods of investment appraisal, the ARR is based on profits rather than cashflow. So it is affected by subjective, non-cash items such as the rate of depreciation you use to calculate profits.
The ARR also fails to take into account the timing of profits. In calculating ARR, a £100,000 profit five years away is given just as much weight as a £100,000 profit next year. In reality, you would...

...INTERNAL RATE OF RETURN
Many companies wants to have a return on their investment in a few years and begin to evaluate their projects optimistically calculating an internal rate of real return not yielding results in the end. This does not end up being expected by the companies; According to the article the authors John C. Kelleher and Justin J. MacCormack . They suggest that there is a tendency to a risky behavior, Companies started to run the risk of creating unrealistic numbers for themselves and shareholder expectations, which it could confuse communications with investors and inflating managerial rewards.
This confronts us with a real and serious problem when it comes to investing in projects because later we can not generate the expected return and risk of failure in the project, the IRR can generate two different values for the same project when future cash flows switch from negative to positive (or positive to negative). In addition, since the IRR is expressed as a percentage, and This can make small projects appear more attractive than large , although large projects with lower IRR may be more attractive as NPV of smaller projects with IRR .
The management of the IRR must be just when the project generates no interim cash flows - or when those interim cash flows really can be invested in real IRR otherwise would not be realistically analyzing the viability of the project,...

...Internal Rate of Return
In investment decision analysis you may need to calculate internal rate of return. “Internal rate of return (IRR) is the discount rate that gives the project a zero NPV” (McLaney, 2006). It is a good choice to use for investment projects. There is a formula for the internal rate of return:
(A is the lower discount rate and B is the higher rate, a is the NPV at the lower rate and b is the NPV at the higher rate.) For example the Net Present Value (NPV) is 88 when the discount rate is 20%, and the NPV is 12 when the discount rate is 30%. Therefore the IRR in this situation is 28.8%. The consequence should be compared with the rate of return which the company’s required. If the IRR higher than that, the project should be accepted otherwise it will not be accepted.
From our lecturer Linda’s lectures we knew that there are some advantages and disadvantages. The internal rate of return is simple to interpret and calculate which more easily understand than some other methods; and it is good if it uses with NPV. However there are some drawbacks as well: the output is a percentage rather than the physical size of the earnings; it may produce more than one rate of...

...Internal Rate of Return
Internal Rate of Return (IRR)
Calculation of the true interest yield expected from an investment. Explanation of Internal Rate of Return. What is Internal Rate of Return? Definition The Internal Rate of Return (IRR) is the discount rate that delivers a net present value of zero for a series of future cash flows. It is an Discounted Cash Flow (DCF) approach to valuation and investing. As is Net Present Value (NPV). IRR and NPV are widely used to decide which investments should be undertaken, and which investments not to make. Difference of IRR and NPV The major difference is that while Net Present Value is expressed in monetary units (Euro's or Dollars for example), the IRR is the true interest yield expected from an investment expressed as a percentage. Internal Rate of Return is the flip side of Net Present Value and is based on the same principles and the same calculations. NPV shows the value of a stream of future cash flows discounted back to the present by some percentage that represents the minimum desired rate of return, often your company's cost of capital. IRR, on the other hand, computes a break-even rate of return. It shows the discount rate below which an investment causes a positive...

...Accountingrate of returnAccountingrate of return (also known as simple rate of return) is the ratio of estimated accounting profit of a project to the average investment made in the project. ARR is used in investment appraisal.
Formula
AccountingRate of Return is calculated using the following formula:ARR =
Average Accounting Profit
Average Investment
Average accounting profit is the arithmetic mean of accounting income expected to be earned during each year of the project's life time. Average investment may be calculated as the sum of the beginning and ending book value of the project divided by 2. Another variation of ARR formula uses initial investment instead of average investment.
Decision Rule
Accept the project only if its ARR is equal to or greater than the required accountingrate of return. In case of mutually exclusive projects, accept the one with highest ARR.
Examples
Example 1: An initial investment of $130,000 is expected to generate annual cash inflow of $32,000 for 6 years. Depreciation is allowed on the straight line basis. It is estimated that the project will generate scrap value of $10,500 at end of the 6th year....

...000 | |
6 | 500,000 | |
7 | 500,000 | 5,650,000 |
a. Compute the NPV and IRR for the above two projects, assuming a 13% required rate of return.
b. Discuss the ranking conflict.
c. What decision should be made regarding these two projects?
Answer:
a. NPV of A = $211,305 NPV of B = $401,592.64
IRR of A = 16.33% IRR of B = 15.99%
b. The later cash flow of B causes its lower IRR even though it has the higher NPV.
c. B should be accepted because it is the mutually exclusive project with the highest positive NPV.
Keywords: NPV, IRR
AACSB: Analytic skil
4) Tangshan Mining Company must choose its optimal capital structure. Currently, the firm has a 40 percent debt ratio and the firm expects to generate a dividend next year of $4.89 per share and dividends are grow at a constant rate of 5 percent for the foreseeable future. Stockholders currently require a 10.89 percent return on their investment. Tangshan Mining is considering changing its capital structure if it would benefit shareholders. The firm estimates that if it increases the debt ratio to 50 percent, it will increase its expected dividend to $5.24 per share. Because of the additional leverage, dividend growth is expected to increase to 6 percent and this growth will be sustained indefinitely. However, because of the added risk, the required return demanded by stockholders will increase to 11.34 percent....

...yield plus the dividend yield on a security is called the:
A. geometric return.
B. average period return.
C. current yield.
D. total return.
2.
The expected return on a security in the market context is:
A. a negative function of execs security risk.
B. a positive function of the beta.
C. a negative function of the beta.
D. a positive function of the excess security risk.
E. independent of beta.
3.
A capital gain occurs when:
A. the selling price is less than the purchase price.
B. the purchase price is less than the selling price.
C. there is no dividend paid.
D. there is no income component of return.
4.
Which one of the following is a correct statement concerning risk premium?
A. The greater the volatility of returns, the greater the risk premium.
B. The lower the volatility of returns, the greater the risk premium.
C. The lower the average rate of return, the greater the risk premium.
D. The risk premium is not correlated to the average rate of return.
5.
You bought 100 shares of stock at $20 each. At the end of the year, you received a total of $400 in
dividends, and your stock was worth $2,500 total. What was your total return?
A. 45%.
B. 50%.
C. 90%.
D. 20%.
6.
You bought 100 shares of stock at $20 each. At the end of the year, you received a total...

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