Nomimal vs effective interest rate

Nominal rate is the stated interest rate usually with the compounding period.
Effective rate is the overall interest rate that the nominal rate translates to(normally
expressed in yearly terms).
Say, a nominal rate of interest is 10% compounding semi-annually. It means that
after every 6 months an interest will be levied at 5%(10 % divided by 2 as it is twice
a year). Hence after 6 months the total value of Rs100/- will be 105. After the next 6
month, another 5% interest will be added to it. This will make the total amount after
1 year to be 105*(1+5%) = 110.25.
Effectively 100 becomes 110.25 after one year. So, the effective rate is 10.25%
against the nominal rate of 10%.s

Average tax rate

The total amount of taxes paid by an individual or business divided

by taxable income. This rate will vary based on the amount
of income received during the taxable period. For example, if Steve paid
$3,000 in taxes on income of $25,000, his average tax rate would be 12%.
Formula: Paid taxes/taxable income = average tax rate.

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Marginal tax rate

The marginal tax rate is the rate of tax applied to the last dollar added to your taxable income.
For example, if you are making $90,000 per year (taxable income, that is total income less
adjustments, deductions, exemptions), then your 90,000th dollar will be taxed at the 28% tax
rate. Your 90,001th and every other tax dollar will be also taxed with the 28% rate until your
taxable income reaches $164,550.

ADVANTAGES OF INTERNAL RATE OF RETURN:

The various advantages of internal rate of return method of evaluating investment

projects are as follows:

Time Value of Money: The first and the most important thing is that it considers time
value of money in evaluating a project which is a big lacking in accounting rate of
return.
Simplicity: The most attractive thing about this method is that it is very simple to
interpret after the IRR is calculated. It is very easy to visualize for managers
and that is why this is preferred till the time they come across certain occasional
situations such as mutually exclusive projects etc.

Hurdle Rate / Required Rate of Return is Not Required: The hurdle rate is a difficult
and subjective thing to decide. In IRR, the hurdle rate or the required rate of return is
not required for finding out IRR. It is not dependent on the hurdle rate and hence the
risk of wrong determination of hurdle rate is mitigated.

Required Rate of Return is a Rough Estimate: A required rate of return is a rough

estimate being made by the managers and the method of IRR is not completely
based on required rate of return. Once IRR is found out, we can compare it with the
hurdle rate. If the IRR is far away from the estimated required rate of return, the
manager can safely take the decision on either side and also keep a room for
estimation errors.

Disadvantages ofintenal rate of return

The method of internal rate of return does not prove very fruitful under certain
special type of conditions which are discussed below:

Economies of Scale Ignored: One pitfall in the use of IRR method is that it ignores
the actual dollar value of benefits. A project value of $1000000 with 18% rate of
return should always be preferred over a project value of $10000 with 50% rate of
return. No need of analysis, we can apparently see that the dollar benefit of former
project is $180000 whereas the latter one is only $5000. Absolutely No Comparison.
IRR method will rank the latter project, with very less dollar benefit, first simply
because the IRR of 50% is higher than 18%.

Impractical Implicit Assumption of Reinvestment Rate: While analyzing a project with

IRR method, it implicitly assumes that the positive future cash flows are reinvested
at IRR. If a project has low IRR, it will assume reinvestment at low rate of return and
on the contrary if the other project has very high IRR, it will assume reinvestment
rate at very high rate of return. This situation is practically not valid. At the time you
receive those cash flows, having the same level of investment opportunity is rarely
possible.

Dependent or Contingent Projects: Many a times, finance managers come across a

situation when the project under evaluation creates a compulsion of investing in
other projects. For example, if you invest in a big transporting vehicle, you would
need to arrange a place for parking that also. Such projects are called dependent or
contingent projects which have to be considered by the manager. IRR may permit
buying of the vehicle but if the total proposed benefits are wiped off in arranging the
parking space, there is no point investing

Mutually Exclusive Projects: Sometimes investors come across mutually exclusive

projects which mean if one is accepted other cannot be accepted. Building a hotel or
a commercial complex on a particular plot of land is an example of mutually
exclusive projects. In such situations, knowing whether they are worth investing is
not enough. Challenge is to know which one is the best. IRR will give a percentage
interpretation value which is not enough. Refer the first disadvantage of economies
of scale which is ignored by IRR.

