BEFA 4TH UNIT
JUNNA MANOJAdvantages Of Accounting Rate Of Return (ARR)
1. ARR is based on accounting information, therefore, other special reports are not required for determining ARR.
2. ARR method is easy to calculate and simple to understand.
3.ARR method is based on accounting profit hence measures the profitability of investment.
Disadvantages Of Accounting Rate OF Return (ARR)
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.
Characteristics of Capital:
The following are the main characteristics of capital:
(i) Capital is man-made. It is, therefore, possible to increase its supply when the situation requires.
(ii) It involves the element of time, as it renders its service over a period of time. That is why payment for capital is calculated in terms of so much per cent per annum.
(iii) The use of capital makes roundabout methods of production possible. Its application increases efficiency and the productive power of all the factors with which it is combined and used.
The Advantages and Disadvantages of the Internal Rate of Return Method
When evaluating potential capital investments by your small business in various projects, the Internal Rate of Return, or IRR, can be a valuable tool in assessing the projects most worth pursuing. IRR measures the rate of return of projected cash flows generated by your capital investment. The IRR for each project under consideration by your business can be compared and used in decision-making.
Advantage: Finds the Time Value of Money
Internal rate of return is measured by calculating the interest rate at which the present value of future cash flows equals the required capital investment. The advantage is that the timing of cash flows in all future years are considered and, therefore, each cash flow is given equal weight by using the time value of money.
Advantage: Simple to Use and Understand
The IRR is an easy measure to calculate and provides a simple means by which to compare the worth of various projects under consideration. The IRR provides any small business owner with a quick snapshot of what capital projects would provide the greatest potential cash flow. It can also be used for budgeting purposes such as to provide a quick snapshot of the potential value or savings of purchasing new equipment as opposed to repairing old equipment.
Advantage: Hurdle Rate Not Required
In capital budgeting analysis, the hurdle rate, or cost of capital, is the required rate of return at which investors agree to fund a project. It can be a subjective figure and typically ends up as a rough estimate. The IRR method does not require the hurdle rate, mitigating the risk of determining a wrong rate. Once the IRR is calculated, projects can be selected where the IRR exceeds the estimated cost of capital.
Disadvantage: Ignores Size of Project
A disadvantage of using the IRR method is that it does not account for the project size when comparing projects. Cash flows are simply compared to the amount of capital outlay generating those cash flows. This can be troublesome when two projects require a significantly different amount of capital outlay, but the smaller project returns a higher IRR.
For example, a project with a $100,000 capital outlay and projected cash flows of $25,000 in the next five years has an IRR of 7.94 percent, whereas a project with a $10,000 capital outlay and projected cash flows of $3,000 in the next five years has an IRR of 15.2 percent. Using the IRR method alone makes the smaller project more attractive, and ignores the fact that the larger project can generate significantly higher cash flows and perhaps larger profits.
Disadvantage: Ignores Future Costs
The IRR method only concerns itself with the projected cash flows generated by a capital injection and ignores the potential future costs that may affect profit. If you are considering an investment in trucks, for example, future fuel and maintenance costs might affect profit as fuel prices fluctuate and maintenance requirements change. A dependent project may be the necessity to purchase vacant land on which to park a fleet of trucks, and such cost would not factor in the IRR calculation of the cash flows generated by the operation of the fleet.
Disadvantage: Ignores Reinvestment Rates
Although the IRR allows you to calculate the value of future cash flows, it makes an implicit assumption that those cash flows can be reinvested at the same rate as the IRR. That assumption is not practical as the IRR is sometimes a very high number and opportunities that yield such a return are generally not available or significantly limited.
Fixed Capital and Working Capital:
Capital may be divided into fixed capital and working capital. Fixed capitals are the durable-use producer goods which are used in production again and again till they wear out. Machinery, tools, railways, tractors, factories, etc., are all fixed capital. Fixed capital does not mean fixed in location.
Capital like plant, tractors and factories are called “fixed” because if money is spent upon these durable-use goods it becomes “fixed” for a long period in contrast with the money spent in purchasing raw materials which is released as soon as the goods made with them are sold out.
Working capital, on the other hand, includes the single-use producer goods like raw materials, goods in process, and fuel. They are used up in a single act of consumption. Moreover, money spent on them is fully recovered when goods made with them are sold in the markeT
Main factors affecting the working capital are as follows:
- (1) Nature of Business:
- (2) Scale of Operations:
- (3) Business Cycle:
- (4) Seasonal Factors:
- (5) Production Cycle:
- (6) Credit Allowed:
- (7) Credit Availed:
- (8) Operating Efficiency:
The Payback Method
The object of the payback method is to determine the number of years that it takes to recover the initial investment. The formula is to take the initial investment and divide by cash flow per year:
Payback in the number of years = Initial Investment/Cash flow per year
Example of an Investment Calculation
The Hasty Rabbit Corporation is considering a $150,000 expansion to the production line that makes their top-selling sneaker – the Blazing Hare. The company receives a gross profit of $40 for each pair of sneakers, and the expansion will increase output by 1,250 pairs per year. The sales manager has assured upper management that Blazing Hare sneakers are in high demand, and he will be able to sell all of the increased production.
The expansion will produce an annual increase in cash flow of $50,000/year (1,250 pairs x $40/pair) from the expansion. At this rate, the company will realize a total of $150,000 cash flow for the first three years of the expansion.
The payback period is therefore expressed this way: Initial investment/cash flow per year = $150,000/$50,000 - 3 years payback.
Advantages of the Payback Method
The most significant advantage of the payback method is its simplicity. It's an easy way to compare several projects and then to take the project that has the shortest payback time. However, the payback has several practical and theoretical drawbacks.
Disadvantages of the Payback Method
Ignores the time value of money: The most serious disadvantage of the payback method is that it does not consider the time value of money. Cash flows received during the early years of a project get a higher weight than cash flows received in later years. Two projects could have the same payback period, but one project generates more cash flow in the early years, whereas the other project has higher cash flows in the later years. In this instance, the payback method does not provide a clear determination as to which project to select.
Neglects cash flows received after payback period: For some projects, the largest cash flows may not occur until after the payback period has ended. These projects could have higher returns on investment and may be preferable to projects that have shorter payback times.
Ignores a project's profitability: Just because a project has a short payback period does not mean that it is profitable. If the cash flows end at the payback period or are drastically reduced, a project might never return a profit and therefore, it would be an unwise investment.
Does not consider a project's return on investment: Some companies require capital investments to exceed a certain hurdle of rate of return; otherwise the project is declined. The payback method does not consider a project's rate of return.
They payback method is a handy tool to use as an initial evaluation of different projects. It works very well for small projects and for those that have consistent cash flows each year. However, the payback method does not give a complete analysis as to the attractiveness of projects that receive cash flows after the end of the payback period. And it does not consider the profitability of a project nor its return on investment.
