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The accounting rate of return (ARR) is the amount of profit, or return, an individual can expect

based on an investment made. Accounting rate of return divides the average profit by the initial

investment to get the ratio or return that can be expected. ARR does not consider the time

value of money, which means that returns taken in during later years may be worth less than

those taken in now, and does not consider cash flows, which can be an integral part of

maintaining a business.

Accounting rate of return is also called the simple rate of return and is a metric useful in the

quick calculation of a companys profitability. ARR is used mainly as a general comparison

between multiple projects as it is a very basic look at how a project is doing.

Calculation of Accounting Rate of Return

The accounting rate of return is calculated by dividing the average annual accounting profit by

the initial investment of the project. The profit is calculated using the appropriate accounting

framework including generally accepted accounting principles (GAAP) or international financial

reporting standards (IFRS). The profit calculation includes depreciation and amortization of

project assets. The initial investment is the fixed asset investment plus any changes to working

capital due to the asset. If the project spans multiple years, an average of total revenue per

year or investment per year is used.

The total profit from a project over the past five years is $50,000. During this span, a total

investment of $250,000 has been made. The average annual profit is $10,000 ($50,000/5 years)

and the average annual investment is $50,000 ($250,000/5 years). Therefore, the accounting

rate of return is 20% ($10,000/$50,000).

PAYBACK PERIOD

The payback period is the length of time required to recover the cost of an investment. The

payback period of a given investment or project is an important determinant of whether to

undertake the position or project, as longer payback periods are typically not desirable for

investment positions. The payback period ignores the time value of money, unlike other

methods of capital budgeting, such as net present value, internal rate of return or discounted

cash flow.

BREAKING DOWN 'Payback Period'

Much of corporate finance is about capital budgeting. One of the most important concepts that

every corporate financial analyst must learn is how to value different investments or

operational projects. The analyst must figuring out a reliable way to determine the most

profitable project or investment to undertake. One way corporate financial analysts do this is

with the payback period.

Capital Budgeting and The Payback Period

Most capital budgeting formulas take the time value of money into consideration. The time

value of money (TVM) is the idea that cash in hand today is worth more than it is in the future

because it can be invested and make money from that investment. Therefore, if you pay an

investor tomorrow, it must include an opportunity cost. The time value of money is a concept

that assigns a value to this opportunity cost.

The payback period does not concern itself with the time value of money. In fact, the time value

of money is completely disregarded in the payback method, which is calculated by counting the

number of years it takes to recover the cash invested. If it takes five years for the investment to

earn back the costs, the payback period is five years. Some analysts like the payback method for

its simplicity. Others like to use it as an additional point of reference in a capital budgeting

decision framework.

Assume company A invests $1 million in a project that will save the company $250,000 every

year. The payback period is calculated by dividing $1 million by $250,000, which is four. In other

words, it will take four years to pay back the investment. Another project that costs $200,000

won't save the company money, but it will make the company an incremental $100,000 every

year for the next 20 years, which is $2 million. Clearly, the second project can make the

company twice as much money, but how long will it take to pay the investment back? The

answer is $200,000 divided by $100,000, or 2 years. Not only does the second project take less

time to pay back, but it makes the company more money. Based solely on the payback method,

the second project is better.

The time value of money (TVM) is the idea that money available at the present time is worth

more than the same amount in the future due to its potential earning capacity. This core

principle of finance holds that, provided money can earn interest, any amount of money is

worth more the sooner it is received. TVM is also referred to as present discounted value.

BREAKING DOWN 'Time Value of Money - TVM'

Money deposited in a savings account earns a certain interest rate. Rational investors prefer to

receive money today rather than the same amount of money in the future because of money's

potential to grow in value over a given period of time. Money earning an interest rate is said to

be compounding in value.

Basic Time Value of Money Formula and Example

Depending on the exact situation in question, the TVM formula may change slightly. For

example, in the case of annuity or perpetuity payments, the generalized formula has additional

or less factors. But in general, the most fundamental TVM formula takes into account the

following variables:

i = interest rate

t = number of years

FV = PV x (1 + (i / n)) ^ (n x t)

For example, assume a sum of $10,000 is invested for one year at 10% interest. The future

value of that money is:

The formula can also be rearranged to find the value of the future sum in present day dollars.

