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Chapter 3:

1. What 3 things does the DuPont identity chart tell you and define them?

a. DuPont identity equation allows us to break up ROE (return on equity) into three
components
1. Operating efficiency which is measured by profit margin
2. Asset use efficiency which is measured by total asset turnover
3. and Financial leverage which is measured by the equity multiplier

DuPont Analysis: benefits of DuPont chart allow us to see an overall picture of a companies
performance and allowing us to determine possible items to improve.

Benefits of DuPont chart:
1. Allows us to examine several ratios at once thereby giving us a better overall picture of
the companys performance and allowing us ways to determine items to improve
2. The chart shows us clearly what areas we can focus on where we can improve
profitability
3. The left hand side of the chart is related to profitability. If we want to focus on
profitability and where to look for costs of goods sold, and general expenses they are
shown on the left side.
4. On the right side of the DuPont chart we are able to see an analysis of key factors
underlying total asset turnover. We can tell if we need to reduce inventory through more
efficient management reduces current assets which reduces total assets which then
improves total asset turnover.


2. Internal and sustainable growth rate
Internal Growth Rate: how quickly the firm can grow using it's own funds (how fast the firm
can grow by relying on internal financing).

Sustainable Growth Rate: the maximum possible growth rate for a firm that maintains a
constant debt ratio and doesnt sell new stock.

Determinants of Growth: ROE can be written as the product of three factors:

ROE = profit margin x total asset turnover x equity multiplier

A firms ability to sustain growth depends on four explicit factors:

1. Profit Margin: An increase in profit margin will increase the firms ability to generate
funds internally and thereby increase it's sustainable growth
2. Total Asset Turnover: an increase in the firms total asset turnover increases the sales
generated for each dollar in assets. This decreases the firms need for new assets as sales
grow and thereby increases the sustainable growth rate.
3. Financial Policy: an increase in the debt equity ratio increases the firms financial
leverage. Since this makes additional debt financing available, it increases the sustainable
growth rate.
4. Dividend Policy: a decrease in the percentage of net income paid out as dividends will
increase the retention ratio. These increases internally generate equity and thus increases
internal and sustainable growth.
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Purpose of sustainable growth rate: what does it illustrate?

1. Shows the relationship between the firms operating efficiency as measured by profit
margin
2. Its asset use efficiency as measured by total asset turnover
3. Its financial policy as measured by the debt-equity ratio
4. Its dividend policy as measured by the retention rate

Why is the sustainable growth rate likely to be larger than the internal growth rate?
Always likely that the sustainable growth will be larger than the internal growth rate
because as the firm grows it will have to borrow additional funds if it is to maintain
a constant debt ratio. The new borrowing is an extra source of financing in addition
to internally generated funds, so the corporation can expand more rapidly.


3. 3.5 Ratios no #1 or #4




4. What do income statement ratios stand for

Common-size financial statements provide the financial manager with a ratio analysis of the
company. The common-size income statement can show, for example, that cost of goods sold as a
percentage of sales is increasing. The common-size balance sheet can show a firms increasing
reliance on debt as a form of financing.

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5. What are 3 kinds of financial ratios?

a. Long term solvency or financial leverage ratios: these types of ratios are intended
to address the firms long run ability to meet its financial leverage obligations. Three
commonly used measures and some variations are used:
i. Total debt ratio: takes into account all debts of all maturities to all creditors
ii. Times interest earned: this ratio measures how well a company has it's
interest obligations covered
iii. Cash Coverage:
b. Asset utilization or turnover ratios
c. Market value ratios

6. Common Size Balance Sheet what do common size balance sheet stand for?

The common size balance sheet is a standardized financial statement presenting all items in
percentage terms. Balance sheet items are shown as percentage of assets and income statement
items as percentage of sales. Common size balance sheets help standardize sheets to help make
comparisons with other similar companies. By working with percentages instead of dollars,
making the statements easier to read and making comparisons with similar companies easier.


6. What are some uses for financial statements?

Internal Uses:
1. Performance evaluations
2. Planning for the future
3. Checking predictions/assumptions made for the future

External Uses:
1. Evaluate suppliers
2. Potential investors to decide whether or not to invest in this company
3. Credit rating companies use these financial statements to determine credit worthiness
before extending credit
4. Also helps us determine who our main competitors are so we can decide whether or not
to launch a new product
5. Also helps us target companies if we are thinking of acquiring other firms. Financial
statement information would be essential in finding potential targets and deciding what to
offer them.


