1(a) Explain the difference between accounting rate of return and internal rate
ID: 2664856 • Letter: 1
Question
1(a) Explain the difference between accounting rate of return and internal rate of
return. What are the merits and demerits of these two methods?
(b) Company A is considering a project that is expected to last six years. It will
generate cash flow before taxes and depreciation of $23,000 per year. It
requires the initial purchase of equipment costing $60,000, which will be
depreciated over four years on straight-line basis. The relevant tax rate is
25%. Cost of capital is 20%. There is no residual value of the project.
Required:
(i) Calculate the project’s net present value, payback period, discounted
payback period, internal rate of return and accounting rate of return (on
total investment)
(ii) Based on the results obtained in (i) above, advise if this project should
be accepted. Why or why not?
2.Harvard Ltd has been trying to improve its management of working capital forthe last 5 years. Historical data for the last 5 years is shown below (all figuresare in $000). Since purchases figures are not easily available, financialmanagers at Harvard Ltd use sales figures to estimate the ageing of accountspayable.
2005 2006 2007 2008 2009
Net sales 2,873 3,475 5,296 7,759 12,327
Accounts receivable 411 538 726 903 1,486
Accounts payable 283 447 466 1,040 1,643
Inventories 220 293 429 251 233
a)Required:Calculate Harvard Ltd’s cash conversion cycle over the 5-year period andcomment on the results obtained.
b)Explain possible actions that might be taken to reduce the length of the cycleand pointing any possible disadvantages of each action you suggest.
Explanation / Answer
1. a) the differance between arr and irr : ARR: The numerator of this ratio may be measured as the avarage annual post tax profit profit over the life of the investment and the denominator is the avarge book value of fixed assets comitted to the project. = profit after tax / book value of the investment it measures average retun of the project. the higher ARR often accepted.. merits: 1.it is easy to caliculate ,based on the accounting information.Generally bussiness man will familier about his transctions.so it calicualte easy. demerits: 1.its based on accounting profit ,not cash flows.. 2.it ignores time value. IRR: the internal rate of return which makes project npv is equals to "0"... here discount rate has to be find out..and it would compare with its cost of capital. if irr is greater the cost of capital the n accept ,otherwise reject. merits: 1.considiration of time value .. demerit: 1.problem with the non conventional cash flows... 2.when deciding the mututally exclusive project ,the irr may mislead.. b) npv cash flows pv of the cf 23000 19166.67 23000 15972.22 23000 13310.19 23000 11091.82 23000 9243.18 23000 7702.65 total 76486.73 initial cost 60000 npv 16486.73 project can be accepted reason : it has positive npv .. IRR: cash flows IRR at 30 % irr at 31% 23000 17692.31 17557.25 23000 13609.47 13402.48 23000 10468.82 10230.90 23000 8052.94 7809.85 23000 6194.57 5961.72 23000 4765.05 4550.93 total 60783.16 59513.13 initial cost 60000 60000 npv 783.16 -486.87 so the irr lies between 30 and 31 that is 30.6% project can be accepted reason : it is greater than the firms cost of capital has 20% only.. project can be accepted reason : it is greater than the firms cost of capital has 20% only.. ARR: dep pbt tax -60000 23000 10000 13000 3250 9750 23000 10000 13000 3250 9750 23000 10000 13000 3250 9750 23000 10000 13000 3250 9750 23000 10000 13000 3250 9750 23000 10000 13000 3250 9750 Avg accountng rtrn $9,750.00 book cot of invsment 60000 ARR 16.25% under this approach project can be rejected. reason : it has good accounting return..but less than the cost of capital under this approach project can be rejected. reason : it has good accounting return..but less than the cost of capital PAY BACK : cash flows 23000 23000 23000 23000 23000 23000 TOAL CF 138000 INVESTMENT 60000 PAYBACK 2.3 YEARS project can be accepted reason : it is getting returns with in projects life span.. project can be accepted reason : it is getting returns with in projects life span.. NOTE : when you caliculate ARR ,then only you need to take net income that is after deduction of deprciation and tax ... on other hand when you caliculate irr ,npv ,pay back you need to take cash flows only... THANK YOU..... cash flows pv of the cf 23000 19166.67 23000 15972.22 23000 13310.19 23000 11091.82 23000 9243.18 23000 7702.65 total 76486.73 initial cost 60000 npv 16486.73Related Questions
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