For example, the value of $5,000 one year from today, compounded at 7% interest, is:

The number of compounding periods can have a drastic effect on the TVM calculations. Taking

the $10,000 example above, if the number of compounding periods is increased to quarterly,

monthly or daily, the ending future value calculations are:

Monthly Compounding: FV = $10,000 x (1 + (10% / 12) ^ (12 x 1) = $11,047

This shows TVM depends not only on interest rate and time horizon, but how many times the

compounding calculations are computed each year.

FUTURE VALUE

The future value (FV) is the value of a current asset at a specified date in the future based on an

assumed rate of growth over time.

If, based on a guaranteed growth rate, a $10,000 investment made today will be worth

$100,000 in 20 years, then the FV of the $10,000 investment is $100,000. The FV equation

assumes a constant rate of growth and a single upfront payment left untouched for the

duration of the investment.

The FV calculation allows investors to predict, with varying degrees of accuracy, the amount of

profit that can be generated by different investments. The amount of growth generated by

holding a given amount in cash will likely be different than if that same amount were invested

in stocks, so the FV equation is used to compare multiple options.

Determining the FV of an asset can become complicated, depending on the type of asset. In

addition, the FV calculation is based on the assumption of a stable growth rate. If money is

placed in a savings account with a guaranteed interest rate, then the FV is easy to determine

accurately. However, investments in the stock market or other securities with a more volatile

rate of return can present greater difficulty. For the purposes of understanding the core

concept, however, simple and compound interest rates are the simplest examples of the FV

calculation.

The FV calculation can be done one of two ways depending on the type of interest being

earned. If an investment earns simple interest, then the formula is as follows:

FV = I * (1 + (R * T))

where I is the initial investment amount, R is the interest rate and T is the number of years the

investment will be held.

For example, assume a $1,000 investment is held for five years in a savings account with 10%

simple interest paid annually. In this case, the FV of the $1,000 initial investment is $1,000 * (1

+ (0.10 * 5)), or $1,500.

With simple interest, it is assumed that the interest rate is earned only on the initial

investment. With compounded interest, the rate is applied to each year's cumulative account

balance. In the example above, the first year of investment earns 10% * $1,000, or $100, in

interest. The following year, however, the account total is $1,100 rather than $1,000, so the

10% interest rate is applied to the full balance for second-year interest earnings of 10% *

$1,100, or $110.

FV = I * ((1 + R) ^ T)

Using the above example, the same $1,000 invested for five years in a savings account with a

10% compounding interest rate would have a FV of $1,000 * ((1 + 0.10) ^ 5), or $1,610.51.

PRESENT VALUE

Present value (PV) is the current worth of a future sum of money or stream of cash flows given

a specified rate of return. Future cash flows are discounted at the discount rate, and the higher

the discount rate, the lower the present value of the future cash flows. Determining the

appropriate discount rate is the key to properly valuing future cash flows, whether they be

earnings or obligations.

PV is also referred to as the "discounted value." The basis is that receiving $1,000 now is worth

more than $1,000 five years from now, because if you got the money now, you could invest it

and receive an additional return over the five years.

calculations. For example, net present value, bond yields, spot rates, and pension obligations all

rely on the principle of discounted or present value. Learning how to use a financial calculator

to make present value calculations can help you decide whether you should accept a cash

rebate, accept 0% financing on the purchase of a car or pay points on a mortgage.

Future Value

Present value is used in reference to future value and the comparison of present value with

future value best illustrates the principle of time value of money and the need for charging or

paying additional risk-based interest rates. Simply put, the money today is worth more than the

same money tomorrow because the passage of time has financial value attached to it and

rewards or costs are demanded for owning or using today's money. Future value can relate to

future investment cash inflows from investing today's money or future payment outflows from

borrowing today's money.