Chapter 6:


YTM

Yield to maturity (YTM), of a bond is the internal rate of return (IRR overall interest rate) earned
by an investor who buys the bond today at the market price, assuming that the bond will be held
until maturity, and that all coupon and principal payments will be made on schedule.

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YTM is a complex but accurate calculation of a bonds return that helps investors
compare bonds with different maturities and coupons.
Yield to maturity accounts for the present value of a bonds future coupon payments. In
other words, it factors in the time value of money, whereas a simple current yield
calculation does not.
An approximate YTM can be found by using a bond yield table. However, because
calculating a bond's YTM is complex and involves trial and error (guessing and
checking), it is usually done by using a business or financial calculator or a computer
program
YTM is the interest rate an investor would earn by investing every coupon payment from
the bond at a constant interest rate until the bonds maturity date.
The present value of all of these future cash flows equals the bonds market price.

What is the Treasury Yield Curve?
Is a curve showing several yields or interest rates across different contract lengths for a similar
bond. The curve shows the relationship between the interest rate (cost of borrowing) and the time
of maturity. Treasury yields depend on three things:
1. the real rate
2. the expected future inflation
3. and the interest rate risk premium

What are the six components that make up a bonds yield?

Bond Yields represent the combined effect of no less than 6 things:
1. The real rate of interest; on top of this is five premiums representing compensation for;
2. Expected future inflation
3. Interest rate risk
4. Default risk
5. Taxability
6. Lack of liquidty
7. As a result, determining the appropriate yield on a bond requires careful analysis of each
of these effects.

PROTECTIVE COVENANTS

WHAT ARE PROTECTIVE COVENANTS?

Protective Covenants: is a part of the indenture or loan agreement that limits certain actions a
company might otherwise wish to take during the term of the loan, usually to protect the
lendor.

2 types of protective covenants:
1. Positive (affirmative covenants) thou shall/shalt type of covenant
2. Negative: thou shall not covenant
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5 types of each:

Negative covenants: thou shall not it limits or prohibits actions that the company might take:
1. firm must limit the amount of dividends it pays according to some formula
2. the firm cannot pledge any assets to other lenders
3. firm cannot merge with another firm
4. firm cannot sell or lease any major assets without approval by the lender
5. firm cannot issue additional long term debt

Positive covenants: thou shall type of covenant. It specifies an action that the company agrees to
take or a condition the company must abide by.
1. company must maintain working capital at or above some specified minimum level
2. the company must periodically furnish audited financial statements to the lender
3. The firm must maintain any collateral or security in good condition

**These are only examples there are definitely more that can be included.

What is an indenture?
Is a written agreement between the corporation and the lender detailing the terms of the debt at
issue. This is a legal document that runs hundreds of pages long and generally makes for very
tedious reading. It is an important document because it includes all the details of the bond. See
page 178.

The bond indenture is a legal document that includes the following provisions:
1. the basic terms of the bond
2. the total amount of bonds issued
3. a description of property used as security
4. the repayment arrangements
5. the call provisions
6. details of the protective covenants

Inverse relationship between bonds and interest rates:

Bonds and interest rates have an inverse relationship. In other words, bond prices rise
when interest rates fall, and bond prices fall when interest rates rise. This is because
investors are constantly comparing the returns on their current investments and what they
could get elsewhere in the market. As market interest rates change a bonds coupon rate
which is fixed becomes more or less attractive to investors.

When you buy a bond, either directly or through a mutual fund, you're lending money to
the bond's issuer, who promises to pay you back the principal/par/face value when the
loan is due (on the bond's maturity date). In the meantime, the issuer also promises to pay
you periodic interest payments to compensate you for the use of your money. The rate at
which the issuer pays you the bond's stated interest rate or coupon rate is generally
fixed at issuance.

When new bonds are issued, they typically carry coupon rates at the prevailing market
interest rate. Interest rates and bond prices have what's called an "inverse relationship"
meaning, when one goes up, the other goes down.

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When interest rates rise, the price of a bond will decline.
When interest rates fall, the price of a bond will rise.


