On successful completion of this module the student will be able to:
1. Evaluate the performance of a company using various financial analytical tools.
2. Analyze different patterns of cost behaviour and apply cost-volume-profit analysis to
business decisions..
3. Evaluate divisional performance using both financial and non-financial measures
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Financial Statement Analysis
1. Financial Statement Analysis - Julius Noble Ssekazinga
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Coventry University/IAA Collaboration
MBA Logistic Management & I.T
2014/15
Partners in Development
Institute of Accountancy Arusha
ARUM58EKM
Financial Statement Analysis
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Student Name:
Julius Noble Ssekazinga
Registration number:
MBA-IT/0218/T.2014
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2. Financial Statement Analysis - Julius Noble Ssekazinga
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Assignment
Intended Learning outcome
On successful completion of this module the student will be able to:
1. Evaluate the performance of a company using various financial analytical tools.
2. Analyze different patterns of cost behaviour and apply cost-volume-profit analysis to
business decisions..
3. Evaluate divisional performance using both financial and non-financial measures.
Assignment questions
Question One
(a) Costs can be classified on the basis of cost objective which could be stock
valuation or decision making or for control purposes. Describe each classification
of cost.(6 marks)
(b) Differentiate between marginal costing and absorption costing.
(6 marks)
(c) Marginal costing can be used in taking number of business decisions. Identify the
areas where you can make use of marginal costing in business decision making. (6
marks)
(d) Operating leverage influences the new operating income of the firm due to the
investment decisions.Describe how operating leverage influences the new
operating income.(6marks)
(e) The application of Break-even-point is vital in a number of business decisions.
What could be those decisions where Break-even-point can be used? State those
areas. (6 marks)
(30 total marks)
Question Two
(a) Why is it necessary to interpret the financial statements?( 5 marks)
3. Financial Statement Analysis - Julius Noble Ssekazinga
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(b) Differentiate between Horizontal, Vertical, and ratio analysis techniques.
(15 marks)
(Total 20 marks)
Question Three
A number of investment appraisal techniques have been developed. Some techniques take into
account the time value of money while others donât.
Appraise two techniques in each case based on their strengths and weaknesses.
(20 marks)
OR
(a) Distinguish between divisional managerial and economic performance.
(10 marks)
(b) Analyze objectives of operating divisionsâ performance appraisal.
(10 marks)
(Total 20 marks)
Coursework Assessment
âĸ The written coursework represents 70% of the module mark
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QUESTION ONE
(f) Costs can be classified on the basis of cost objective which could be stock
valuation or decision making or for control purposes. Describe each classification
of cost.
Classification of Cost for Stock valuation:
ī§ Un-expired costs; the portion of an economic benefit of the expenditure which is not
yet used and remains as an asset for future use, for example stock of goods can be
sold in given periods of time and yet contribute to future revenue. (Jain M, 2000)
ī§ Expired costs; cost which has been recognized as an expense and it cannot contribute
to future revenue, itâs when an organization receives the benefits of cost. For example
an organization pays 100,000 tshs. For telephone expenses for a given accounting
period as a pre-payment.
ī§ Period costs; cost which associates with time passage and does not vary with the
amount of production incurred, for example rent of a production facility is paid every
month regardless of the variation in the amount of quantities produced
ī§ Product costs; are all those costs which are incurred in producing a certain product
such as material cost and direct labour cost. (Jain M, 2000)
Classification of Cost for Decision Making:
ī§ Variable costs; are the costs which change in total, with the changes in a production
output, that is when production output is high the variable costs will increase and
when the production output is low the variable cost decreases. For example a
company manufacturing laptops its variable costs will be such as the mouse,
motherboard.
ī§ Fixed costs; costs which do not change in total as the rate of production output vary,
these costs will always be there whether a firm produce more or produce less output
such variation will not affect fixed costs. For example a building facility where the
laptops are assembled.
ī§ Semi-variable cost; these are costs which contain entities of both fixed costs and
variable costs, for example the cellular phone bundle is 10 minutes talk time per day
5. Financial Statement Analysis - Julius Noble Ssekazinga
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if the users exceed to use those minutes the users will pay for every additional minute.
