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ACCOUNTING RATE OF RETURN

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.

BREAKING DOWN 'Accounting Rate of Return - ARR'


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.

Accounting Rate of Return Example

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

What is the '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.

Payback Period Example

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.

TIME VALUE OF MONEY

What is the 'Time Value of Money - TVM'

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:

FV = Future value of money

PV = Present value of money

i = interest rate

n = number of compounding periods per year

t = number of years

Based on these variables, the formula for TVM is:

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:

FV = $10,000 x (1 + (10% / 1) ^ (1 x 1) = $11,000

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:

PV = $5,000 / (1 + (7% / 1) ^ (1 x 1) = $4,673

Effect of Compounding Periods on Future Value

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:

Quarterly Compounding: FV = $10,000 x (1 + (10% / 4) ^ (4 x 1) = $11,038


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

Daily Compounding: FV = $10,000 x (1 + (10% / 365) ^ (365 x 1) = $11,052

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

What is 'Future Value - FV'

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.

BREAKING DOWN 'Future Value - FV'

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.

Simple Annual Interest

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.

Compounded Annual Interest

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.

The formula for the FV of an investment earning compounding interest is:

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

What is 'Present Value - PV'

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.

BREAKING DOWN 'Present Value - PV'

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.

The calculation of discounted or present value is extremely important in many financial


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

What is 'Net Present Value - NPV'

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.

The following is the formula for calculating NPV:

where

Ct = net cash inflow during the period t


Co = total initial investment costs

r = discount rate, and

t = number of time periods

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.

BREAKING DOWN 'Net Present Value - NPV'

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.

Drawbacks and Alternatives

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

What is a '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.

BREAKING DOWN 'Fixed 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.

Fixed Costs and Economies of Scale

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.