Lecture 27 - Business Finance (ACC501) Lesson 27 Review of...

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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 5-years 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
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This note was uploaded on 08/04/2011 for the course ACCT 501 taught by Professor Na during the Spring '11 term at Virtual University of Pakistan.

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Lecture 27 - Business Finance (ACC501) Lesson 27 Review of...

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