Question

5. What is the difference between the payback period and the discounted payback?

6. Define the Average Accounting Return (AAR). What are the disadvantages of the AAR?

7. What is the Internal Rate of Return (IRR)? What is the IRR rule? How is the IRR calculated?

8. Do the NPV rules and IRR rules lead to identical investment decisions? If so, under what circumstances?

Answer 1

5. The difference between payback and the discounted payback is that the discounted payback period takes into account the time value of money, hence it is a more reliable measure.

6. The AAR is calculated as the Net income/ initial cost of the asset. It decides which project to accept or reject and for that it required a cut off rate.

The disadvantages of the AAR is that it can easily manipulated , hence it is not a reliable measure. Since, it is not based on cash flows and market values, it can be subject to manipulation. Secondly It does not take into account the time value of money. The use of the cut off rate, which is arbitrarily decided is also a disadvantage.

7. IRR is the rate at which the NPV is zero, it is a metric used in capital budgeting to evaluate the profitability of potential projects.  The IRR rule states that, if the IRR > Cost of capital then the project should be accepted and if the IRR < cost of capital then the project should be rejected.

IRR is calculated as :

If a project has a initial cash flow of $5000 and the cash flows for year 1 to year 3 is $10,500

So, the IRR is calculated as :

($5000) + $1050/ (1 + IRR)^1 + 1080/ (1 + IRR)^2 + $7000/ (1 + IRR)^3

So, the IRR is = 23.4779

8. The NPV and the IRR lead to identical investment decisions :

When the projects are independent, with conventional cash flows and there is no capital rationing then the NPV and IRR will lead to the same decision.