Question

Accounting Rate of Return Payback Period Net Present Value Internal Rate of Return Profitability Index 1) Select three of the analytical tools and provide supportive statements explaining how each can be used to screen and/or rank future available projects. 2) Select one of the analytical tools listed and provide supportive statements explaining why you believe it provides the most important information in the decision process.

Answer 1

answer 1

Accounting Rate of return(ARR):

ARR= Average annual net income / initial Investment

ARR measures the average net income of the project (incremental) as a percentage of investment.The numerator is the average annual net accounnting income(as per GAAP applicable) generated by project over its useful life.The denominator can be either the initial investment or average investment.

Decision if ARR>= Minimum required return - accept

              if ARR< Minimum required return - reject

Net Present Value

NPV = Present value of net cash inflows - total net initial investment

The npv technique is a discounted cash flow method that considers the time value of money in evaluating capital investments.An investment has cash flos throughout its life,and it is assumed that a $ of cash flow in the early years of an investment is worth more than a $ of cash flow in a later year.

The NPV method uses a specified discount rate to bring all subseuent net cash inflows after initial investment to their present values(The time of the initial investment is year 0).

Decision if NPV>= 0 ACCEPT THE PROJECT

               if NPV< 0   REJECT

Internal Rate of Return(IRR)

IRR considers time value of money,the initial cash investment,and all cash flos from the project.IRR estimates the discount rate that makes the present value of subseuent net cash flows equal to the initial investment.This discount rate is called IRR.This IRR is then compared to a criterion rate(desired return) for evaluating capital investments.

Decision if IRR>= CUT OFF RATE(cost of capital)     :   accept the project

                if IRR<   CUT OFF RATE                              :   reject

Answer 2

Generally NPV and IRR are considered most useful in taking investment decisions.

These are two separate benchmarks. NPV is an absolute number in terms of the value of your asset at a given point of time. IRR on the contrary is a benchmark or percentage value which would help you understand the kind of returns you could churn out of an investment.

You can look at these independently. But in no way are the two comparable.

On the contrary, you should use both while evaluating an investment. Only if you have a positive NPV or NPV over and above what you pay while acquiring it, should you make an investment. And if that is the case, calculate the IRR so that you can get an idea if it is worth the risk investment in a particular or stick to less risky avenues which may give comparable or better IRR.