Chapter 4

Question 1

How does the payback method work?

Answer 1

The payback period for a capital investment is the length of time before the cumulated stream of forecasted cash flows equals the initial investment

Question 2

Drawbacks of payback

Answer 2

• Makes no allowance for the time value of money
• Receipts beyond the payback period are ignored
• Arbitrary selection of the cut-off point

Question 3

Attractions of payback

Answer 3

• Supplements the more sophisticated methods
• An early stage filter
• It is simple and easy to use
• Projects which return their outlay quickly reduce the exposure of the firm to risk
• If funds are limited, there is an advantage in receiving a return on projects earlier rather than later
• Cash flow the first years predict som indication of the cash flows in later years

Question 4

Accounting rate of return (ARR /ROI)

Answer 4

Uses accounting information and is a ratio of the accounting profit to the investment in the project, expressed as a percentage

Question 5

Decision rule of ARR

Answer 5

If ARR is greater than, or equal to, a hurdle rate, then accept.

Question 6

ARR - annual basis

Answer 6

ARR = (profit for the year / asset book value at start of year) * 100

Question 7

ARR - total investment basis

Answer 7

ARR = (Average annual profit / initial capital invested) * 100

Question 8

ARR = Average investment basis

Answer 8

ARR = (Average annual profit / Average capital invested) * 100

Question 9

Drawbacks of ARR

Answer 9

• Accounting used
• many different methods, possible to choose a method which suits their purpose
• Profit figures are very poor substitutes for cash flows
• Fails to take account for the time value of money
• High degree of arbitrariness in defining the cut-off or hurdle rate

Question 10

Attractions of ARR

Answer 10

• Familiar to managers
• Divisional performance and the entire firm are often judged on a profit-to-assets employed ratio

Question 11

Attractions - IRR

Answer 11

• Psychological - familiar with expressing financial data in percentage
• IRR can be calculated without knowledge of the required rate of return
• Ranking

Question 12

Tha managerial “art” of investment appraisal:

Answer 12

• startegy
• social context
• expense
• stifling the entrepreneurial spirit
• intangible benefits

Question 13

Proces - Pre-appraisal

Answer 13

1. Generation of ideas
2. Development of proposals
3. Project classification
4. Screening with budget and corporate strategy formulation
5. Appraisal!

Question 14

Process - post-appraisal

Answer 14

6. Project report
7. Implementation
8. Post-completion audit (monitoring and evaluatiing the progress of a capital investment project through a comparsion of the actual cash flows and other costs and benefits with those forecasted)