Investment Appraisal Methods

Question 1

What are the advantages of the ARR method? [2]

Answer 1

• It is fairly easy to understand. It uses concepts that are familiar to business managers, such as profits and capital employed.
• It is easy to calculate.

Question 2

What are the disadvantages of the ARR method? [7]

Answer 2

• It is not linked to the wealth maximisation objective. In other words, it does not select projects based on their ability to increase the wealth of the owners of the company.
• It can be calculated in different ways so may cause confusion in interpretation.
• It is based on accounting profits (mainly based on accrual and historical cost convention), and not cash flows. However investments are about investing cash to obtain cash returns. Investment decisions should therefore be based on cash flows, and not accounting profits.
• Since it is based on profits (more subjective) is easy to manipulate and will be different under different accounting policies and estimates. For example, the annual profit and the average annual investment can both be changed simply by altering the rate of depreciation and the estimated residual value.
• The ARR method ignores the time value of money.
• The ARR is a percentage return, relating the average profit to the size of the investment. It does not give us an absolute return. However the absolute return can be significant. For example if the ARR on an investment of Rs.1,000 is 50%, the average profit is Rs.500; whereas if the ARR on an investment of Rs.1 million is 20%, the average annual profit will be Rs.200,000. An accounting return of Rs.200,000 on an investment of Rs.1 million might be preferred to an accounting return of 50% on an investment of Rs.1,000.
• When using the ARR method for investment appraisal, a decision has to be made about what the minimum target ARR should be. There is no rational economic basis for setting a minimum target for ARR. Any such minimum target accounting return is a subjective target, with no economic or investment significance.

Question 3

What are the advantages of the payback method? [3]

Answer 3

• Simplicity – The payback is easy to calculate and understand.
• The method analyses cash flows, not accounting profits. Investments are about investing cash to earn cash returns. In this respect, the payback method is better than the ARR method.
• Payback concentrate on earlier cash flows in the project’s life time, which are more certain and more important if the firm has liquidity concerns.

Question 4

What are the disadvantages of the payback method? [5]

Answer 4

• It is not linked to the wealth maximisation objective. In other words, it does not select projects based on their ability to increase the wealth of the owners of the company. There is no measure of the change in wealth either in absolute (Rs) or relative (%) terms.
• Setting a minimum payback period is very subjective. (Note: The deep you go in time period to collect cash from the project, less attractive it would be due to higher uncertainty and risks).
• Target payback period may cause the company to select a less attractive project in terms of NPV just because its payback period is more than target payback period.
• It ignores all cash flows after the payback period, and so ignores the total cash returns from the project. This is a significant weakness with the payback method.
• It ignores the timing of the cash flows during the payback period. For example, for an investment of Rs.100,000, cash flows of Rs.10,000 in Year 1 and Rs.90,000 in Year 2 are no different from cash flows of Rs.90,000 in Year 1 and Rs.10,000 in Year 2, because both pay back after two years. However it is clearly better to receive Rs.90,000 in Year 1 and Rs.10,000 in Year 2 than to receive Rs.10,000 in Year 1 and Rs.90,000 in Year 2.

Question 5

What are the advantages of the NPV method compared to the IRR method? [2]

Answer 5

• NPV provides a single absolute value indicating the amount by which the project should add to the company’s value.
• The NPV decision rule aligns with the objective of maximising shareholders’ wealth.

Question 6

What are the disadvantages of the NPV method compared to the IRR method? [4]

Answer 6

• The time value of money and present value concepts may not be easily understood by those without a financial education.
• There might be uncertainty about the appropriate cost of capital or discount rate for applying to any project.
• Companies do not operate with perfect information, which undermines the usefulness of NPV.
• The inability to measure a cost of capital could be considered a weakness of the IRR because the IRR has to be measured against a benchmark, and the best of these would be the cost of capital.

Question 7

What are the advantages of the IRR method compared to the NPV method? [3]

Answer 7

• People are used to receiving information based on percentages, which may make the IRR method more comfortable for them.
• The IRR method presents investment appraisal as a percentage return, which is an average that takes into account the** time value of money**.
• It does not require an estimate of the cost of capital to calculate the IRR.

Question 8

What are the disadvantages of the IRR method compared to the NPV method? [4]

Answer 8

• The IRR method is a relative measure, not an absolute measure, and cannot choose between projects with different initial investments but the same IRR.
• The supposed simplicity of IRR is an illusion, as understanding the percentage answer requires a certain level of financial education.
• While the cost of capital is not necessary in the calculation of the IRR, it is important in its use, as the IRR must be compared to something, usually the cost of capital.
• The IRR method’s decision rule is not consistent with the objective of maximising shareholders’ wealth.

Question 9

What is the decision-making process for mutually exclusive projects using IRR and NPV methods? [3]

Answer 9

• For accept/reject decisions on individual projects, both IRR and NPV methods will generally give the same decision.
• However, when choosing between two mutually exclusive projects, the IRR method might give a decision that conflicts with the NPV method.
• This is illustrated by NPV profiles at different costs of capital for two projects, where the choice of cost of capital can affect the decision.