Suppose the ABC company offers a new issue of bonds carrying a 7% coupon. This means it
would pay you $70 a year in interest. After evaluating your investment alternatives, you decide
this is a good deal, so you purchase a bond at its par value, $1,000.1

What if Rates Go Up?
Rate Interest Rate/Bond Price Relationship
Now let's suppose that later that year, interest rates in general go up. If new bonds costing
$1,000 are paying an 8% coupon ($80 a year in interest), buyers will be reluctant to pay you
face value ($1,000) for your 7% ABC bond. In order to sell, you'd have to offer your bond
at a lower price a discount that would enable it to generate approximately 8% to the
new owner. In this case, that would mean a price of about $875.1

What if Rates Fall?
Similarly, if rates dropped to below your original coupon rate of 7%, your bond would be worth
more than $1,000. It would be priced at a premium, since it would be carrying a higher interest
rate than what was currently available on the market.1
Of course, many other factors go into determining the attractiveness of a particular bond: the
length of time until the bond matures, whether or not its interest is taxable, the creditworthiness of
its issuer, the likelihood that the issuer will pay off debt early, and more.

What Type Of bonds are not affected In A Rising Interest Rate Environment?

There are two types of bonds which may not go down when interest rates rise. Both floating rate
bonds funds and inflation-adjusted bond funds will fare well in a rising interest rate
environment, because the interest payments on these types of bonds will adjust.

In addition, if you own individual bonds rather than bond funds and plan to hold your bonds to
maturity, then you will not need to be concerned about changes in interest rates as you have no
plans to sell your bond so it's interim price is irrelevant to you.


GOVERNMENT BONDS V. FLOATING-RATE BONDS:

Different types of bonds:
1. Plain vanilla corporate bonds
2. Government bonds: issued by uncle sam, these are coupon bonds that are sold when the
government wishes to borrow money for more than one year it sells treasury notes and
bonds to the public.
a. U.S. Treasury issues unlike essentially other bonds have no default risk because (we
hope) that the government can always come up with the $$ to make the payments.
b. Treasury issues are exempt from state income taxes (not federal income tax)
therefore the coupons you receive on a Treasury note or bond are only taxed at the
federal level.
c. Highly liquid, taxable, and default free
3. Zero coupon bonds: a bond that makes no coupon payments and thus is initially priced at
a deep discount.
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4. Floating rate bonds: also known as floaters the coupon payments are adjustable. Most
other bonds are fixable dollar obligations because the coupon rate is set as fixed
percentage of the par value.
5. All other types of bonds too many to name

Gov Bonds v. Floating rate Bonds:

1. Floating rate bonds: the coupon payments are adjustable
2. The adjustments are tied to an interest rate index such as the treasury bill interest rate or
the 30 year treasury bond rate
3. Floating bond rate depends on exactly how the coupon payments are defined

Rights holder of floating rate bonds:
1. The holder of the bond has the right to redeem the note at par on the coupon payment
date after some specified amount of time. This is called put provision, and it is discussed
in the following section.
2. The coupon rate has a floor and a ceiling meaning that the coupon is subject to a
minimum and a maximum. In this case, the coupon rate is said to be capped and the
upper and lower rates are sometimes called the collar.
3. An interesting type of floating rate bond is called the inflation linked bond which are
adjusted according to the rate of inflation. The US treasury began issuing such
bonds in January 1997. The issues are sometimes called TIPS or treasury inflation
protection securities.



WHAT IS THE DIFFERENCE BETWEEN A NOTE, BOND, AND BILL?

1. Treasury Bills, as the table "Treasury Securities at a Glance" indicates, are short-term
instruments with maturities of no more than one year. They fill investment needs similar
to money market funds and savings accounts. They could be a place to "hold" money an
investor may need to be able to access quickly, for example in the event of an emergency.
The Treasury bill market is highly liquid; investors can quickly convert bills to cash
through a broker or bank. Treasury bills function like zero-coupon bonds, which do not
pay periodic interest payments. Investors buy bills at a discount from the par, or face
value, and then receive the full amount when the bill matures. For example, an individual
could buy a 26-week bill that pays the full $1,000 at maturity for $970.28 at the time of
purchase, effectively earning an annualized yield of 6.28% on the investment.
2. Treasury Notes are intermediate- to long-term investments, typically issued in maturities
of two, three, five, seven and 10 years. These are typically purchased for specific future
expenses, such as college tuition, or used to generate cash flow during retirement. Interest
is paid semi-annually.
3. Treasury Bonds cover terms of longer than 10 years, and are currently being issued in
maturities of 30 years. Interest is also paid semi-annually.


