Chapter 6 - Investment Appraisal - further aspects

Question 1

What is the payback period?

Answer 1

Time a project will take to pay back the money spent on it

Question 2

What are the pros of the payback method?

Answer 2

Payback method is simple to understand
Selecting projects on the basis of payback may help reduce the risk of liquidity problems
Uses cash flows, not subjective accounting profits
Emphasises the cash flows in the earlier years

Question 3

What are the cons of payback method?

Answer 3

Is not a measure of absolute profitability
Ignores the time value of money
Does not take into account cash flows beyond the payback period

Question 4

What does the accounting rate of return calculate?

Answer 4

Calculates a percentage return provided by the accounting profits of the project

Question 5

What are the pros to the Accounting rate of return method?

Answer 5

The ARR method is simple to understand
It is widely used and accepted
It considers the whole life of the project

Question 6

What are the cons of the accounting rate of return method?

Answer 6

It ignores the time value of money
It is not a measure of absolute profitability
Does not take into account cash flows and uses subjective accounting profits which include depreciation

Question 7

What is the impact of taxation on cash flows?

Answer 7

Operating cash inflows will be taxes at the prevailing tax rate
Operating cash outflows will be tax deductible.
Investment spending will attract tax-allowable depreciation
Business is making net profits overall
Tax is paid one year after the related operating cash flow is earned

Question 8

How do we treat working capital in the NPV?

Answer 8

Initial investment is a cash outflow at the start of the project
If investment is increase, the increase is a relevant cash outflow
If investment is decreased, the decrease is a relevant cash inflow
Working capital does not qualify for tax relief
At the end of the project the working capital is released

Question 9

Where cash flows have not been increased for expected inflation what are the known as?

Answer 9

Current cash flows or real cash flows

Question 10

Where cash flows have been increased for expected inflation they are known as what?

Answer 10

Money cash flows or nominal cash flows