Chapter 13 - Test your knowledge

Question 1

What are the basic decision-making factors to consider when
making a choice between two or more projects using payback
period?

Answer 1

A few factors need to be considered in deciding whether to accept this project:

1. a project is acceptable if it pays back within the target period when
   choosing between two or more projects, the project(s) with the fastest
   payback is chosen.

Question 2

How do depreciation and sunk costs affect the decision-making
process in project appraisal?

Answer 2

Sunk costs and depreciation are non-relevant factors for project appraisal. Sunk costs are past expenditure that cannot be recovered and hence
cannot influence the current decision.

Depreciation is a non-cash item and does
not affect future cash flows

Question 3

What are the limitations of using ARR for evaluating projects?

Answer 3

The key limitations of using ARR are listed below…

1. It ignores factors such as project life (the longer the project, the greater
   the risk), working capital and other economic factors which may affect the profitability of the project.
2. Accounting rate of return is based on accounting profits that vary depending on accounting policies (such as depreciation policy).
3. Accounting rate of return does not take into account the time value of
   money.
4. Accounting rate of return can be calculated using different formulas.

For example, ARR can be calculated using profit after tax and interest, or
profit before tax, thus leading to different outcomes.

It is important to ensure that ARRs are calculated on a consistent basis when comparing
investments.

5. It is not useful for evaluating projects where investment is made in parts at
   different times.
6. It does not take into account any profits that are reinvested during the
   project period.