Financial Decision Making

Edison Electric Company’s (E.E.C.) operational managers have been struggling to
understand the Internal Rate of Return (IRR), simple rate of return, and net present value
(N.P.V.). This summary demonstrates how each method is applied.
How IRR is calculated
The internal rate of return is a capital budgeting method that, when computed, finds the
discount factor that equates the present value of the company’s cash inflows with the present
value of the company’s cash outflows (Brewer, 2020). The IRR method considers the time value
of money and is easy to compute. Some factors must be taken into consideration, such as
whether the capital project or asset has a salvage value and whether the cashflows are the same
for every year of its usable life. For example, in case the asset has no residual value and the
cashflows are the same, then the IRR can be computed by dividing the initial outlay by the
annual cashflows. The result is then checked against the Present Value Interest Factor of an
Annuity (P.V.I.F.A.) table. For example, if the useful life of the asset is 15 years, the answer is
cross-checked against the 15-year column to determine the corresponding rate. The rate then
becomes the project’s IRR. The conditions for acceptance depend on the company’s minimum
rate of return. For instance, if in a capital project, the E.E.C.’s minimum rate of return is 20% and
the computed IRR is 15%, the E.E.C. cannot accept the project. On the other hand, if the
project’s IRR is 22% and E.E.C.’s minimum rate of return is 20%, then the project is accepted.
N.P.V. vs. IRR
The IRR is, therefore, the discount factor at which the Net Present Value (N.P.V.) of the
project’s cashflows equals zero (Brewer, 2020). When E.E.C. sets its minimum rate of return,

capital projects must return a rate higher than that to be accepted using the IRR method. When
comparing the IRR vs. N.P.V. method, N.P.V. takes precedence. IRR assumes that the rate of
returns earned on the project is the rate of return of the project, which may be unrealistic with
projects that have a high internal rate of return.
The simple rate of return
The simple rate of return, also known as the accounting rate of return or unadjusted rate
of return, is computed by dividing the annual incremental net operating income (N.O.I.) by the
initial investment (Brewer, 2020). Several adjustments are made, such as deducting depreciation
from the annual incremental N.O.I. and deducting salvage value from the initial investment. This
method has several limitations, such as it does not consider the time value of money and uses
accounting N.O.I. rather than project cashflows. This makes it difficult to use in projects that
lack constant incremental revenues.
References
Brewer, R.H.G.E.N. P. (2020). Managerial Accounting (17th ed.). McGraw-Hill Higher
Education (U.S.). https://coloradotech.vitalsource.com/books/9781260709568