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While IRR base the value on rate of return, the ARR ignores the time value of money and it is not accounting based of return. Under ARR, depreciation is calculated in different methods such as accelerate or straight line, and the technique ignores the salvage value of the initial investment.
5. "Explain the relative significance of the unadjusted payback period in this decision situation."
Payback period assists in determining payback period in the life cycle of the project. Typically, it would be more than 8 years before NPV would become negative. However, the payback may not be useful in determining acceptance of a project because it ignores cash flow and does not consider time value for money after the payback in the life of a project.
Payback period is the time duration that is required to recoup the initial costs that has been committed in a project. The pay back period is the number of years that it will take cash flows from project to recover initial investment put in the project.
The relative significant of the unadjusted payback period in this situation is that payback period helps to determine the payback period in the project lifecycle. In the project, it would be more than 8 years before the Net Present Value (NPV) would be negative. Application of pay back is easy and it is easy to understand. Another significant of unadjusted pay back period is that it stress the period of recouping the investment put in the project.
The significant shortcoming of pay back period is that it ignores that cash...
Since payback period emphasizes on early recovery, it does not lay emphasis on the cash inflow after the payback period.
6. "Explain how the weighted average cost of capital should be used in capital budgeting analysis when utilizing the NPV method."
Weighted average cost of capital (WACC) should be used as discount rate in the project life cycle as well as to discount all cash flows. To determine the Net Present Value of a project, it is essential to discount the cash flows at weighted average cost of capital using the following formula:
NPV = "Present Value (PV) of the Cash Flows discounted at WACC."
Typically, the weighted average of capital is the cost of capital and the weight is the proportion of the total project value. By weighting the costs, it would be easy to obtain overall opportunity costs of all the dollars put in the investment.
7. "Explain how the weighted average cost of capital should be used in capital budgeting
Analysis when utilizing the IRR method."
The Internal Rate of Return should be compared with weighted average cost of capital in order to determine whether a project is viable or whether the project should be undertaken or not undertaken. If IRR is greater than WACC, it is revealed that the project should be undertaken. (Sullivan, Steven (2003).
References
Sullivan, a; Steven M.S. (2003). "Economics: Principles in action." Upper Saddle River, New Jersey 07458: Pearson Prentice Hall.
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