Finance Chapter 7: Figures of Merit

Fig. 1:  ARR for a container loading pier (taken from Higgins Analysis for Financial Management, p251) 

1. Figures of merit
1. ARR= accounting rate of return= (annual ave. cashflow) / (total cash outflow)
2. Container loading pier example:  costs 40m, has residual value of 9.5m, and delivers 7.5m per year for 10 years. (see Fig. 1 above for how to calculate ARR)
3. ARR=0.213 or 21.3%
4. ARR is insensitive to the timing of cashflows
5. Pay Back Period is a rough measure of investment risk, good for short time periods.  
1. For the case with equal cash flows (in above case 7.5m/yr) Pay Back = 40/7.5=5.33 years.
2. Ignores the time value of money, which stems from the existence of inflation or decreasing monetary value over time.
3. PV=Present Value = FV/(1+i)^n  (Discounting Formula)
4. Interest Rate i, used in PV calculations is called the "discount rate"
5. For uneven cashflows, calculate cumulative cashflow by using a table.  This allows you to track when the principal is paid back.  
6. NPV= PV of future cash flows-Initial Investment (NPV is net present value)
1. PV is calculated by using financial calculator such as TI BAII Plus
7. IRR= Internal Rate of Return = discount rate at which NPV is 0
1. If IRR exceeds the opportunity cost of capital (% earned otherwise) then the investment makes sense.  If not, it doesn't.
2. IRR can be calculated by entering the investment cost (-40) as PV, n=10, PMT=7.5, and FV=9.5  Press CPT I/Y to get 15% for the pier example.