140
Business Finance (ACC501)
Lesson 27
Review of the Previous Lecture
•
Net Present Value
–
Estimating NPV
–
Using NPV
•
The Payback Rule
–
Advantages and Disadvantages
Topics under Discussion
•
Average Accounting Return
•
Internal Rate of Return
–
Problems with IRR
Average Accounting Return
•
It is defined as:
Some measure of average accounting profit
Some measure of average accounting value
•
Specifically:
Average net income
Average book value
•
Suppose we are deciding whether or not to open a store in a new shopping center.
•
The required investment in improvements is $500,000
•
The store has a 5years life, as everything reverts to the owners of the shopping
center after that time.
•
The required investment would be 100% depreciated over 5 years, i.e.
$500,000 / 5 = $100,000 per year
•
Tax rate is 25%
Average Accounting Return
Year 1
Year 2
Year 3
Year 4
Year 5
Revenue
$433,333 $450,000
$266,667
$200,000
$133,333
Expenses
200,000
150,000
100,000
100,000
100,000
Earnings before
depreciation
$233,333 $300,000
$166,667
$100,000
$
33,333
Depreciation
100,000
100,000
100,000
100,000
100,000
Earnings before
taxes
$133,333 $200,000
$
66,667
$
0
$
66,667
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141
Taxes (25%)
33,333
50,000
16,667
0

16,667
Net income
$100,000
$150,000
$
50,000
$
0
$
50,000
•
Average net income is:
[$100,000 + 150,000 +50,000 + 0 + (50,000)]/5
= $50,000
•
Average book value =
($500,000 + 0)
/ 2 = $250,000
•
The average accounting return is:
Average net income
=
$50,000
Average book value
250,000
“A project is acceptable if its average accounting return exceeds a target average
accounting return”
•
Drawbacks of AAR
–
It is not a rate of return in any meaningful economic sense, as it ignores time value
of money
–
It lacks an objective or target AAR to be compared with
–
It focuses on net income and book value rather than cash flow and market value
•
Advantages
–
Easy to calculate
–
Needed information will usually be available
Internal Rate of Return
•
With IRR, we try to find a single rate of return that summarizes the merits of a project
•
We want this rate to be an “internal” rate in the sense that it only depends on the cash
flows of a particular investment, not on rates offered elsewhere
•
Consider a project that costs $100 today and pays $110 in one year.
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 Spring '11
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 Accounting, Net Present Value, Internal rate of return

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