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**Unformatted text preview: **e / average book value
Note that the average book value depends on how
Note
the asset is depreciated.
the Need to have a target cutoff rate
Decision Rule: Accept the project if the AAR
Decision
is greater than a preset rate.
is
19
19 Computing AAR for the Project Assume we require an average accounting
Assume return of 25%
return Average Net Income: (13,620 + 3,300 + 29,100) / 3 = 15,340 AAR = 15,340 / 72,000 = .213 = 21.3% Do we accept or reject the project? 20
20 Decision Criteria Test - AAR Does the AAR rule account for the time value of
Does
money?
money?
Does the AAR rule account for the risk of the
Does
cash flows?
cash
Does the AAR rule provide an indication about
Does
the increase in value?
the
Should we consider the AAR rule for our primary
Should
decision rule?
decision 21
21 Advantages and Disadvantages
Advantages
of AAR
of Advantages Easy to calculate
Needed information
Needed
will usually be
available
available Disadvantages Not a true rate of
Not
return; time value of
money is ignored
money
Uses an arbitrary
Uses
benchmark cutoff rate
benchmark
Based on accounting
Based
net income and book
values, not cash flows
and market values
and 22
22 Internal Rate of Return This is the most important alternative to
This NPV
NPV It is often used in practice and is intuitively
It
appealing
appealing It is based entirely on the estimated cash
It
flows and is independent of interest rates
found elsewhere
found 23
23 IRR – Definition and Decision
IRR
Rule
Rule Definition: IRR is the return that makes the
Definition:
NPV = 0
NPV
Decision Rule: Accept the project if the IRR
Decision
is greater than the required return
is 24
24 Computing IRR for the Project If you do not have a financial calculator, then this
If
becomes a trial and error process
becomes
Calculator Enter the cash flows as you did with NPV
Press IRR and then CPT
IRR = 16.13% > 12% required return Do we accept or reject the project? 25
25 NPV Profile for the Project
70,000 IRR = 16.13% 60,000
50,000 NPV 40,000
30,000
20,000
10,000
0
-10,000 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14...

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