Chapter 8

Question 1

Advantages

Accounting Rate of Return (ARR)

Answer 1

Relatively easy to use
A rate is always easy to interpret

Question 2

Disadvantages

Accounting Rate of Return (ARR)

Answer 2

Ignores cash flows

Ignores the time value of money

Ignores risk

The target rate of return is set subjectively by management

Question 3

Advantages

Payback method

Answer 3

Easy to use

Good for quantifying risk: longer payback = more risk

Question 4

Disadvantages

Payback method

Answer 4

Target period subjective (set by management)
Ignores inflation and TVM

Risk not explicitly considered

Ignores CFL after the payback period (i.e., ignores need to be profitable and maxmise s/h wealth)

Question 5

Advantages

Net Present Value (NPV)/ Discounted Cash flows (DCF)

Answer 5

Takes cashflows into account
Takes TVM into account
Risk explicitly taken into account in WACC
Theoretically superior to other methods

Question 6

Disadvantages

Net Present Value (NPV)/ Discounted Cash flows (DCF)

Answer 6

Answer in monetary form and not % (more difficult for non-financial managers to interpret)

Question 7

Advantages

Internal Rate of Return (IRR)

Answer 7

Considers CF, risk and TVM

A rate easier to interpret than a Rand amount

Question 8

Disadvantages

Internal Rate of Return (IRR)

Answer 8

N/A

Question 9

Advantages

Profitability index

Answer 9

Theoretically similar to NPV method – therefore, reliable

Index value – can be compared to other projects easily

Help choose best alternative

Question 10

Qualitative considerations

Answer 10

Ethics

Supply chain

Changing Tech

Lifespan

Question 11

Dealing with uncertainty in the investment decision

Answer 11

Risk premium
Finite horizon
Scenario analysis
Use of statistics and probability methods to quantify risk