(accounting tools 2014)
ī§ Sunk cost; these are historical costs which cannot be recovered in a given situation,
for example a car brought in 2006 for 1,000,000 Ugshs. And sold for 500,000 Ugshs.
In 2012 the cost of another 5,000,000 Ugshs. Cannot be recovered.
ī§ Opportunity cost; itâs the measurable advantage which is foregone as a result of the
rejection of alternative uses of resources, it can be labour, material or facilities.
ī§ Marginal cost; changes in total cost resulting from changes in output.
Classification of Cost for Control Purposes
ī§ Profit centre; operating unit manager has responsibility and authority over sales and
production costs, they make decisions over the quality of the product, selling price
and how the distribution network will operate.
ī§ Investment centre; when the unit manager has the responsibilities and authority on his
centre working capital and physical assets, which is capital investment decisions as
well as revenue and costs For example an investment manager, is measured by
metrics such as return on investment.
ī§ Cost centre; a business unit which is responsible only for the cost which it incurs, the
manager of cost centre is responsible for the cost centre unit performance.
(accounting tools, 2014, Kaplan R, 2006)
(g) Differentiate between marginal costing and absorption costing.
The Following are the differences between marginal and absorption costing;
According to a particle perspective of P.K. Sikdar, Sr. Faculty EIRC of ICWAI,
ī§ Marginal costing also termed as variable costing, a technique which includes only
variable manufacturing costs, in form of direct material, direct labour and variable
manufacturing overheads while determining the cost per unit of a product. Whereas
Absorption costing, is a costing technique that involves all manufacturing costs in form
6. Financial Statement Analysis - Julius Noble Ssekazinga
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of direct materials, direct labour and both variable and fixed manufacturing overheads,
while determining cost per unit of a product.
ī§ Marginal costing helps an organization to make short term decisions basing on the forms
of break-even analysis, margin of safety and contribution sales ratio. Whereas Absorption
costing, is used to calculate the profit of an organization and calculation of stock
evaluation.
ī§ Marginal costing is the accounting system which includes only variable production cost
as product cost, the fixed overheads cost are regarded as period costs. Whereas
Absorption costing is the accounting system which includes production costs both fixed
and variable costs as product cost.
ī§ Marginal costing recognize that fixed period costs changes as time changes and not as
activity changes and also it recognize the variable production cost of one additional unit.
While Absorption costing absorbs all production costs into each unit of output, through
the overhead absorption rate, therefore the high amount of goods produced will result into
lesser cost per unit, because the overheads are spread into a larger number of units.
(h) Marginal costing can be used in taking number of business decisions. Identify the
areas where you can make use of marginal costing in business decision making.
The following areas make use of marginal costing in business decision making according to
Prof. Vinod, kumar (2011).
ī§ Calculation of Margin of Safety Marginal costing can be utilized for calculating margin
of safety. Margin of safety is difference between actual sale and sale at breakeven point.
According to marginal costing rules, production will follow sales.
ī§ Exploring a new market; in exploring new markets an organization have to estimate to
cost of initiating a new product to penetrate through the market but in estimation of the
costs, the variable costs should be lower so as he price of the product should be low and
enable easy penetration of the product.
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ī§ Dropping a product, line or department; an organization should not think immediately
about dropping a product or a line when the demand is too low, since it is short term
decision which will lead to a lot of customerâs going away. It should rather think about
exceeding the demand. Further on, the product to be dropped may be a complementary
one to another product made by the company.
ī§ Introducing a new product or line; the organization should make a pricing decision of the
product which will be easily accepted in the market and hence the production of this new
product or line should not have a very high cost so as not to increase the marginal costing
of these products.
ī§ Achieving a target profit; variable costs of an organization should be optimized to be
more efficient in production and result to lesser cost thus marginal costing will be lower
and will result in to greater profit which is desirable by an organization.
(i) Operating leverage influences the new operating income of the firm due to the
investment decisions. Describe how operating leverage influences the new
operating income.
Operating Leverage
According to Prof. Vinod Kumar (2011),
Operating leverage measures a companyâs fixed operating costs as a percentage to all of its
operating costs at different levels of sales. As per the definition, Operating leverage is the extent
to which a firms fixed costs contribute to the total operating costs at different levels of sales.
