9 29 sample calculation the project cost is 500000

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Unformatted text preview: count rate used • Does the discounted payback rule provide an indication about the increase in value? No. 9-28 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. 9-29 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%. 9-30 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 9-31 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 . 9-32 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 9-33 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 0 1 2 3 Am...
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