Topic 8 - Investment appraisal techniques

Question 1

Payback period

Answer 1

use cash flows: profit + depreciation

Question 2

Disadvantages of payback period

Answer 2

• short-termist - ignores longer term cashflows
• choice of target payback period is subjective
• ignores time value of money

Question 3

ARR

Answer 3

(Average annual accounting profit/ Initial or Average investment) x 100%

cashflow - deprecaiton = PROFIT

Question 4

Advantages and disadvantages of ARR

Answer 4

• recognise a/c profits from F.S.
• average profit per annum means that all projec’ts life is incorporated
• accounting profit can be manipulated
• ignores timing of profit
• ignores time value of money
• not universally agreed as it be based on intial or average investment making it hard to interpret

Question 5

Advantages of NPV

Answer 5

• directly linked to shareholder wealth
• considers all relevant cashflows + time value
• can incorporate risk

Question 6

Disadvantages of IRR

IRR = discount rate at which NPV = 0

Answer 6

• ignores absolute size of investment
• unconventional cashflows can get multiple IRRs
• tends to give too optimitc result

Question 7

What does it mean if IRR is greater than captial cost?

Answer 7

later cash flows have been discounted too much

Question 8

A ranking of IRR gives the same order as ranking by payback

Question 9

A ranking of projects by NPV gives the same order as ranking by payback

Question 10

If IRR is less than cost of capital then NPV will be negative