Operating Leverage = (Contribution Margin/Operating Income)
Operating leverage influences the new operating income as follows;
Operating leverage is highest in companies that have a high proportion of fixed operating costs
in relation to variable operating costs. This kind of company uses more fixed assets in the
operation of the company. Conversely, operating leverage is lowest in companies that have a low
8. Financial Statement Analysis - Julius Noble Ssekazinga
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proportion of fixed operating costs in relation to variable operating costs influencing the
operating income.
Organizations with high operating leverage generate more income from every additional unit of
sales, due to the fact that high operating leverage organizations have more fixed costs than the
variable costs so the cost of producing additional output units is immersed within the fixed costs,
variable cost is lower and hence increase in sales leads to new operating income that is gross
income from sales â operating expenses.
Operating Leverage also influences new operating income by the effect Fixed Cost has On
change in Operating Income as changes occur in Units Sold & Contribution Margin, Greater
Degree Operating Leverage means Small changes in Sales equals Large change Operating.
In good times, operating leverage can supercharge profit growth. In bad times, it can crush
profits. Even a rough idea of a firm's operating leverage can tell you a lot about a company's
prospects hence influence on the new operating income.
Also Operating leverage can tell investors a lot about a company's risk profile and although high
operating leverage can often benefit companies, companies with high operating leverage are also
vulnerable to sharp economic and business cycle swings
(j) The application of Break-even-point is vital in a number of business decisions.
What could be those decisions where Break-even-point can be used? State those
areas.
Breakeven point is the point of activity where total sales and total costs are equal meaning an
organization doesn't gain profit nor incur loss, also The point where sales or revenues equal
expenses (Weetman, 2006; Charles T. Horngren (2009))
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The following areas decisions and areas where break-even can be used;
ī§ Beyond the breakeven point, an organization realises the breakeven point that is the point
it's fixed costs are covered and sales in more units marks a profit contribute, the higher
the contribution per unit, the greater the profit. (Charles T. Horngren (2009))
ī§ Generation of profit after covering fixed costs, the organization can determine the levels
of sales necessary to cover its fixed costs and to generate the required profit, the
awareness of the fixed costs, selling price per unit and variable cost per unit will help to
determine where an organization will break even and at that point an increase in sales
will be generating profit.
ī§ Margin of safety determination, it's a difference between break even sales and normal
level of sales, if an organization wants to reduce the risk of lower sales, it can determine
the margin of safety between its various products and yet decide which product to sale or
produce, given a lower risk of market uncertainties.
ī§ Breakeven point helps to estimate the remaining capacity of an organization; after a
breakeven point is reached, which can help determine the amount of super normal profit
which can be earned by the organization.
ī§ Determining changes in selling price, if the selling price per unit increases and the cost
remains constant, the contribution per unit increases and break even volume remains
lower.
ī§ Determining changes in variable cost, effect of change increase in variable cost per unit,
will lead decrease in contribution per unit that is more products will have to be sold to
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reach the breakeven point, if the variable costs are decreased, contribution per unit will
increase. Here an organization will reach breakeven at a lower cost and earn profits more
quickly. (Charles T. Horngren (2009))
ī§ Variations in fixed costs, if the fixed costs increases more products have to be sold to
meet breakeven point, because high fixed costs leads to greater risk and if any hindrance
in production occurs it will lead to greater loss here an organization will be more
concerned about the margin of safety, but if fixed costs are low the breakeven point is
low and the risk is also low. (Weetmaan, 2006)
QUESTION TWO
(c) Why is it necessary to interpret the financial statements?
The following points explain the necessity of interpret the Financial Statements;
Financial statements are a collection of organizations financial reports concerning an
organizationâs financial results and cash flows and provide various financial information that
investors and creditors use to evaluate a companyâs financial performance. Jay Way, (2007).
ī§ To determine the ability of an organization to generate cash and the sources where that
cash originates from and the uses of such cash.
ī§ To estimate the capability of an organization on paying back of its debts, financial
statements such as financial leverage ratios indicate a companyâs ability to pay short-term
debts. They focus on current assets and current liabilities.
ī§ To derive the financial ratios from the statements that can determine the position of an
organization in the competing firm.
