Question

NEED NEW ANSWER ASAP / ANSWER NEVER USED BEFORE

Discuss the similarities and difference between net present value, payback method, internal rate of return, and average accounting rate of return. Describe each of these and provide unique examples of each one.

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Answer 1

NPV >> The NPV or the Net Present Value of an asset or a project is the difference between the discounted cash inflows generated by an asset or a project and the cash outflow by the asset or a project generated over a period of time. It can be expressed as

NPV = PV of Cash Inflows - Cash Outflow

The decision rule for NPV is that if it is positive we should accept the project , if negative then reject and if zero then we are indifferent.

IRR >> The IRR or the Internal Rate of Return of a project or an asset is the rate at which the present value of cash inflows equates the present value of cash outflow. In other words it is the rate at which the NPV of the project is zero. It is used to estimate the profitability return of a business.

Decision Rule . If IRR is > Cost of Capital = Accept the Project

If IRR is < Cost of Capital = Reject the Project

If IRR = Cost of Capital = Indifferent.

The similarity between NPV and IRR is that the decision criteria is based on the acceptance and the rejection of the independent or mutually exclusive project. Such similarities arise during the process of decision making.

The payback method comes under the traditional methods of capital budgeting. It is defined as the minimum time period under which the initial cost of the project is returned by the generation of cash inflows. It is usually expressed in terms of years. The formula is PBP = Initial cash Outflow / Annual Cash Inflow ( when cash inflows are constant)

For uneven cash inflows we take cumulative cash inflows starting from the first year and then we divide the unrecovered amount by the cash inflow in that year plus the year till which the cash inflow is being considered.

Decision Rule >>> PBP under proposal<Predetermined PBP, accepted, otherwise rejected.

Accounting Rate of Return>> ARR computes the return on an investment by considering the changes in the net income of the firm. In other words it depicts how much extra income the company could expect if it undertakes the required project . It compares the income generated with the initial investment in the project rather than cash inflows. The formula is ARR = (Incremental Revenues - Incremental Expenses) / Initial Investment

Decision Rule >>> If ARR>Desired rate of return, accepted otherwise rejected.

They both have some similarity which is that both the PBP and ARR do not take into consideration the discounting factor since both the techniques are traditional techniques of capital budgeting. Also the decision criteria is based on the acceptance and rejection of the project after all the working has been done.

Examples

NPV calculation when discount rate is 10%

Year	Cash Flows	Present Value@ 10%( 1 / (1+.10)^n)	PV of cash Flows
0	(10000)	0
1	2000	.909	1818
2	5000	.826	4130
3	3000	.751	2253
4	4000	.683	2732
		Total>>>>>	10933
		Less: Cash Outflow	(10000)
		NPV	933

Since NPV >0, Hence accept the project

Payback Period

Year	Cash Inflow	Cumulative CF's
0	5000
1	2000	2000
2	1500	3500
3	2500	6000

PBP =2nd Year +(6000 - 5000) / 5000 = 2 + .4 = 2.4 years