The Accounting Rate of Return (ARR) is a widely used technique for investment evaluation. However, like all other measurement processes, it has both merits and demerits.Merits of Using ARRFollowing are some of the merits of using ARR in evaluating an investment −Simplicity − The ARR method is one of the easiest methods to evaluate an investment. Unlike NPV and IRR methods, it does not involve critical and complex computations. Moreover, being simple to understand, ARR is widely used for audiences who have less knowledge of finance. Simplicity makes ARR the preferred choice of investment evaluation for non-finance managers.Use of accounting ... Read More

Despite being a popular tool of investment evaluation, payback is not applicable in all investment evaluation projects. In this article, we will highlight some of the shortcomings of using the Payback Period in evaluating an investment.Cash Flows after PaybackThe payback period fails to consider the cash inflows after the payback period is over. As in the calculation of payback, the year in which the cash inflows become positive is considered as the payback year, and the cash inflows occurring in subsequent years are ignored. This leads to the erroneous calculation of cash inflows and returns on investment.Missing the calculations of ... Read More

There is a broad difference between external equity or new issue of shares and internal equity which is retained earnings. The cost of equity is applicable to both external as well as internal equity. Both have many other similarities too, however in this article, we will highlight the major differences between the cost of external equity and the cost of internal equity.Equity Capital is Not Cost-freeSome economists and finance professionals believe that equity capital is cost-free. The reason for this belief is that it is not legally binding for companies to pay dividends to ordinary shareholders. Also, the equity dividend ... Read More

CAPM is often used by accountants and financial analysts to derive the cost of shareholder’s equity. As a relation between systematic risk and expected return on assets, CAPM is often used as the pricing model for riskier securities. CAPM model generates expected returns for assets which are used to calculate the cost of equity.How to Calculate the Cost of EquityThe CAPM formula needs only three pieces of information, namely the rate of return for the general market, the risk-free rate, and the beta value of the stock in question, $$\mathrm{𝑅_{𝑎} = 𝑅_{rf} + [𝐵_{𝑎} × (𝑅_{𝑚} − 𝑅_{rf})]}$$where −$𝑅_{𝑎}$ =Cost ... Read More

Modified Internal Rate of Return, commonly known as MIRR, is an investment evaluation technique. It is a modified version of the internal rate of return (IRR) that overcomes some of the drawbacks of IRR.MIRR is normally used in capital budgeting decisions to check the feasibility of an investment project.For example, when the MIRR of a project is higher than its expected return, the investment is considered to be attractive.Conversely, it would be unwise to take up a project if the MIRR of the project is lower than the expected return of the project.How to Calculate Modified ARR?The formula to calculate ... Read More

Companies often need to make investment decisions at some specific points in time. Incremental cash flow helps find the better project to invest the money in, as it helps the companies generate incremental income from the investments.In general, investors and lenders are interested in finding out the future cash flows that keep the businesses growing. If the incremental cash flow is calculated, they can be more or less sure if the project will churn out profits or it will be a loss-making project.What is Incremental Cash Flow?Incremental cash flow is the cash flow that a company acquires when it takes ... Read More

What is Equity Cost of Capital?The "cost of equity" is related to the shareholder’s return. In general, the Cost of Equity is the shareholder’s required rate of return that makes the market value of share equal to anticipated dividends. The cost of equity, in other words, is the expense of capital a company pays to its shareholders for the investment they have provided in the business.Equity capital can be raised both internally and externally.In case of internal cost of capital, the companies raise capital through retained earnings.In case of external cost of equity, the companies earn the investment by issuing ... Read More

The Accounting Rate of Return is an annual percentage of the average net income an asset is estimated to generate divided by the average capital cost. It is used in capital budgeting decisions in situations where companies decide whether to invest or not in an asset-based on net future earnings compared to the capital cost.The Accounting Rate of Return is a measurement of future profitability more than the assessment of risks. It deals with the required rate of return which is the minimum return an investor seeks than the risks associated with the particular investment.The Accounting Rate of Return is ... Read More

To check the feasibility of projects, investors and companies normally use the Net Present Value (NPV) and the Internal Rate of Return (IRR) methods. Each of these two techniques has different assumptions, including the assumption of reinvestment rate.Generally, NPV doesn’t have a reinvestment rate assumption, while IRR does have it. The reinvestment rate assumption, therefore, changes the IRR’s overall outcome.Net Present ValueNPV is tool companies use for capital budgeting decisions. NPV is calculated by determining the expected cash outflows and inflows for a project and discounting them with a discount rate. NPV has more inputs and flexibility in comparison to ... Read More

The Pure Play Technique is a frequently used method of determining the cost of a divisional project. It involves the following major steps −Identifying Comparable FirmsThe first step in the Pure Play Method is to find identical firms with similar features. In the real world, it is impossible to find exactly similar firms, as even the most resembling firms have different features. However, it is not impossible to find two or three firms that have quite similar features, and hence finding two to three firms with similar features (not exactly similar) is sufficient for the process.If no matches are found, ... Read More