accounting rate of return

freeze4real

hi guys,

i am studying some acconting mcq's and i am stuck on a question.

how do I calculate the accounting rate of return in investment projexts.

The formula is Average Book Income/Average Book Assets.

how do i get my average book income.
i have a certain number of cashflows e.g 95000 in year, 105000 in yr 2, 125000 in yr 3 and 105000 in year 4 while the original source of investment is 300000.

There is also a straight line depreciation of 25%.

i have the answer but i dont know how the figures were derived.

cheers

TiGeR KiNgS

Have a look

http://opentuition.com/acca/f9/investment-appraisal-methods-accounting-rate-of-return-payback-period/

I got 22% done very quickly

backtothebooks

I reckon 22% is spot on.

freeze4real

TiGeR KiNgS wrote: »

Have a look

http://opentuition.com/acca/f9/investment-appraisal-methods-accounting-rate-of-return-payback-period/

I got 22% done very quickly

thanks for the link.

yes its 22% i was confused on how to get the book income.

freeze4real

Hi guys another problem, but with Internal rate of return using the trial and error or linear interpolation.

after pickng two random discount rates to get the IRR from a set of cash flows. i used this formula which i attached as an image.

my cash flows are
Y0 = 385,000 outflow
Y1 = 100,000 inflow
Y2 = 200,000 inflow
Y3 = 300,000 inflow


I got the IRR to be 21.74% but when i sub it in thats is testing if the npv will be 0, i am way off in thousands.


I have used my lecturers examples, test assignments, etc and its the same thing.


any suggestions.


cheers

TiGeR KiNgS

I havent bothered to do the IRR, (as I assume you have done it right), but the key thing about IRR is that doing it manually will never be exact. It is only a rough estimation or inference of the true value.

basically, Being off by a few percent is normal.

hivizman

Using the IRR function in Excel, I have calculated the IRR as being 21.51%. This is actually quite close to the value you got by using the method of linear interpolation.

For your calculated rate of 21.74%, I calculate the NPV to be -£1,638. Given the magnitude of the cash flows (total inflows of £600,000, net cash flow of £215,000), this is quite close to zero.

It looks like you have used the method of linear interpolation correctly to get a close approximation of the actual IRR, which is what examiners are likely to be assessing.

freeze4real

hivizman wrote: »

Using the IRR function in Excel, I have calculated the IRR as being 21.51%. This is actually quite close to the value you got by using the method of linear interpolation.

For your calculated rate of 21.74%, I calculate the NPV to be -£1,638. Given the magnitude of the cash flows (total inflows of £600,000, net cash flow of £215,000), this is quite close to zero.

It looks like you have used the method of linear interpolation correctly to get a close approximation of the actual IRR, which is what examiners are likely to be assessing.

thanks for that, how did you use it to cacukate the npv.

The formular is cashflows over the IRR so was it -385000 + 100,000/1.2174 .. etc.

thanks

freeze4real

TiGeR KiNgS wrote: »

NO,
I suggest you go to open tuition again and review Project appraisal.

Your post above shows a serious lack of understanding in Project appraisal and the use of discounting.

TK

From the notes that i have there's no way of working backwards/forwards to see how far off one's from the npv being close to 0.

I also have a corporate finance book but its not there.

TiGeR KiNgS

freeze4real wrote: »

From the notes that i have there's no way of working backwards/forwards to see how far off one's from the npv being close to 0.

I also have a corporate finance book but its not there.

I don't know if I understand you, but your lecturer should of shown you a graph curved downwards. This is the problem with IRR being inexact as it deals with a linear dimension. You wont be able to figure out the error manually, you would need a computer model to do that.

freeze4real

TiGeR KiNgS wrote: »

freeze4real wrote: »

From the notes that i have there's no way of working backwards/forwards to see how far off one's from the npv being close to 0.

I also have a corporate finance book but its not there.

I don't know if I understand you, but your lecturer should of shown you a graph curved downwards. This is the problem with IRR being inexact as it deals with a linear dimension. You wont be able to figure out the error manually, you would need a computer model to do that.

Yes he did show me that diagram and he also mentioned that axed in linear interpolation we won't be able to gt the exact figure of the IRR.

But I would like to prove that with the IRR I got, the NPV is as close to 0.

I hav used the npv formulae with the difference that's it's the original investment minus cash flow divided by 1 + IRR.

Am I right I using that formulae ?

TiGeR KiNgS

freeze4real wrote: »

Yes he did show me that diagram and he also mentioned that axed in linear interpolation we won't be able to gt the exact figure of the IRR.

But I would like to prove that with the IRR I got, the NPV is as close to 0.

I hav used the npv formulae with the difference that's it's the original investment minus cash flow divided by 1 + IRR.

Am I right I using that formulae ?

edit

NO.
use the IRR as the r in the NPV.

barneystinson

freeze4real wrote: »

From the notes that i have there's no way of working backwards/forwards to see how far off one's from the npv being close to 0.

I also have a corporate finance book but its not there.

Yes, there's a way - and you posted a jpg of it further up the thread - it's the IRR formula. It's a Trial and Error methodology, by trying out two estimated rates, you will always get an improved estimate.

If you use 10% and 30%, you'll get a rate of 22.9%. (NPV of -€9,612)

If you then use 22.9% and 20%, you'll get a rate of 21.54%. (NPV of -€236)

If you then use 21.54% and 21%, you'll get a rate of 21.5067% (NPV of -€1.79)....

The bottom line is that the closer either / both of the rates you plug into the equation is to the true IRR, then the closer you will be to the solution that gives you a NPV of Zero. But in an exam situation all you need to do is apply the formula to get your answer, which will be slightly positive / negative, and if you want, mention that the reason it isn't exactly zero is that the IRR formula used is an approximation...

freeze4real

barneystinson wrote: »

But in an exam situation all you need to do is apply the formula to get your answer, which will be slightly positive / negative, and if you want, mention that the reason it isn't exactly zero is that the IRR formula used is an approximation...

Thanks that's exactly what i needed.

ebayissues

Guys a project be selected based on the IRR if the cash flows are different.

project A has 25000 for 3 years and project B as 20000 for 3yrs and using the interpolation method to try and rank the project using the same discount rate.

hivizman

ebayissues wrote: »

Guys a project be selected based on the IRR if the cash flows are different.

project A has 25000 for 3 years and project B as 20000 for 3yrs and using the interpolation method to try and rank the project using the same discount rate.

You haven't told us what the initial investment is for the two projects, so there isn't enough information to calculate an IRR or an NPV.

However, if the initial investment for Project A is the same as for Project B, and Project A generates cash inflows of 25,000 each year for three years, while Project B generates cash inflows of only 20,000 each year for three years, Project A will always be superior to Project B, as it generates additional cash of £5,000 per year for three years.

ebayissues

hi,
In a theoretical if project A -co is 12500 and project B is 145000.

I have used all the five capital appraisal techniques and now I am using IRR.

They dont have the same cash flow but we are using the same discount rate of lets say 9 and 25% just to estimate on the IRR.

Based on this how would one evaluate/ rank the project.

My initial thought is that if NPV one has to chose the project based on the npv decision.

Is that right ?

sorry i should have explained it clearly