l8 : alternative investment appraisal rules

Question 1

what is a payback period?

Answer 1

the number of years it takes to recover the initial investment value through accumulated future cash flows

Question 2

give three advantages of payback.

Answer 2

1. easy to compute and understand
2. encourages cash generation
3. values early cash flows over late cash flows

Question 3

give five disadvantages of payback.

Answer 3

1. adds cash flows ignoring the time value of money
2. choice of cut-off period is arbitrary / objective
3. ignores cash flows after cut-off period
4. biased towards rejecting long-lived projects with + NPVs
5. biased towards accepting short-lived projects with - NPVs

Question 4

what is a discounted payback period?

Answer 4

the number of years it takes to recover the initial investment value through discounted accumulated future cash flows.

Question 5

what is the benefit of using discounted payback period?

Answer 5

solves the issues of not considering time value of money and prevents bias towards short-lived projects with - NPVs

Question 6

define IRR.

Answer 6

internal rate of return. the rate of return that give a zero NPV using DCF.

Question 7

what makes an investment project “non-conventional”?

Answer 7

when the project has a cash outflow, then a cash inflows then cash outflow again

Question 8

when should projects be accepted according to IRR?

Answer 8

if IRR is greater than the target cut-off return, then the project should be accepted.

Question 9

when is using IRR an issue?

Answer 9

when projects are non-conventional causes an issue as you get more than one IRR. also causes issue when project is mutually exclusive as IRR and NPV rule can conflict.

Question 10

what is ARR?

Answer 10

annual percentage rate of return of a project calculated using average accounting profits and average NBV of assets

Question 11

what is an advantage of using ARR?

Answer 11

• easy, cheap & quick to compute as uses accounting information which is collected anyway

Question 12

give 5 disadvantages of using ARR.

Answer 12

1. ignores time value of money
2. choice of target accounting rate of return is arbitrary / objective
3. asset value based on NBV, not cash flows and market values
4. no standardised calculation methods
5. not a true rate of return

Question 13

what is PI?

Answer 13

profitability index - it is a capital budgeting tool. it is ratio of PV of cash flows from a project and the initial investment.

Question 14

when should managers accept projects according to PI?

Answer 14

PI > 1