Discount Rate

The discount rate is the sum of the time value and a relevant interest rate that mathematically

increases future value in nominal or absolute term. Conversely, the discount rate is used to

work out future value in terms of present value, allowing a capital provider or user to settle on

the fair amount of any future earnings or obligations in relation to the present value of the

capital. The word "discount" refers to future value being discounted to present value, as future

value is inflated after adding on to it the time value and associated interest.

Present Value

Present value provides a basis for assessing the fairness of any future financial benefits or

liabilities. For example, a future cash rebate discounted to present value may or may not be

worth having a potentially higher purchase price. The same financial calculation applies to 0%

financing when buying a car. Paying some interest instead on a lower sticker price may work

out better for the buyer than paying zero interest on a higher sticker price. Paying mortgage

points now in exchange for lower mortgage payments later makes sense only if the present

value of the future mortgage savings is greater than the mortgage points paid today.

Net Present Value (NPV) is the difference between the present value of cash inflows and the

present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of a

projected investment or project.

where

Co = total initial investment costs

A positive net present value indicates that the projected earnings generated by a project or

investment (in present dollars) exceeds the anticipated costs (also in present dollars).

Generally, an investment with a positive NPV will be a profitable one and one with a negative

NPV will result in a net loss. This concept is the basis for the Net Present Value Rule, which

dictates that the only investments that should be made are those with positive NPV values.

When the investment in question is an acquisition or a merger, one might also use the

Discounted Cash Flow (DCF) metric.

Apart from the formula itself, net present value can often be calculated using tables,

spreadsheets such as Microsoft Excel or Investopedias own NPV calculator.

Determining the value of a project is challenging because there are different ways to measure

the value of future cash flows. Because of the time value of money (TVM), money in the

present is worth more than the same amount in the future. This is both because of earnings

that could potentially be made using the money during the intervening time and because of

inflation. In other words, a dollar earned in the future wont be worth as much as one earned in

the present.

The discount rate element of the NPV formula is a way to account for this. Companies may

often have different ways of identifying the discount rate. Common methods for determining

the discount rate include using the expected return of other investment choices with a similar

level of risk (rates of return investors will expect), or the costs associated with borrowing

money needed to finance the project.

For example, if a retail clothing business wants to purchase an existing store, it would first

estimate the future cash flows that store would generate, and then discount those cash flows

(r) into one lump-sum present value amount of, say $500,000. If the owner of the store were

willing to sell his or her business for less than $500,000, the purchasing company would likely

accept the offer as it presents a positive NPV investment. If the owner agreed to sell the store

for $300,000, then the investment represents a $200,000 net gain ($500,000 - $300,000) during

the calculated investment period. This $200,000, or the net gain of an investment, is called the

investments intrinsic value. Conversely, if the owner would not sell for less than $500,000, the

purchaser would not buy the store, as the acquisition would present a negative NPV at that

time and would, therefore, reduce the overall value of the larger clothing company.

Let's look at how this example fits into the formula above. The lump-sum present value of

$500,000 represents the part of the formula between the equal sign and the minus sign. The

amount the retail clothing business pays for the store represents Co. Subtract Co from $500,000

to get the NPV: if Co is less than $500,000, the resulting NPV is positive; if Co is more than

$500,000, the NPV is negative and is not a profitable investment.

One primary issue with gauging an investments profitability with NPV is that NPV relies heavily

upon multiple assumptions and estimates, so there can be substantial room for error.

Estimated factors include investment costs, discount rate and projected returns. A project may

often require unforeseen expenditures to get off the ground or may require additional

expenditure at the projects end.

Additionally, discount rates and cash inflow estimates may not inherently account for risk

associated with the project and may assume the maximum possible cash inflows over an

investment period. This may occur as a means of artificially increasing investor confidence. As

such, these factors may need to be adjusted to account for unexpected costs or losses or for

overly optimistic cash inflow projections.

