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Note that the average book value depends on how
the asset is depreciated.
the Need to have a target cutoff rate
Decision Rule: Accept the project if the AAR
is greater than a preset rate.
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 the AAR rule account for the risk of the
Does the AAR rule provide an indication about
the increase in value?
Should we consider the AAR rule for our primary
21 Advantages and Disadvantages
of Advantages Easy to calculate
will usually be
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
22 Internal Rate of Return 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
23 IRR – Definition and Decision
Rule Definition: IRR is the return that makes the
NPV = 0
Decision Rule: Accept the project if the IRR
is greater than the required return
24 Computing IRR for the Project If you do not have a financial calculator, then this
becomes a trial and error process
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
-10,000 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14...
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This document was uploaded on 03/01/2014 for the course FINANCE 250 at Indiana.
- Spring '14
- Net Present Value