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Unformatted text preview: count rate used
• Does the discounted payback rule provide
an indication about the increase in value?
No.
928 Average Accounting Return 9.3
• There are many different definitions for
average accounting return (AAR)
• The one used in the book is:
AAR = Average net income / Average book value • Need to have a target cutoff rate
• Decision Rule: Accept the project if the
AAR is greater than the target cutoff
rate.
929 Sample calculation • The project cost is 500,000 and depreciates down to a
book value of 0 in year 5. Assume the target cutoff rate
is 15%.
• AAR = Average net income / average book value =
50,000 / 250,000 = 20%
• Approve the project, since 20% > 15%.
930 Advantages and Disadvantages
of AAR
• Advantages
• Easy to calculate
• Needed information is
usually available • Disadvantages
• Not a true rate of
return; time value of
money is ignored
• Uses an arbitrary
benchmark cutoff rate
• Based on accounting
net income and book
values, not cash flows
and market values 931 Decision Criteria Test  AAR
• Does the AAR rule account for the time value of
money?
• Does the AAR rule account for the risk of the
cash flows?
• Does the AAR rule provide an indication about
the increase in value?
• The answer to all of these questions is no. In
fact, this rule is even worse than the payback
rule in that it doesn’t even use cash flows for the
analysis. It uses net income and book value .
932 Internal Rate of Return 9.4
• This is the most important alternative to NPV
• It is often used in practice and is intuitively
appealing
• It is based entirely on the estimated cash flows
and is independent of interest rates found
elsewhere
• Definition: IRR is the return that makes the NPV
=0
• Decision Rule: Accept the project if the IRR is
greater than the required return
933 Computing IRR For The Project
• Use the cash flow
function in the calculator
• BAIIPlus
• Enter the cash flows as you
did with NPV
• Press IRR and then CPT • Casio Time
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 Fall '14

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