Payback period is one popular metric that is frequently used as an alternative to net present

value. It is much simpler than NPV, mainly gauging the time required after an investment to

recoup the initial costs of that investment. Unlike NPV, the payback period (or payback

method) fails to account for the time value of money. For this reason, payback periods

calculated for longer investments have a greater potential for inaccuracy, as they encompass

more time during which inflation may occur and skew projected earnings and, thus, the real

payback period as well.

Moreover, the payback period is strictly limited to the amount of time required to earn back

initial investment costs. As such, it also fails to account for the profitability of an investment

after that investment has reached the end of its payback period. It is possible that the

investments rate of return could subsequently experience a sharp drop, a sharp increase or

anything in between. Comparisons of investments payback periods, then, will not necessarily

yield an accurate portrayal of the profitability of those investments.

Internal rate of return (IRR) is another metric commonly used as an NPV alternative.

Calculations of IRR rely on the same formula as NPV does, except with slight adjustments. IRR

calculations assume a neutral NPV (a value of zero) and one instead solves for the discount rate.

The discount rate of an investment when NPV is zero is the investments IRR, essentially

representing the projected rate of growth for that investment. Because IRR is necessarily

annual it refers to projected returns on a yearly basis it allows for the simplified comparison

of a wide variety of types and lengths of investments.

For example, IRR could be used to compare the anticipated profitability of a 3-year investment

with that of a 10-year investment because it appears as an annualized figure. If both have an

IRR of 18%, then the investments are in certain respects comparable, in spite of the difference

in duration. Yet, the same is not true for net present value. Unlike IRR, NPV exists as a single

value applying the entirety of a projected investment period. If the investment period is longer

than one year, NPV will not account for the rate of earnings in way allowing for easy

comparison. Returning to the previous example, the 10-year investment could have a higher

NPV than will the 3-year investment, but this is not necessarily helpful information, as the

former is over three times as long as the latter, and there is a substantial amount of investment

opportunity in the 7 years' difference between the two investments.

FIXED COST

A fixed cost is a cost that does not change with an increase or decrease in the amount of goods

or services produced or sold. Fixed costs are expenses that have to be paid by a company,

independent of any business activity. It is one of the two components of the total cost of

running a business, along with variable cost.

A fixed cost is an operating expense of a business that cannot be avoided regardless of the level

of production. Fixed costs are usually used in breakeven analysis to determine pricing and the

level of production and sales under which a company generates neither profit nor loss. Fixed

costs and variable costs form the total cost structure of a company, which plays a crucial role in

ensuring its profitability.

Examples of Fixed Costs

Accountants perform extensive analysis of different expenses to determine whether they are

variable or fixed. Higher fixed costs in the total cost structure of a company require it to achieve

higher levels of revenues to break even. Fixed costs must be incurred regularly, and they tend

to show little fluctuations from period to period. Examples of fixed costs include insurance,

interest expense, property taxes, utilities expenses and depreciation of assets. Also, if a

company pays annual salaries to its employees irrespective of the number of hours worked,

such salaries must be counted as fixed costs. A company's lease on a building is another

common example of fixed costs, which can absorb significant funds especially for retail

companies that rent their store premises.

A business must incur variable and fixed costs to produce a given amount of goods. Variable

costs per item stay relatively flat, and the total variable costs change proportionately to the

number of product items produced. Fixed costs per item decrease with increases in production.

Thus, a company can achieve economies of scale when it produces enough goods to spread the

same amount of fixed costs over a larger number of units produced and sold. For example, a

$100,000 lease spread out over 100,000 widgets means that each widget carries with it $1 in

fixed costs. If the company produces 200,000 widgets, the fixed cost per unit drops to 50 cents.

Companies with large fixed costs and unchanged variable costs in their production process tend

to have the greatest amount of operating leverage. This means that after a company achieves

the breakeven point, all else equal any further increases in sale will produce higher profits in

proportion to sales increase for a company up to a point where fixed costs per unit sold

become negligible. Conversely, decreases in sales volume can produce disproportionately

higher declines in profits. An example of companies with high fixed cost component are utility

companies, which have to make large investments in infrastructure and have subsequently

large depreciation expenses with relatively stable variable costs per unit of electricity produced.

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