5. Describe the Accounting Rate of Return in your own words. What are its weakne

Question

5. Describe the Accounting Rate of Return in your own words. What are its weaknesses as an investment evaluation tool?

6. Describe the calculation of NPV in your own words. What does the word "Net" in Net Present Value refer to?

7. Define the Internal Rate of Return.

8. Johnson Company plans to spend $3,993 on a 5 year project that will return $1,000 cash per year. Calculate the IRR; is it 8%?

9. Johnson Company spends $2709 for an investment that returns $2,000 the first year, and $1,000 the second year. Is the IRR also 8%?

10. In practice, it seems that the NPV method is used more often than IRR. Why do you think this would be the case?

11. Johnson Company calculated the NPV of an investment, and using a discount rate of 10%, the NPV was zero. Does this mean that the investment is unacceptable? What does it mean?

12. Suppose Johnson calculated the NPV and found that the NPV was $3,400 using a discount rate of 6%. Do you think the internal rate of return in this case would be a. less than 6% or b. greater than 6% or c. exactly equal to 6%?

13. Describe what is meant by the following terms:

a. cost of capital

b. hurdle rate

c. the time value of money

14. What is capital rationing?

Explanation / Answer

5.Accounting rate of return is a financial ratio used in capital budgeting.Accounting Rate of return calculates the return, generated from net income of the proposed capital investment.

Its weaknesses as an investment evaluation tool are:-

1. ARR ignores the time value of money.

2. ARR method ignores the cash flow from investment

3. ARR method does not consider terminal value of the project.

6.NPV is used in capital budgeting to analyze the profitability of a projected investment or project.

.Net means the difference between the present value of cash inflows and the present value of cash outflows.

7.Internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a

particular project equal to zero.

(10) It seems that the NPV method is used more often than IRR because:

(1)NPV method tells us whether an investment will create value for the company or the investor, and by how much in terms of dollars.

(2)NPV method takes into consideration the cost of capital and the risk inherent in making projections about the future.

11.This mean that the investment is acceptable becuase PV of outflow is equal to PV of Inflow.

12.Greater than 6%

13.(a)Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of return that

could have been earned by putting the same money into a different investment with equal risk.

(b) Hurdle rate is the minimum rate of return on a project a manager or company is willing to accept before starting a project, given its risk and the opportunity cost of forgoing other projects

(c) Money available at the present time is worth more than the same amount in the future due to its potential

earning capacity.

(d)The act of placing restrictions on the amount of new investments or projects undertaken by a company.

8 Amount($) Year Cash Flow Pv@8% PV of CashFlow 0 3993 1 -3993 1 1000 0.926 926 2 1000 0.857 857 3 1000 0.794 794 4 1000 0.735 735 5 1000 0.681 681 NPV 0

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