Module 5 Capital Investment Appraisal

Question 1

Methods of Investment Appraisal

Answer 1

• Payback
• Accounting Rate of Return
• Net Present Value
• Internal Rate of Return

Question 2

Accounting Rate of Return (ARR)

Answer 2

• AAP formula
• ACI formula

Question 3

Average Annual profits (AAP)

Answer 3

If no additional information is given on depreciation, you should assume assets are depreciated on a straightline basis over their useful economic life.

Question 4

Average Capital Investment (ACI)

Answer 4

Question 5

Advantages of Payback

Answer 5

• popular method due to the simplicity
• easy to see the length of time that the capital is at risk

Question 6

Disadvantages of Payback

Answer 6

• The time value of money is not taken into account
• There is a built-in discrimination in favour of short-term investments
• Cash flows after the payback period are ignored
• It does not provide a measurement of absolute gain in wealth of the shareholders

Question 7

Advantages of ARR

Answer 7

• relatively straightforward
• easily understood technique

Question 8

Disadvantages of ARR

Answer 8

• ARR cannot be compared meaningfully to the cost of capital
• The life of the project is ignored
• ARR does not account for the time value of money
• It does not provide a measurement of absolute gain in wealth of the shareholders

Question 9

Advantages of NPV

Answer 9

• The time value of money is considered
• NPV is relatively easy to calculate
• Use of WACC as a discount rate ensures that the NPV exactly measures the increase in shareholder’s wealth represented by undertaking the project

Question 10

Disadvantages of NPV

Answer 10

• using the firm’s overall cost of capital as the discount factor for a particular project is
  only appropriate if the potential new investment has the same risk exposure as the company
• The concept of the time value of money and the NPV itself can be difficult to understand for non-financial accountants

Question 11

IRR Formula

Answer 11

Question 12

Advantages of IRR

Answer 12

• more easily understood by non-accountants since it generates a relative measure
• The IRR technique gives due consideration to the time value of money

Question 13

Disadvantages of IRR

Answer 13

• The calculation, is more difficult to understand than other techniques
• If there are changes in the direction of cash flows over a project’s life, more than one IRR may be possible
• Comparing IRRs for two projects of different sizes may give different project ranking results compared to NPV technique. The NPV technique should always be used where this conflict occurs.