Fisher Effect:

Fisher Effect: the relationship between nominal returns, real returns, and inflation.
Named after the great economist Irving Fisher
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Investors are ultimately concerned what they can actually buy with their money, they
require compensation for inflation
Formula is: 1+ R = (1 + r ) x (1 + h )
Real rate = the nominal interest rate expected inflation.
Or easier way to see it

Nominal rate the inflation rate = the real rate

The Fisher effect can be seen each time you go to the bank; the interest rate an investor
has on a savings account is really the nominal interest rate. For example, if the nominal
interest rate on a savings account is 4% and the expected rate of inflation is 3%, then
money in the savings account is really growing at 1%. (4% nominal 3% inflation rate =
1% as the real rate. The smaller the real interest rate the longer it will take for savings
deposits to grow substantially when observed from a purchasing power perspective.



Fisher effect states that the real interest rate equals the nominal interest rate minus the expected
inflation rate. Therefore, real interest rates fall as inflation increases, unless nominal rates
increase at the same rate as inflation.


Chapter 8: NPV and other investment criteria

In real world situations, a company may have a choice of investing in several competing projects at the
same time while resources may be sufficient for one. Both IRR & MIRR fail to capture the Present
Value of money and are hence called Internal Rates! The best method must factor Internal Return as
well as the Cost of Capital to determine Present Value. The Net Present Value (NPV) method aims to
capture both and hence is the preferred choice by managers all over the world.

Investment Criteria:

Net present value (NPV)
The payback rule (PR)
The average accounting return (AAR)
The internal rate of return (IRR)
The profitability index (PI)
The practice of capital budgeting


1. What is Discounted Cash Flow? DCF





2. Summary of investment criteria chart page 261



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3. What are the advantages and disadvantages of PI?

A profitability index attempts to identify the relationship between the costs of a project
and the benefits or profits of that project. . A PI greater than 1.0 indicates that
profitability is positive, while a PI of less than 1.0 indicates that the project will lose
money. As values on the profitability index increase, so does the financial attractiveness
of the proposed project.
A profitability index of 1.1 implies that for every $1 of investment, we create an
additional $0.10 in value.
This measure can be very useful in situations where we have limited capital.
Decision rule: If PI > 1.0 Accept

Formula: Profitability index is an investment appraisal technique calculated by taking the present
value of future cash flows of a project and dividing it by the initial investment required for the
project.
Example: Company C is undertaking a project at a cost of $50 million which is expected to
generate future net cash flows with a present value of $65 million. Calculate the profitability
index.

Solution
Profitability Index = PV of Future Net Cash Flows / Initial Investment Required
Profitability Index = $65M / $50M = 1.3
Net Present Value = PV of Net Future Cash Flows Initial Investment Rquired
Net Present Value = $65M-$50M = $15M.


Advantages
Closely related to NPV, generally leading to identical decisions
Easy to understand and communicate
May be useful when available investment funds are limited
Disadvantages
May lead to incorrect decisions in comparisons of mutually exclusive investment

4. Why do we aim for a 0 NPV?

NPV allows us to assess the profitability of a proposed investment. NPV compares the
present value of money today to the present value of money in the future. NPV is a great
indicator of how much value an investment or project will add to the firm. Aiming for a
zero NPV means that the investment earns a rate of return equal to the discount rate. This
means that the investment will remain neutral and will not increase or decrease the value
of the firm. Of course positive NPV investments are better, but if there arent any positive
NPV projects, zero NPV projects are good to take up because the project will return
exactly the required rate of return.

NPV is the present value of future revenues minus the present value of future costs. It is
a measure of wealth creation relative to the discount rate. So a negative or zero NPV
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does not indicate no value. Rather, a zero NPV means that the investment earns a rate
of return equal to the discount rate. If you discount the cash flows using a 6% real rate
and produce a $0 NPV, then the analysis indicates your investment would earn a 6% real
rate of return.

The larger the NPV, the more financial value the project adds to our company; NPV
gives us the project amount of value that a project will add to our company. Projects with
a positive NPV add value, and should be accepted. Projects with negative NPVs destroy
value, and should be rejected. It is generally regarded as the single best criterion for
screening projects.

NPV is the sum of the present values of projects cash flows. NPV specifically measures
(after considering the time value of money) the net increase or decrease in the firms
wealth due to accepting or rejecting the project. The decision rule of the NPV is to accept
projects that have a positive NPV (or that will add value to the firm) and reject projects
with a negative NPV (or that will take value from the firm) NPV is superior to the other
methods of investment analysis because it does not have any major flaws. The NPV can
differentiate between projects based on scale, and time horizon. The only major drawback
f the NPV is that it relies on cash flow and discount rates that are often estimates and not
certain. This problem is also shared by other performance criterias as well.