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ī§ Financial statements help the organization to predict the future events of the organization
or the industry in which the company is in by making comparison on the financial trend
information by using the past financial statements.
ī§ Financial statements are necessary to external users such as potential investors, creditors,
stock market analysts and auditors to acquire necessary and vital information for example
potential investors would require financial statements of the previous period of an
organization so as to make decisions if it will be healthy for them to invest in such an
organization.
(d) Differentiate between Horizontal, Vertical, and ratio analysis techniques.
Vertical analysis, horizontal analysis and financial ratios analysis are part of financial
statement analysis whose techniques are used by financial analysts for company analysis.
Harold Averkamp (2003).
Horizontal, Vertical and Ratio Analysis techniques can be differentiated as follows;
With Horizontal analysis, an organization make an analysis of the financial statements by
comparing more than two accounting periods, the analysis of a certain item may be based on
currency or trends in percentages. It shows a comparison of financial data of various years
against the base year. For example, the statements for two or more periods are used in
horizontal analysis. The earliest period is usually used as the base period and the items on the
statements for all later periods are compared with items on the statements of the base period.
The changes are generally shown both in dollars and percentage.
Dollar and percentage changes are computed by using the following formulas:
Whereas for vertical analysis, an organization make an analysis of the financial statements
for one accounting period only, it compares the individual components within the financial
12. Financial Statement Analysis - Julius Noble Ssekazinga
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statement, it converts each component in the income statement to sales percentage. More to
that, Vertical analysis reports each amount on a financial statement as a percentage of another
item. For example, the vertical analysis of the balance sheet means every amount on the
balance sheet is restated to be a percentage of total assets. For example, To conduct a vertical
analysis of income statement, sales figure is generally used as the base and all other
components of income statement like cost of sales, gross profit, operating expenses, income
tax, and net income etc. are shown as a percentage of sales.
In a vertical analysis the percentage is computed by using the following formula:
For ratio analysis comprises of studying numerous relationships between different items
which are reported in a given accounting period at a specific of financial statement. Another
point that differentiated Ratio Analysis from others, it involves calculating various financial
ratios, such as profit margin, accounts receivable-to-sales, and inventory turnover ratios and
comparing them to other companies or general rules of thumb. Ratio analysis also involves
calculations of Short-term Solvency Ratios, Market Value Ratios, Profitability Ratio, Debt
Management Ratios and Asset Management Ratios. (John Freedman, 2014)
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QUESTION THREE
A number of investment appraisal techniques have been developed. Some techniques take into
account the time value of money while others donât.
Appraise two techniques in each case based on their strengths and weaknesses.
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The following are two techniques that donât take into account the time value of money
(Accounting Rate of Return technique & Payback Period Method) highlighting their
strength and weaknesses
1. Payback Period Method
The payback period is defined as the time required recovering the initial investment in a project
from operations. The payback period method of financial appraisal is used to evaluate capital
projects and to calculate the return per year from the start of the project until the accumulated
returns are equal to the cost of the investment at which time the investment is said to have been
paid back and the time taken to achieve this payback is referred to as the payback period.
It emphasizes the managementâs concern with liquidity and the need to minimize risk through a
rapid recovery of the initial investment. (Weetman, 2006; Alaba Femi, AWOMEWE & Oludele
Olawale OGUNDELE (2008))
Payback Period =
Initial Investment
Cash Inflow per Period
Payback period strengths are appraised as follows;
īˇ It doesnât involve tedious calculations, mainly the calculations assume certainty about
the cash flow that is predicted for each project & usually the risk is attached to each cash
flow
īˇ It is widely used and easily understood.
īˇ It favours capital projects that return large early cash flows.
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īˇ It allows a financial manager to cope with risk by examining how long it will take to
recoup initial investment, although it does not treat risk directly.
īˇ It addresses capital rationing issues easily.
īˇ period is a restrained method to introduce a certain product in undefined markets
īˇ The ease of use and interpretation permit decentralization of the capital budgeting
decision which enhances the chance of only worthwhile items reaching the final budget.
īˇ It contains a built-in safeguard against risk and uncertainty in that the earlier the payback
the lower the risk.
īˇ It remains a major supplementary tool in investment analysis.
