Chapter 24, Problem 4BTN

To determine

Memo:

To: The Manager

From: ABC

Subject: To identify the measurement basis and unit that the payback period, accounting rate of return, net present value, and internal rate of return offers and the advantages and disadvantages of each method.

Explanation:

Payback period:

Payback period is a type of capital budgeting technique which describes the number of year or length of time required for proposals cumulative cash inflow to be equal to its cash outflow.

It is measured in periods and on the basis of cash flows.

The advantages of the method are as follows:

It is easy to understand.

It allows comparison of projects.

The disadvantages of payback period are as follows:

It ignores the time value of money.

It ignores cash flows after payback period.

Accounting rate of return:

Accounting rate of return is a type of capital budgeting technique which is based on accounting principle of return on investment. It is the annualized net income received on the average number of funds invested in a project.

It is measured in percentage and on the basis of accrual income.

The advantages of the method are as follows:

It is easy to understand.

It allows comparison of projects.

The disadvantages of payback period are as follows:

It ignores the time value of money.

It ignores the annual rates over the life of the project.

Net present value:

Net present value can be referred to as a discounted cash flow technique which is applied to weight the items of trade-off between investment and future returns. It is the sum of the present value of all the cash inflows less the sum off present value of all cash outflow. Hence, it is the sum of all the discounted value of cash flows of the project.

It is measured in dollars and on the basis of cash flows and profitability.

The advantages of net present value are as follows:

It reflects time value of money.

It reflects different risk levels over project’s life.

The disadvantage of net present value is difficult to compare dissimilar projects.

Internal rate of return:

Internal rate of return (IRR) can be defined as the yield or the rate of return earned by a project. It is that rate of return which a project earns. It is the rate of return at which present value of cash inflows is equal to the present value of cash outflows. In other words, at IRR the net present value equals zero.

The advantages of internal rate of return are as follows:

It reflects time value of money.

It allows comparisons of dissimilar projects.

The disadvantage of internal rate of return is that it ignores varying risk levels over life of the project.