ActSc371_Lecture 16_Chapter 7 (Ross) - cont'd part 2

ActSc371_Lecture 16_Chapter 7 (Ross) - cont'd part 2 -...

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Unformatted text preview: Lecture 15 Sections 7.4-7.6: Net Present Value and Other Investment Rules(Corporate Finance by Ross et al.) ActSc 371 Corporate Finance 1 Instructor: Dr. Lysa Porth 1 The Average Accounting Return (AAR) The AAR method is very attractive as an alternative method, however, it is fatally flawed. AAR is still used in business. Calculated as the average project earnings after taxes and depreciation, divided by the average book value of the investment during its life. AAR Example evaluating whether to buy a newly built mall for $500,000. 5 year life. If the firm had a target rate of return greater than 20%, the projected would be accepted. It would be rejected if the target was less than 20%. Year 1 Year 2 Year 3 Year 4 Year 5 Revenue $433,333 $450,000 $266,667 $200,000 $133,333 Expense s 200,000 150,000 100,000 100,000 100,000 B-T CF 233,333 300,000 166,667 100,000 33,333 Deprec. 100,000 100,000 100,000 100,000 100,000 EBT 133,333 200,000 66,667-66,667 Tc @ 0.25 33,333 50,000 16,667-16,667 NI 100,000 150,000 50,000-50,000 Av. NI (100,000+150,000+50,000+0-50,000)/5 = $50,000 Av invest. 500,000+400,000+300,000+200,000+100,00+00/6=$25 0,000 AAR 50,000/250,000=20% Analyzing the Average Accounting Return Method What is wrong with AAR method? 1. It does not work with the right raw materials. It uses net income and book value of the investment, both of which come from the accounting books. (accounting numbers are somewhat arbitrary). Certain cash outflows such as the cost of abuilding, are depreciated under current accounting rules. Other flows such as maintenance, are expensed. In real world situations, the decision to depreciate or expense an item involves judgement....
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This note was uploaded on 12/16/2011 for the course ACSTC 371 taught by Professor Lisaporth during the Fall '11 term at Waterloo.

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ActSc371_Lecture 16_Chapter 7 (Ross) - cont'd part 2 -...

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