īˇ The project which will be more desirable by an organization is the one which pays back
the cash quickly; this is important in many organizations which have limitations in their
cashflows that means the quick the project can pay back the cashflow, the more the
chance an organization has to initiate other projects and also use the same cash to expand
the desirable operating project for future purposes
Payback period weaknesses are appraised as follows;
īˇ Payback period ignores interest charges on long term projects; investing funds in a long
term project is costful in terms of interest charges considering the funds are borrowed and
the interest that is foregone by purchasing fixed assets , such interest costs are regarded as
time value of money the cash flows should be sufficient enough to repay capital invested
and also rewards to the investors
īˇ It ignores any benefits that occur after the payback period i.e. it does not measure total
income.
īˇ The time value of money is ignored.
īˇ It is difficult to distinguish between projects of different size when initial investment
amounts are vastly divergent.
īˇ It over-emphasizes short run profitability.
īˇ The overall payback periods are shortened by postponing replacement of depreciated
plant and equipment. This policy may do more harm than good to the production process.
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īˇ focuses on speed of salvage of cash flows; the method ignores any cashflows arising after
the payback period, a project which would make a fortunate return but in the long run is
foregone for short term benefits in a project within the short run.
2. Accounting Rate of Return technique(ARR)
Accounting Rate technique focuses on a projectâs net income rather than its cash flow, is the
second-oldest evaluation technique. In its most commonly used form, the ARR is measured as
the ratio of the projectâs average annual expected net income to its average investment.
Accounting rate of return also bases on calculating the accounting profit of the project divided by
initial investment in the project, normally used in capital budgeting to estimate whether or not an
organization should continue with the project. (Steven. Bragg, (2014), Weetman, 2006)
ARR =
Average Accounting Profit
Average Investment
The Accounting rate of return techniqueâs strengths and weaknesses are explained as follows
According to Prof. R. Madumathi (2006);
Accounting Rate of Return Strengths appraised below;
īˇ Accounting rate of return uses accounting profits; it is centred on the accounting measure
of profit thus regarded to be convenient because it takes into account computations all the
profits which are expected during the period that the project will be operated
īˇ Accounting rate of return is a familiar concept to return on investment (ROI), or return on
capital employed.
īˇ Accounting rate of return technique is easy to understand and calculate.
īˇ This is a simple capital budgeting technique and is widely used to provide a guide to how
attractive an investment project is. (Prof. R. Madumathi (2006))
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Accounting Rate of Return Weaknesses appraised below;
īˇ Accounting rate of return ignores the cash flow of an investment project; this is due to the
fact that it includes non-cash expenses such as depreciation and other pre-paid expenses
such as provisions for bad debts, this limits the ability of the project manager to
determine the actual cash flows on an investment project
īˇ This technique is based on profits rather than cash flow. Therefore it can be affected by
non-cash items such as the depreciation and bad debts when calculating profits. The
change of methods for depreciation can be manipulated and lead to higher profits.
īˇ The accounting rate of return technique does not adjust for the risk to longer term
forecasts.
īˇ Accounting rate of return technique does not take into account the time value of money,
whereas the amount of money now is more worth at the current moment than in the
future, the accounting rate of return doesnât reconsider this fact because if the interest
rates are higher at the time an investment project is on-going the accounting rate of return
reports higher profits and by the end of an investment project the profits will be lower
probably because of the changes in the interest rates thus overstate the profit due to
accrual basis of reporting the profit without considering time value of money. ( Prof. R.
Madumathi (2006))
Methods or techniques based on the TimeâValue of Money
1. Net Present Value (NPV)
Net present value is the present value of cash inflows of a project deducting the present value of
cash outflows of the project. If the expected present value of cash flows is greater than the funds
invested, net present value will be positive and thus a project will be accepted but if the present
value of cash flows is less than funds invested, the net present value will be negative and thus the
project will be neglected. (Weetman, 2006)
NPV = R Ã
1 â (1 + i)-n
â Initial Investment
i
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In the above formula,
R is the net cash inflow expected to be received each period;
i is the required rate of return per period;
n are the number of periods during which the project is expected to operate and generate cash
inflows.
