Advantages and Disadvantages of Internal Rate of Return essay
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Return on Equity
Return on equity reveals the amount of profit generated in comparison to the total amount of shareholders equity indicated in the balance sheet (Pinto, Henry, Robinson and Stowe, 2010). Shareholders equity is what shareholders own in the company. In the balance sheet, it is the difference between total assets and total liabilities of a company. The formula for calculating the return on equity is net income after tax divided by shareholders equity. Using this formula, a company that obtains a high return on equity is better as compared to a company with a lower return on equity. This shows that the company has high ability to generate funds internally as compared to the one with a lower return on equity.
Advantages of return on equity are that shareholders can use this information to establish whether their money will bear fruits if they decide to invest in a certain company. Second, creditors are able to know whether the company is able to make payments if they lend them with money. Finally, it used to evaluate the performance of a company by the management. As a result, management is able to know where they can make changes in the company to improve return on equity (Pinto, Henry, Robinson and Stowe, 2010).
However, return on equity has certain disadvantages. When a company is starting, it may be difficult to calculate return on equity. This can be extremely difficult for users to apply the information obtained. Return on equity is not considered straightforward. This might confuse most investors because they are used to revenues as compared to return on equity that uses net figures (Pinto, Henry, Robinson and Stowe, 2010).
Internal Rate of Return
Internal rate of return is used to maintain or measure profitability of an investment (Accounting Education, 2010). The internal rate of return can be calculated as a discounted figure of net present value. In this case, a project that has the highest internal rate of return is extremely desirable because it is likely to bring more returns as compared to projects with lower internal rate of return. Therefore, internal rate of return helps in evaluating the best project or decisions to take.
One of the importances of internal rate of return is that it offers equality to all cash flows of the company. Secondly, the internal rate of return has uniformity in its calculations. The method is considered straightforward in capital budgeting as compared to net present value. The method can be said to be realistic since it considers the time value of money and finally, it is important in ranking projects from the best to the worst (Accounting Education, 2010).
On the other hand, internal rate of return contains certain disadvantages. The first disadvantage is that the technique is difficult to understand. Illiterate people will not be able to understand what in the financial statement. Second, when classifying different projects it fails to recognize size of the projects. For this reason, it may mislead users. Finally, it does not put into account cost of the projects. Therefore, it may be difficult for the users to evaluate the best project based on costs (Accounting Education, 2010).
Computations of Return on Equity
Return on Equity = Net income after tax divided by share equity.
Net income = 5503.1
Share equity = total assets – total liabilities = 32989.9 – 18599.7 = 14390.2
Therefore, return on equity = 5503.1/14390.2 = 0.38*100 = 38% (MSN Money, 2012)
Net income = 186.8
Share equity = total assets – total liabilities = 2747.2 – 1618.8 = 1128.4
Therefore, return on equity = 186.8/1128.4 = 0.17*100 = 17% (Hoovers, 2012)
According to the return on equity of the two companies, McDonalds has the higher return on equity. In this case, it means that McDonald has a high rate of generating internal funds as compared to Burger King that has a lower return on equity. Therefore, since the two companies are in the same industry, users of this information may note that McDonalds is doing better as compared to Burger King.