A. The accounting rate of return is a ratio of the amount of increased book income to the required investment. It is calculated as follows: Increase in Expected Annual Average After Tax Accounting Net Income ÷ Net Initial Investment. Sometimes the average investment figure is used rather than the total investment. Since this method uses accrual accounting income, it includes depreciation. However, it does not take into account the time value of money.
B. The net present value method is used to determine the difference between the present value of all future cash inflows and the present value of all (the initial as well as all future) cash outflows, using the required rate of return. A project with a positive NPV is acceptable. It does not utilize a division of the project's annual after-tax net income by the average investment cost to measure the estimated performance of a capital investment.
C. The internal rate of return is the discount rate at which the NPV of an investment will be equal to 0, or the discount rate at which the present value of the expected cash inflows from a project equals the present value of the expected cash outflows. If the IRR is higher than the company's minimum desired rate of return, the project is acceptable. The IRR does not utilize a division of the project's annual after-tax net income by the average investment cost to measure the estimated performance of a capital investment.
D. The Payback Method is used to determine the number of periods that must pass before the net after-tax cash inflows from the investment will equal (or "pay back") the initial investment cost. If the incoming cash flows are constant over the life of the project, the payback period may be calculated with a simple division as follows: Initial net investment Periodic constant expected cash flow If the cash flows are not constant over the life of the project, the Payback Period is calculated by adding up the cash inflows and determining on a cumulative basis when the inflows equal the outflows. The Payback Method does not utilize a division of the project's annual after-tax net income by the average investment cost to measure the estimated performance of a capital investment.