Strengths of Net Present Value (NPV) appraised below;
ī§ Enables an organization to determine if it will increase its value; this is because if an
organization plans to initiate an investment project and calculates the net present value
and if the answer of the net present value is positive then it means the cash flows
generated will increase more value to the organization.
ī§ Considers all the cash flows; net present value calculates all the cash inflows and cash
outflow of an investment project, this makes it more accurate for the organization to
determine the actual value by the end of the project if it is a profit or a break even or if
the project will result to loss. (Weetman, 2006)
ī§ Net present value considers time value of money; time value of money is the concept that
the current value of a currency now, will not worth the same in future time, net present
value takes in account the interest rates thus lead to the development of discontinued cash
flows techniques where present value factor is considered to determine the present value
of expected net cash.
ī§ Indicates if an investment project will payback investorâs required rate of return; in
computation of net present value where all the cash inflows are deducted against all cash
outflows, the net value in the end will determine if it is the value the investors were
expecting in return of the proposed project. (Weetman, 2006)
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Weaknesses Net Present Value (NPV) appraised below;
ī§ Net Present value is sensitivity to discount rates. NPV computations are really just a
summation of multiple discounted cash flows - both positive and negative - converted
into present value terms for the same point in time (usually when the cash flows begin).
ī§ Decision makers find it difficult to interpret since it is expressed in terms of currency
rather than percentage; net present value is expressed in currency terms for example
Tanzanian shillings, because it calculates the cash inflow and outflows and cannot be
easily converted into percentage form thus posing difficulty during interpretation.
(Weetman, 2006)
ī§ An estimate of the cost of capital of the project is hard to determine; in order for an
organization to calculate the estimated net present value of the proposed project it should
know the exact cost of capital which can be hard to determine because there several
changes which happen in the market capital. (Weetman, 2006)
ī§ It wholly excludes the value of any real options (opportunities to expand and cease
projects) that may exist within the investment.
2. Internal Rate of Return (IRR)
Internal rate of return is the discount rate at which present value of the cash flows generated by
the project is equal to the present value of the capital invested, so that the net present value of the
project is equal to 0. In other words, IRR is the discount rate which equates the present value of
the future cash flows of an investment with the initial investment. (Accounting Explained, 2006;
Marty Schmidt, (2004))
PV of future cash flows â Initial Investment = 0
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The Strengths of internal rate of return are appraised below;
ī§ Considers the time value for money; a shilling which is received today worthâs a lot more
than a shilling which will be received next month or next day.(Pandey, 2009)
ī§ Profitability measure; it reflects all cash flows occurring over the entire life of the project;
calculate its rate of return.(Pandey, 2009)
ī§ Acceptance rule; this pinpoints that the proposed project is being proposed should be
accepted if the internal rate of return is higher than the cost of capital, that is the net
present value of the project will be positive and if the internal rate of return is lower than
the cost of capital the proposed project will not be allowed thus the net present value will
be negative. (Weetman, 2006)
The Weaknesses of internal rate of return are appraised below;
ī§ An organization canât determine if it will increase value; (Pandey, 2009)
ī§ Multiple rates of return; a proposed project might have multiple rates of return
ī§ Mutual exclusive projects; internal rate of return fails to make an appropriate selection
between the mutually exclusive projects.(Pandey, 2009)
ī§ Internal Rate of Return method does not account for the project size when comparing
projects. Cash flows are simply compared to the amount of capital outlay generating
those cash flows. This can be troublesome when two projects require a significantly
different amount of capital outlay, but the smaller project returns a higher Internal Rate of
Return.
ī§ Although the Internal Rate of Return allows you to calculate the value of future cash
flows, it makes an implicit assumption that those cash flows can be reinvested at the same
rate as the Internal Rate of Return. That assumption is not practical as the Internal Rate of
Return is sometimes a very high number and opportunities that yield such a return are
generally not available or significantly limited
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Financial management by pandey,I.M. (2009) Vikes Mumbai
Financial Management by C. Paramasivan and T. Subramanian
Financial and management Accounting by Pauline Weetman 2006
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22/10/2014
Chris gallant, 2013 [Online]
Available <http://www.investopedia.com/ask/answers/06/npvdisadvantages.asp> retrieved on
29/10/2014