Investment appraisal

Question 1

What is payback?

Answer 1

The amount of time required for an investment to generate cash flows sufficient to recover its initial cost.

Question 2

What is discounted payback?

Answer 2

The length of time required for an investment’s discounted cash flows to equal its initial cost.

Question 3

What are advantages of the payback period rule?

Answer 3

Easy to understand.
Adjusts for uncertainty of later cash flows.
Biased towards liquidity.

Question 4

What are disadvantages of the payback period rule?

Answer 4

Ignores time value of money.
Requires an arbitrary cut-off point.
Ignores cash flows beyond the cut-off point.

Question 5

What are advantages of discounted payback rule?

Answer 5

Includes time value of money.
Easy to understand.
Does not accept negative estimated NPV investments.
Biased towards liquidity.

Question 6

What are disadvantages of discounted payback rule?

Answer 6

May reject positive NPV investments.
Requires an arbitrary cut-off point.
Ignores cash flows beyond the cut-off date.

Question 7

What is NPV?

Answer 7

The difference between an investment’s market value and cost.

Question 8

What are mutually exclusive investments?

Answer 8

A situation where taking one investment prevents taking the other.

Question 9

What are strengths of NPV?

Answer 9

Uses cash flows (better than earnings).
Uses all cash flows (other approaches ignore cash flows beyond a certain date).
Discounts cash flows (incorporates the time value of money)

Question 10

What is the internal rate of return?

Answer 10

The discount rate that makes the NPV of an investment zero.

Question 11

What are advantages of IRR?

Answer 11

Closely related to NPV, often leading to identical decisions.
Easy to understand and communicate.

Question 12

What are disadvantages of IRR?

Answer 12

May result in multiple answers, or not deal with non-conventional cash flows.
May lead to incorrect decisions in comparisons of mutually exclusive investments.

Question 13

What is the average accounting return?

Answer 13

An investment’s average net income divided by its average book value.

Question 14

What are advantages of ARR?

Answer 14

Easy to calculate.
Required info will usually be available.

Question 15

What are disadvantages of ARR?

Answer 15

Not a true rate of return, time value of money is ignored.
Uses an arbitrary benchmark cut-off rate.

Question 16

What is the profitability index?

Answer 16

The present value of an investment’s future cash flows divided by its initial cost.

Question 17

What are advantages of the profitability index?

Answer 17

Closely related to NPV, generally leading to identical decisions.
Easy to understand and communicate.

Question 18

What are disadvantages of the profitability index?

Answer 18

May lead to incorrect decisions in comparisons of mutually exclusive investments.

Question 19

What is capital rationing?

Answer 19

The situation that exists if a firm has positive NPV projects but cannot find the necessary financing.

Question 20

What is soft rationing?

Answer 20

The situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting.

Question 21

What is hard rationing?

Answer 21

The situation that occurs when a business cannot raise financing for a project under any circumstances.