Section B question! Flashcards
(4 cards)
Order the following four methods of investment appraisal from best to worst and give a justification for your chosen ordering:
. Accounting Rate of Return
. Payback Period
. Net Present Value
. Internal Rate of Return
**1st: Net Present Value
2nd: Internal Rate of Return
3rd: Accounting Rate of Return
4th: Payback Period**
Discounted cash flow techniques are superior to the traditional methods (ROCE and Payback) as they use cashflows, take into account the time value of money and can also accommodate risk.
NPV is superior to IRR, due to:
1) Being able to give the correct decision with mutually exclusive project
2) Being able to accommodate non-conventional cash flows
3) Its reinvestment assumptions being far more realistic, and;
4) Being able to handle changes in discount rate
While IRR does give an identifiable risk margin, it is inferior to NPV but is still much superior to ARR (ROCE)/ Payback for reasons cited above
ARR doesn’t take into account the time value of money and also uses accounting profits rather than cash flows
Payback period can be based on discounted cash flows; however the main issue here is that all cash flows after the initial payback period have no impact on the decision. Equally, choice of the payback target rate is arbitrary.
Identify and explain the reasons why a company might be subjected to soft capital rationing.
1) Policy of stable growth: Management may deliberately limit investment to maintain a steady, controlled rate of growth, avoiding the risks associated with rapid expansion.
2) Reluctance to issue new equity: Issuing new shares may dilute existing ownership or signal a lack of confidence, so management may restrict capital to avoid this.
3) Avoiding more fixed interest debt: Taking on additional debt increases financial risk and fixed obligations. Management may cap investment to maintain financial stability and a healthy gearing ratio.
4) Encouraging competition for funds: Limiting available investment capital can create internal competition between projects, ensuring that only the most profitable and strategically aligned projects are approved.
Explain the meaning of and relevance to the investment appraisal processes for the following type of projects:
1) Mutually exclusive projects
1) Mutually Exclusive Projects
. These are projects where choosing one means you cannot choose the other - only one can be accepted.
Example: If a company its choosing between two different delivery vans, selecting one rules out the need for the other.
In investment appraisal, this is important because IRR can sometimes lead to incorrect decisions between mutually exclusive projects. In such cases, NPV should be used to choose the project that adds the most value.
Explain the meaning of and relevance to the investment appraisal processes for the following type of projects:
2) Divisible Projects
2) Divisible Projects
. These are projects that can be partially accepted, rather than needing full investment.
Example: A distribution project that plans to buy 20 vans could instead invest in only 10 vans if funds are limited.
In investment appraisal, Profitability Index (PI) is used for divisible projects to help rank and allocate limited capital efficiently, unlike NPV which assumes full investment.
