Question

a) Define rate of return analysis and list one advantage of rate of return analysis.

b) How do fees or discounts affect the interest rate?

c) Explain some of the disadvantages of rate of return analysis (Hint, think about how they are dealt with.)

Answer 1

a) Define rate of return analysis and list one advantage of rate of return analysis.

Rate of return analysis can be defined as the Gain or loss made on the investment over a specific period of time. It is generally expressed as a percentage of the investment's cost.

Advantage- It helps to compute how much return the investment is providing the investor and whether it is able to cover its costs or not and whether any other investment must be chosen or considered. Also it takes into account the Time value of money.

b) How do fees or discounts affect the interest rate?

Let us understand this answer with a scenario- when the economy is growing at a rate that may lead to hyperinflation, the fed may increase the discount rate . Also when member banks cannot borrow from the central bank at an interest rate which is cost effective , then lending to the public may be tightened wntill the interest rates are reduced. So the discounts affect the interest rate in these conditions.

c) Explain some of the disadvantages of rate of return analysis.

1. Sometimes rate of return analysis gives conflicting answers as compared to NPV for mutually existing projects.

2. Multiple IRR problem- This problem occours when cash flows during the project lifetime is negative This is known as non normal cash flow thus resulting in multiple rate of returns.