Businesses can sometimes find themselves with more investment opportunities than finances. While a good problem to have, decisions have to be made as to which opportunities to pursue and which to reject. Capital budgeting deals with analyzing potential projects using tools like internal rate of return and accounting rate of return.
The internal rate of return (IRR) is the interest rate at which the present value of the dollars invested in a particular project would equal the present value of the cash inflows from the project. The present value means future cash discounted back to the current period. This interest rate is the break-even point. For a company to invest in the project, it would have to earn a greater return. For example, a project with a $1,100,000 investment, payments of $400,000 in Year 1 and $600,000 in Year 2 with a $250,000 salvage value would have an IRR of 8%.
The accounting rate of return (ARR) is the average annual income from a project divided by the initial investment. For instance, if a project requires a $1,000,000 investment to begin, and the accounting profits are projected to be $100,000 annually, the ARR is 10%. The advantage of the ARR compared to the IRR is that it is simple to calculate.
Only the IRR takes the time value of money into account. The time value of money is the idea that money now is worth more than money in the future because it can be invested and grow. Not only does the ARR not take the time value of money into account for stable cash flows, but a project that pays out $500 in the fifth year will have the same ARR as a project that pays out $100 a year for five years (assuming the same initial investment).
The ARR uses accounting profits while the IRR uses cash inflows. Accounting profits are subject to a number of different treatments that can affect the bottom line profits. For instance, depreciation can be calculated in different ways, such as straight-line or accelerated. It will also ignore the salvage value of the initial investment at the end of the project, such as a factory that can be sold at the end of its useful life.