If the NPV is greater than zero (NPV > 0) than accept the project
If the NPV is less than zero (NPV < 0) than reject the project.
If we have more than one project accept the highest NPV project from mutually
exclusively projects


5. Definition MIRR v. IRR

IRR: INTERNAL RATE OF RETURN

Most important alterative to the NPV
Universally known as the IRR
With the IRR we try to find a single rate of return that summarizes the merits of a project
IRR is beneficial because we want this rate to be an internal rate in the sense that it
only depends on the cash flows of a particular investment, not on the rates offered
elsewhere.
Based on the IRR rule an investment is acceptable if the IRR exceeds the required
return. It should be rejected otherwise.

Problems with IRR:
1. Cash flows are not conventional
2. Difficult to compare two investments to see which one is best
3. Whats the return can become difficult to answer

Positives:
1. People like IRR because it talks about rates of returns and not dollar values.
2. Also provides a simple way of communicating information about a proposal
3. Easier to say remodeling the clerical wing has a 20% return rather than saying at a 10%
discount rate the net present value is 4000.
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4. IRR is simpler because we can still estimate the IRR even if we dont know the
appropriate discount rate. We could not calculate the NPV without knowing the
discount rate.
5. For the IRR if we knew the required return for an investment but we did not know the
appropriate discount rate, we could still calculate the IRR.

Advantages
1. Knowing a return is intuitively appealing
2. It is a simple way to communicate the value of a project to someone who doesnt
know all the estimation details
3. If the IRR is high enough, you may not need to estimate a required return, which
is often a difficult task
Disadvantages
1. Can produce multiple answers
2. Cannot rank mutually exclusive projects
3. Reinvestment assumption flawed

MODIFIED INTERNAL RATE OF RETURN (MIRR)
To address some of the problems that come up with the standard IRR it is often proposed
that a modified version be used
1. The discounting approach
2. The reinvestment approach
3. The combination approach

MIRR v. IRR: which one is better?!

The modified internal rate of return is a financial measure of an investments attractiveness.
1. Some critics refer to the MIRR as the meaningless internal rate of return
2. Different ways of calculating MIRR which may lead to problems
3. Not clear how to interpret a MIRR
4. It may look like a rate of return on a modified set of cash flows, not the project
actual cash flows
5. Because an MIRR depends on an externally supplied discount rate the
answer you get is not truly an internal rate of return, which depends on only
the projects cash flows. This leads to an unrealistic optimistic picture of the
projects under review.



6. What are differences between AAR and Payback Period?

PAYBACK PERIOD RULE (PB) V. AAR (AVERAGE ACCOUNTING RETURN)


Payback Rule: the amount of time required for an investment to generate cash flows
sufficient to recover its initial cost. In other words, the payback is the length of time to
recover our initial investment or get our bait back or to break even. The payback rule asks
the wrong questions it should be more focused on what impact an investment will have
on the value of our stock, and not how long it takes to recover the initial investment. For
example, a $1000 investment which returned $500 per year would have a 2 year payback
period.
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The major shortcomings associated with the payback period is that it
1. Ignores the time value of money. By ignoring time value we are lead to take
investments that are worth less than what they cost.

2. In addition, the selection of a hurdle point for payback period is arbitrary exercise
that lacks any rule or method.

3. The payback period is also biased towards short-term projects that may lead the firm
to give up more profitable long term projects.

4. Using a payback period rule will tend to bias us towards shorter-term investments
which may not be profitable to the firm in the long run.

5. Payback rule also fails to consider risk differences. The payback rule is calculated in
the same way for both risky and safe projects which produces an unrealistic result.

6. Further, the payback period fully ignores any cash flows that occur after the cutoff
point.
7. Payback rule is calculated simply by adding up the future cash flows there is no
discounting involved so the time value of money is completely ignored.

