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present value factors corresponding to an 8% discount rate. The project has a positive net present
value of $35,843. Interestingly, had the annual net income of $19,500 been erroneously substituted
for the $29,500 annual cash flow, this analysis would have produced a negative net present value!
One cannot underestimate the importance of considering tax effects on the viability of investment
alternatives. 5.4 Accounting Rate of Return
The accounting rate of return is an alternative evaluative tool that focuses on accounting income
rather than cash flows. This method divides the average annual increase in income by the amount of
initial investment. For Mirage’s project above, the accounting rate of return is 13%
($19,500/$150,000). The accounting rate of return is simple and easy. The decision rule is to accept
investments which exceed a particular accounting rate of return. But, the method ignores the time
value of money, the duration of cash flows, and terminal returns of invested dollars (e.g., notice that
Mirage plans to get the $100,000 back at the end of the project). As a result, by itself, the
accounting rate of return can easily misidentify the best investment alternatives. It should be used
with extreme care. Download free ebooks at bookboon.com
32 Evaluation of Long-Term Projects Analytics for Managerial Decision Making 5.5 Internal Rate of Return
The internal rate of return (also called the time-adjusted rate of return) is a close cousin to NPV.
But, rather than working with a predetermined cost of capital, this method calculates the actual
discount rate that equates the present value of a project’s cash inflows with the present value of the
cash outflows. In other words, it is the interest rate that would cause the net present value to be zero.
IRR is a ranking tool. The IRR would be calculated for each investment opportunity. The decision
rule is to accept the projects with the highest internal rates of return, so long as those rates are at
least equal to the firm’s cost of capital. This contrasts with NPV, which has a general decision rule
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