Different Terms of Projects: Consider two projects with different project duration.
One ends after 2 years and the other ends after 5 years. The first project has an
additional point of reinvesting the money which is unlocked at the end of 2 nd year for
another 3 years till the other project ends. This point is not considered by IRR
method.

Mix of Positive and Negative Future Cash Flows: When a project has some negative
cash flow in between other positive cash flow, the equation of IRR is satisfied with
more than one rate of return i.e. it reaches the trap of Multiple IRR.

Benefits of AE analysis
AE analysis is recommended over PW analysis in many key real-world situations for the following
reasons:

1. In many financial reports, an annual-equivalence value is preferred over a presentworth value,

for ease of use and its relevance to annual results.

2. Calculation of unit costs is often required in order to determine reasonable pricing for sale
items.

Calculation of cost per unit of use is required in order to reimburse employees for business use
of personal cars.

3. Make-or-buy decisions usually require the development of unit costs so that make costs can
be compared with prices for buying.

4. Comparisons of options with unequal service lives is facilitated by the AE method, assuming
that the future replacements of the project have the same initial and operating costs.
However, this method is not practical in general, as future replacement projects typically have
quite different cost streams. It is recommended that you consider various future replacement
options by estimating the cash flows associated with each of them.
Difference between payback period & discounted payment period
When a small business invests in new capital, the owners often want to know when they can expect to
recover the costs of that investment. In capital budget accounting, the payback period pertains to the time
period needed for the return on an investment to equal the sum of the first investment. The discounted
payback period also measures the time needed to recover the original investment costs, but it also
accounts for time value of money.

How depreciation affect corporate tax?

Depreciation directly affects a corporation's tax liability. How much effect it has in a given year depends
on the value of the asset being depreciated, the length of time over which the company is depreciating the
asset, and the depreciation schedule the company uses. The larger the depreciation expense in a given
year, the larger the tax savings in that year. -Say a company buys a $100,000 machine that has a useful
life of 10 years and that will have no residual value at the end of that 10 years, so the full cost can be
depreciated. Under straight-line depreciation, the company simply takes a $10,000 depreciation expense
each year, reducing pretax earnings by $10,000. Assuming the company pays 35 percent in corporate
income taxes, that translates into a $3,500 tax savings each year. Under an accelerated depreciation
schedule, the company might take a yearly depreciation expense of 40 percent of the "net book value" of
the machine -- that is, the cost minus the accumulated depreciation. In the first year, the company claims
an expense for 40 percent of $100,000, or $40,000. That translates into a $14,000 tax savings. The next
year's expense is 40 percent of $60,000, or $24,000, which produces a tax savings of $8,400. Each year,
the expense decreases, and so does the tax savings. In the last year, the company claims a depreciation
expense for whatever's left. Under this schedule, that's about $1,000, or a tax savings of $350 .

How does depreciation affect cash flow

Depreciation is considered a non-cash expense, since it is simply an ongoing charge to the carrying
amount of a fixed asset, designed to gradually reduce the recorded cost of the asset over its useful
life. When creating a budget for cash flows, depreciation is typically listed as a reduction from
expenses, thereby implying that it has no impact on cash flows. Nonetheless, depreciation does have
an indirect affect on cash flow.

When a company prepares its income tax return, depreciation is listed as an expense, and so reduces
the amount of taxable income reported to the government (the situation varies by country). If
depreciation is an allowable expense for the purposes of calculating taxable income, then its presence
reduces the amount of tax that a company must pay. Thus, depreciation affects cash flow by reducing
the amount of cash a business must pay in income taxes.

This tax effect can be increased if the government allows a business to use accelerated
depreciation methods to increase the amount of depreciation claimed as a taxable expense, which
thereby reduces the amount of cash outflow for tax payments even further in the short term (though
this leaves less depreciation to claim in later periods, which reduces the favorable tax effect in those
periods).

However, depreciation only exists because it is associated with a fixed asset. When that fixed asset
was originally purchased, there was a cash outflow to pay for the asset. Thus, the net positive affect
on cash flow of depreciation is nullified by the underlying payment for a fixed asset.