8. Payback rule doesnt have a right cutoff period we dont have an objective basis for
choosing a particular number.
9. No economic rationale for looking at payback in the first place

Despite its major shortcomings, payback rule is often used because (Positives)
(1) its analysis is straight forward and simple which is used by large and
sophisticated corporations when they are making minor decisions
(2) Some decisions do not require detailed analysis and the payback rule and the
costs of conducting a full-fledge analysis would exceed the loss from a
mistake.
(3) Accounting numbers and estimates are readily available
(4) Since payback is biased towards liquidity it may be a useful analysis method
for short-term projects where cash management is most important.
(5) An investment that pays back rapidly and has some benefits the cutoff period
probably has a positive NPV.
(6) Small investment decisions are made 100s of times every day in large
organizations not enough time to conduct full analysis and it's not
uncommon for those small corporations to require a two year payback period
on all investments less than $10,000.
(7) Larger investments are subject to more scrutiny and do not use the payback
rule

Payback rule has other positive features:
1. because it is biased towards short term projects therefore biased towards liquidity
2. favors investments that free up cash for others to use more quickly
3. the cash flows that are expected to occur later in a projects life are probably more
uncertain
4. payback rule is more intuitive and easier to understand

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How many years do we have to wait until the accumulated cash flows from this
investment equal or exceed the cost of the investment? As Figure 8.2 indicates, the initial
investment is $50,000. After the first year, the firm has recovered $30,000, leaving
$20,000 outstanding. The cash flow in the second year is exactly $20,000, so this
investment pays for itself in exactly two years. Put another way, the payback period(or
just payback) is two years. If we require a payback of, say, three years or less, then this
investment is acceptable. This illustrates the payback period rule:
Based on the payback rule, an investment is acceptable if its calculated payback period is
less than some pre-specified number of years.


Summary of payback rule:
kind of breakeven measure
length of time to break even in an accounting sense but not an economic sense
the rule asks the wrong questions should be more focused on what impact an
investment will have on the value of our stock, and not how long it takes to recover the
initial investment

Advantages
o Easy to understand
o Adjusts for uncertainty of later cash flows
o Biased towards liquidity
Disadvantages
o Ignores the time value of money
o Requires an arbitrary cut-off point
o Ignores cash flows beyond the cut-off date
o Biased against long-term projects, such as research and development, and new
projects

AAR

AAR: Average Accounting Return: is an attractive, but fatally flawed accounting method
used for the purposes of comparison with other capital budgeting calculations, such as NPV, PB
period and IRR.

To find AAR, first, determine the average net income of each year of the project's life. Second,
determine the average investment, taking depreciation into account. Third, determine the AAR by
dividing the average net income by the average investment.

The benefits of the AAR are that it provides a quick estimate of a projects worth over its life.
Calculating AAR is easy to calculate and accounting numbers are readily available from the firms
accounting system.


The AARs major drawbacks/ negatives are that it ignores the time value of money. By
ignoring the time value of money, the capital investment under consideration will appear to have
a higher level of return than what will happen in reality. The capital investment may appear to be
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more lucrative than alternative investments, (such as investing in the financial markets), when it
is actually less lucrative. Thus, it is not a rate of return meaningful economic sense.

Second problem with the AAR is similar to a problem we have with the payback period rule
concerning the lack of an objective cutoff period.

Third, the AAR doesnt even look at the right things. Instead of looking at the cash flow and
market value, it uses net income and book value. As a result of this, AAR doesnt tell us what the
effect on share price will be by taking on a new investment, so it doesnt tell us what we really
want to know.

Formula: net income (after taxes and depreciation) / book value
Formula: net income divided by book value.

The book value as long as we use straight-line depreciation and a zero salvage value,
the average investment will always be of the initial investment.
Purchasing a new business: net income is 50,000 / $250,000 (half of 500k using straight
line depreciation) = 20%
Thus the AAR return rule is: based on the average accounting return rule, a project is
acceptable if it's average accounting return exceeds a target average accounting return.
Accept the project with the highest ARR.
Here is a simple example of an ARR calculation: A project requiring an average
investment of $1,000,000 and generating an average annual profit of $150,000 would
have an ARR of 15%.

While ARR is easy to calculate and can be used to gauge the results of other capital budgeting
calculations, it is not the most accurate metric.


AAR:

Advantages
Easy to calculate
Needed information usually available
Disadvantages
Not a true rate of return
Time value of money ignored
Uses an arbitrary benchmark cut-off rate
Based on accounting net income and book values, not cash flows and market
values


8.3a What is an average accounting rate of return, or AAR?

AAR is average net income / average book value.

8.3b What are the weaknesses of the AAR rule?
Weaknesses of AAR are that it is not a true return measure, it ignores time value of
money, uses an arbitrary cutoff, and is not based on cash flows or market values.