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Internal Rate of Return Example

Initial investment is $303,280.

Useful life is five years.

Net cash inflows is $80,000 per year.

What is the IRR of this project?

$303,280 ÷ $80,000 = 3.791 (PV annuity factor)

10% (from the table, five-period line)

©2003 Prentice Hall Business Publishing,

*Cost Accounting 11/e,*

Horngren/Datar/Foster

21 - 1

Comparison of NPV and IRR

The NPV method has the advantage that the end result of the computations is expressed in dollars and not in a percentage.

Individual projects can be added.

It can be used in situations where the required rate of return varies over the life of the project.

©2003 Prentice Hall Business Publishing,

*Cost Accounting 11/e,*

Horngren/Datar/Foster

21 - 2

Comparison of NPV and IRR

The IRR of individual projects cannot be added or averaged to derive the IRR of a combination of projects.

©2003 Prentice Hall Business Publishing,

*Cost Accounting 11/e,*

Horngren/Datar/Foster

21 - 3

**Use and evaluate the payback method.**

©2003 Prentice Hall Business Publishing,

*Cost Accounting 11/e,*

Horngren/Datar/Foster

21 - 4

Payback Method

*Payback*

measures the time it will take to recoup, in the form of expected future cash flows, the initial investment in a project.

©2003 Prentice Hall Business Publishing,

*Cost Accounting 11/e,*

Horngren/Datar/Foster

21 - 5

Payback Method Example

Assisted Living is considering buying Machine 1.

Initial investment is $210,000.

Useful life is eleven years.

Estimated residual value is zero.

Net cash inflows is $35,000 per year.

©2003 Prentice Hall Business Publishing,

*Cost Accounting 11/e,*

Horngren/Datar/Foster

21 - 6

Payback Method Example

How long would it take to recover the investment?

$210,000 ÷ $35,000 = 6 years

Six years is the payback period.

©2003 Prentice Hall Business Publishing,

*Cost Accounting 11/e,*

Horngren/Datar/Foster

21 - 7

Payback Method Example

Suppose that as an alternative to the $210,000 piece of equipment, there is another one

(Machine 2) that also costs $210,000 but will save $42,000 per year during its

*five-year life*

.

What is the payback period?

$210,000 ÷ $42,000 = 5 years

Which piece of equipment is preferable?

©2003 Prentice Hall Business Publishing,

*Cost Accounting 11/e,*

Horngren/Datar/Foster

21 - 8

Payback Method Example

Assisted Living is considering buying Machine 3.

Initial investment is $250,000.

Useful life is eleven years.

Cash savings are $160,000, $180,000, and $110,000 over its life.

What is the payback period?

©2003 Prentice Hall Business Publishing,

*Cost Accounting 11/e,*

Horngren/Datar/Foster

21 - 9

Payback Method Example

Year 1 brings in $160,000.

Recovery of the amount invested occurs in Year 2.

©2003 Prentice Hall Business Publishing,

*Cost Accounting 11/e,*

Horngren/Datar/Foster

21 - 10

Payback Method Example

**=**

**=**

**+**

**÷**

Payback = 1 year

$ 90,000 needed to complete recovery

180,000 net cash inflow in Year 2

1 year + 0.5 year

1.5 years or 1 year and 6 months

©2003 Prentice Hall Business Publishing,

*Cost Accounting 11/e,*

Horngren/Datar/Foster

21 - 11

**Use and evaluate the accrual accounting rate-of-return**

**(AARR) method.**

©2003 Prentice Hall Business Publishing,

*Cost Accounting 11/e,*

Horngren/Datar/Foster

21 - 12

Accrual Accounting

Rate-of-Return Method

The accrual accounting rate-of-return (AARR) method divides an accounting measure of income by an accounting measure of investment.

AARR

=

Increase in expected average annual operating income

÷

Initial required investment

©2003 Prentice Hall Business Publishing,

*Cost Accounting 11/e,*

Horngren/Datar/Foster

21 - 13

Accrual Accounting

Rate-of-Return Method Example

Initial investment is $303,280.

Useful life is five years.

Net cash inflows is $80,000 per year.

IRR is 10%.

What is the average operating income?

©2003 Prentice Hall Business Publishing,

*Cost Accounting 11/e,*

Horngren/Datar/Foster

21 - 14

Accrual Accounting

Rate-of-Return Method Example

Straight-line depreciation is $60,656 per year.

Average operating income is

$80,000 – $60,656 = $19,344.

What is the AARR?

AARR

= ($80,000 – $60,656) ÷ $303,280

= .638, or 6.4%

©2003 Prentice Hall Business Publishing,

*Cost Accounting 11/e,*

Horngren/Datar/Foster

21 - 15

**Identify and reduce conflicts from using DCF for capital budgeting decisions and accrual accounting for performance evaluation.**

©2003 Prentice Hall Business Publishing,

*Cost Accounting 11/e,*

Horngren/Datar/Foster

21 - 16

Performance Evaluation

A manager who uses DCF methods to make capital budgeting decisions can face goal congruence problems if AARR is used for performance evaluation.

Suppose top management uses the AARR to judge performance if the minimum desired rate of return is 10%.

A machine with an AARR of 6.4% will be rejected.

©2003 Prentice Hall Business Publishing,

*Cost Accounting 11/e,*

Horngren/Datar/Foster

21 - 17

Performance Evaluation

The conflict between using AARR and

DCF methods to evaluate performance can be reduced by evaluating managers on a project-by-project basis.

©2003 Prentice Hall Business Publishing,

*Cost Accounting 11/e,*

Horngren/Datar/Foster

21 - 18

©2003 Prentice Hall Business Publishing,

*Cost Accounting 11/e,*

Horngren/Datar/Foster

21 - 19