Lesson-5 on Finance

Question:  What is Accounting Rate of Return in Finance?

Answer:

The average rate of return expresses the profits arising from a project as a percentage of the initial capital cost.

Question:  What are the limitations  of  Accounting  Rate of Return  Method in evaluation of Project ?

Answer:

1)  It considers Accounting profit instead of cash inflow in evaluation of project. The concept of profit can be very subjective, varying with specific accounting practice and the capitalization of project costs. As a result, the ARR calculation for identical projects would be likely to result in different outcomes from business

2) It ignores time value of money.

3) It does not consider that  the profit can be reinvested.

4) There is no definitive signal given by the ARR to help managers decide whether or not to invest. This lack of a guide for decision making means that investment decisions remain subjective.

Question: What Net Present value in Finance?

Answer:

The Net Present Value (NPV) is the difference between the present value future cash inflows and the initial investment which determines whether the project is an acceptable investment.

Question: What are the limitations  of  Net Present Value   Method in evaluation of Project ?

Answer:

1.     It requires estimates of cash flows which is a tedious task.

2.     It Requires computation of the opportunity cost of the capital which posed practical difficulties

3.     It assumes a constant discount rate over life of investment

Question:  What Internal Rate of Return(IRR)   in Finance?

Answer:

Ø The internal rate of return on an investment or project is the discount rate that makes the net present value of all cash flows (both positive and negative) from a particular investment equal to zero.

Ø An investment is considered acceptable if its internal rate of return is greater than an cost of capital.

Question: What are the limitations of  Internal Rate of Return   Method in evaluation of Project ?

Answer:

Ø The calculated IRR can not be used to for taking decision on  mutually exclusive projects, but only to decide whether a single project is worth investing in.

Ø IRR assumes reinvestment of interim cash flows in projects with equal rates of return (the reinvestment can be the same project or a different project). Therefore, IRR overstates the annual equivalent rate of return for a project whose interim cash flows are reinvested at a rate lower than the calculated IRR

Ø Requires estimates of cash flows which is a tedious task.

Ø Does not hold the value additivity principle (i.e IRRs of two or more projects does not add)

Ø Relatively difficult to compute which require repetitive calculation. That’s why it also called Trial & Error Method.

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