Satyajit Mandeville
MCE’s Financial Analyst
1) Accounting Rate of Return – ARR
Disadvantages of ARR:
- The ARR disregards changes in the structure of income over time, so it does not provide for calculating the present value of future cash flows, therefore profitability is overstated.
- The ARR disregards the fact that cash flows change over time. This measure is in particular unsuitable in the situation when it is obvious that cash flows would significantly change during the project.
2) Payback period
Disadvantages of the payback period:
where:
RR – simple rate of return (profit) on capital engaged
Pna – annual net profit
Ia – annual interest on loans
Ca – capital engaged
4) Simple rate of return on equity
where:
RRe – simple rate of return on equity
Pna – annual net profit
Ci – equity
5) Average rate of return
where:
RRa – average simple rate of return
Pna – annual net profit
Ci – capital engaged
These methods take into account:
It requires the knowledge of:
where:
CFi – cash flows in subsequent years i – 1, 2, …, n, equal to the difference of net cash inflows from operating activities and investment outlays,
r – interest rate used for discounting, namely discount rate.
Advantages of NPV:
Disadvantages of NPV:
Calculated in the following stages:
where:
PV – present value (positive) for a low discount rate i1,
NV – net present value (negative) for a high discount rate i2.
1. An absolute value of NV is used in the formula.
2. The discount rates r1 and r2 should not differ from each other by more than one percentage point.
IRR reflects the actual rate of return for the whole project.
MCE’s Financial Analyst
1) Accounting Rate of Return – ARR
Disadvantages of ARR:
- The ARR disregards changes in the structure of income over time, so it does not provide for calculating the present value of future cash flows, therefore profitability is overstated.
- The ARR disregards the fact that cash flows change over time. This measure is in particular unsuitable in the situation when it is obvious that cash flows would significantly change during the project.
2) Payback period
Disadvantages of the payback period:
- Future revenues are not discounted.
- It is focused only on revenues during the payback period. Revenues in subsequent years are disregarded; this method does not determine the way of formulating the criterion based on the payback period (what should be the maximum payback period?).
where:
RR – simple rate of return (profit) on capital engaged
Pna – annual net profit
Ia – annual interest on loans
Ca – capital engaged
4) Simple rate of return on equity
where:
RRe – simple rate of return on equity
Pna – annual net profit
Ci – equity
5) Average rate of return
where:
RRa – average simple rate of return
Pna – annual net profit
Ci – capital engaged
These methods take into account:
- Estimation of total investment outlays.
- Identifying sources of outlays financing.
- Determining total manufacturing costs and inflows from operating activities.
- Discounting cash flows and calculating NPV or IRR
It requires the knowledge of:
- Total future inflows and outflows in individual years during the functioning of the project in order to determine cash flows.
- Period of the cash flows (determining the time horizon of the analysis).
- Proper discount rate.
NPV = CF1(1 + r)-1 + CF2(1 + r)-2 + … CFn(1 + r)-n
where:
CFi – cash flows in subsequent years i – 1, 2, …, n, equal to the difference of net cash inflows from operating activities and investment outlays,
r – interest rate used for discounting, namely discount rate.
Advantages of NPV:
- Selective method; it takes into account the whole period of the project and the cash flow schedule.
Disadvantages of NPV:
- Difficulty in selecting the proper level of the discount rate.
- It does not reflect the profitability of the project in a precise way.
- The discount rate should be related to the average interest rate for long-term loans on the capital markets or the interest rate paid by the borrower. It should be a minimum rate ensuring the profit below which an entrepreneur would not achieve any benefits from investments in a given sector.
Calculated in the following stages:
- Preparation of the cash flow table for all the years subject to the calculation.
- Accepting the discount rate level and calculating the present value.
- Carrying out calculations for a higher level of the discount rate, if the obtained updated value is positive,
- When the NPV remains positive at higher discount rate, the discount rate is increased until obtaining negative NPV. If NPV is negative, IRR remains within the range between the discount rate for which the NPV is positive and the discount rate for which the NPV is negative.
where:
PV – present value (positive) for a low discount rate i1,
NV – net present value (negative) for a high discount rate i2.
1. An absolute value of NV is used in the formula.
2. The discount rates r1 and r2 should not differ from each other by more than one percentage point.
IRR reflects the actual rate of return for the whole project.
