Chapter 2 - Basic investment appraisal techniques

Question 1

What is another name for the “Accounting rate of return”? (ARR)

Answer 1

Return on capital employed (ROCE)

Question 2

What is the initial method for calculating the ARR?

Answer 2

(Average annual pre-tax profit) ÷ (Initial investment)

Question 3

What is the average method for calculating the ARR?

Answer 3

(Average annual pre-tax profit) ÷ (1/2* (initial investment + scrap))

Question 4

What are the three advantages of ARR?

Answer 4

• Simple to calculate & understand
• Answer is in % format (easily comparable)
• Considers the projects entire life

Question 5

What are the three disadvantages of ARR?

Answer 5

• Based on profit not cash
• % answer therefore not an absolute answer
• Ignores time value of money

Question 6

What are the three advantages of the payback period?

Answer 6

• Simple to calculate
• Based on cash, not profit
• Favors short term projects so minimizes risk

Question 7

What are the three disadvantages of the payback period?

Answer 7

• Ignores time value of money
• No guide to an acceptable time period
• Ignores cash flow after payback period

Question 8

What are the four things that can be ignored for ‘Relevant cashflows’?

Answer 8

• Sunk costs
• Committed cost (future unavoidable)
• Non-cash items (depreciation)
• Allocated costs (Allocated/apportioned)