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ACC501 Business Finance GDB Solution Fall 2012

Creative Company (Private) Limited has been operating in the field of financial consultancy business for last 25 years. It has become a well-known company due to its efficient and well-educated management. One of the financial experts of the company has recently left the company due to some unknown reasons. HR Department is now searching for a new financial expert who should have special expertise in the field of project evaluation as the company has to deal with the project evaluations for its clients on regular basis. After advertising the said vacancy, the company is now going through the recruiting process and the short listing has almost been done for the post. The interviews have been scheduled in the coming week. One of the HR managers suggests that the financial skills regarding project evaluation should be tested by having a discussion on two of the capital budgeting techniques i.e. IRR and AAR. On the day of interview, the interviewees have been provided with the following details about three projects:

 

Years

Project A

Project B

Project C

0

(Rs. 100,000)

(Rs. 100,000)

(Rs. 100,000)

1

Rs. 25,000

Rs. 15,000

0

2

25,000

20,000

0

3

25,000

25,000

0

4

25,000

30,000

0

5

25,000

35,000

Rs. 125,000

Depreciation (per year)

Rs. 5,000

Rs. 5,000

Rs. 5,000

Net Profit

Rs. 100,000

Rs. 100,000

Rs. 100,000

IRR

              7.93 %

               6.91%

               4.56%

ARR

              20.0 %

              20.0 %

              20.0 %


Required:
How would you respond to the following questions during the interview if you are one of the potential candidates for the said post?

  1. Why IRR (Internal Rate of Return) is different for all three projects?
  2. Why AAR (Average Accounting Return) is same for all three projects?
  3. Which of the techniques is better to use in order to select the project in this particular scenario and why? Explain with rationale.
Solution:

1- IRR rate is different due to factor of time value of money.
2- AAR rate is same because it ignore the factory of time value of money.

3- IRR is better technique for projects.


Accounting Rate of Return (ARR)

Accounting rate of return or simple rate of return is the ratio of the estimated accounting profit of a project to its average investment. It is an investment appraisal technique. ARR ignores the time value of money.

Formula
Accounting Rate of Return is calculated as follows:

ARR = Average Accounting Profit
Initial Investment
Average accounting profit is the arithmetic mean of accounting income expected to be earned during each year of the project’s life time. Initial investment is sometimes replaced by average investment due to the reason that the book value of the project usually declines over its life time. Average investment is calculated as the sum of the beginning and ending book value of the project divided by 2.

Decision Rule

Accept the project only if its ARR is NOT less than the required accounting rate of return. In case of mutually exclusive projects, accept the one with highest ARR.

The internal rate of return (IRR)

The internal rate of return (IRR) is the rate of return promised by an investment project over its useful life. It is some time referred to simply as yield on project. The internal rate of return is computed by finding the discount rate that equates the present value of a project’s cash out flow with the present value of its cash inflow In other words, the internal rate of return is that discount rate that will cause the net present value of a project to be equal to zero

***IRR is better. Just go through these two points.
1- IRR rate is different due to factor of time value of money.
2- AAR rate is same because it ignore the factory of time value of money.


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