Question

Eddison Electronic Company (EEC) provides electricity for several states in the United States. You have been employed as a cost accountant at this organization. You were asked to provide training to operational managers in areas in which they are struggling, such as internal rate of return, simple rate of return, and net present value. Please discuss the following:

How is the internal rate of return calculated?

Explain how it supports a capital business decision versus the NPV model.

Explain how simple rate of return has been used in a company you are familiar with related to capital budgeting.

Answer 1

Internal rate of return:

Internal rate of return is the return at which the present value of cash inflows is equal to the present value of cash outflows. Internal rate of return can be calculated by trial and error method by taking different discount rates and see if NPV is zero or not. If any discount rate gives zero NPV it is internal rate of return. If the NPV is not exactly zero at a discount rate then NPV is calculated for 2 different discount rates one which gives positive NPV and negative NPV and then IRR is calculated by interpolation method to give exact IRR.

LR+ (HR-LR) (NPVLR-0/NPVLR- NPVHR)

LR= lower rate

HR= higher rate

Alternatively as a simplification, excel function of IRR can be used to calculated exact IRR for a project.

Decision rule in case of Internal rate of return and Net present value:

Internal rate of return gives the rate at which Net present value is zero. If the IRR is higher than cost of capital the project is accepted else the project is rejected. The higher the IRR it is considered good for investment. The NPV model uses the discount rate to arrive at the absolute value of net present value. The net present value is calculating by discounting the future cash inflows minus the initial investment. If net present value is positive the project is accepted else the project is rejected. Hence the basic difference between IRR and NPV is IRR gives the rate of return and NPV the absolute net present value. Both methods consider cash flows only in evaluation of capital projects.

Simple rate of return:

Simple rate of return is calculated by dividing net income of the project by initial investment or average investment. Average investment is average of Initial investment and salvage value. The simple rate of return uses the net income and not the cash flow unlike NPV or IRR method. If the simple rate of return is higher than the cost of capital then the project is recommended else project is rejected. This is the only method of capital budgeting which considers net income of project for evaluation. The net income is calculated by annual cash inflows minus the depreciation expense. Depreciation expense is initial investment minus salvage value divided by life of project.