1. State and define the other methods available for undertaking investment appraisal?

Provide
one strength and weakness for each appraisal method.

Average accounting rate of return: The average accounting return (AAR) is defined as the average
project earnings divided by the average book value of the investment. Accept projects for which the
AAR is equal to or greater than the firm’s standard average accounting return. Reject all other
projects with AAR less than the target return. It is a simple return based measure. Does not use cash
flows and does not account for the time value of money. It also uses arbitrary target rate

Payback: Payback Period is the length of time for cumulated future cash inflows to equal an initial
outflow. Accept any project with a payback period equal to or shorter than the company’s standard
payback period or benchmark. Reject all other projects. It is simple and easy to use, it complements
sophisticated methods and good for non-specialists. Some drawbacks include no allowance for the
time value of money, cash flows after the cut-off are ignored and the arbitrary selection of cut-off
date.

Discounted payback the length of time for cumulated future cash inflows to equal an initial outflow,
but the cash flows are discounted to account for time value of money. Accept any project with a
discounted payback period equal to or shorter than the company’s standard or benchmark. Reject all
other projects. It is simple and easy to use, and considers time value of money. Some drawbacks
include cash flows after the cut-off are ignored and the arbitrary selection of cut-off date.

Profitability Index: The profitability index (PI) is the present value of the cash flows subsequent to
the initial investment divided by the initial investment. Accept any project for which the profitability
index is greater than or equal to one. Reject any project that has a PI less than one. Helps in ranking
projects for capital rationing

2. In your view, if the payback period method is used in conjunction with the NPV method, should
it be used before or after the NPV evaluation?

While the payback method is simple to use and can be used to initially screen projects, the major
disadvantage is that a very rewarding project may be overlooked if it does not meet the arbitrary
payback period. For example, if all projects that do not make a specified payback period—say, 3
years—are rejected, the company might forgo a very rewarding project whose payback is justified
at, say, 3.5 years.

The projects most likely rejected by the payback analysis that could be acceptable using the NPV
method are those that are slow to provide a return cash flow in early years but that provide a
significant cash flow in outlying years. However, the further out the cash flows are, the more
uncertain they become.

Therefore, if there is an abundance of projects to evaluate, it may make sense to use a simple
method such as the payback period analysis to winnow down the projects before applying a more
sophisticated method, such as the NPV method, to the survivors. If there is not an abundance of
projects or if time allows, it makes sense to apply more than one method of analysis to all of the
projects before making a final decision. Another variation is to extend the payback period an extra
year on the initial screen so that those projects just beyond the preferred payback horizon are given
a second chance.
3. List the commonly used discounted cash flow and non-discounted cash flow techniques used in
capital appraisal. Explain the difference between the discounted cash flow techniques and the
non-discounted cash flow techniques.

DCF techniques involve the discounting of relevant cash flows from a capital project, at a required
rate of return. This process involves estimating relevant cash flows and their timing and an
assessment of the rate required by investors in the project. Non-DCF techniques may also involve
the estimation of relevant cash flows but, by definition, will not take account of the time value of
money through the process of discounting. In the case of the average accounting rate of return
technique, accounting profits not cash flows are estimated and used in the calculation process

4. What advantages does IRR have over NPV?

 Easier to understand.

 Measures as a percentage.

 Shouldn’t be underestimated.

However, there are some weaknesses of the IRR:

 Biased upwards due to the assumption that intra-project cash flows are assumed to be reinvested.

 Percentage returns cause ranking problems (mutual exclusive).

 Non-conventional cash flows can lead to multiple solutions.

 Additivity is not possible.

5. Explain the following (using diagrams where appropriate) (15 marks)

- Conventional Cash Flows and Non-conventional Cash Flows.

Conventional Cash flows change sign once

- Baumol model and Miller-Orr model of cash management.

The Baumol Model: the optimal cash balance is found where the opportunity costs equal the trading
costs. Students should using diagrams to explain this model in term of opportunity cost and trading
costs The Miller-Orr Model: the firm allows its cash balance to wander randomly between upper and
lower control limits. Students should using diagrams to explain this model.
- A flexible short-term finance policy and a restrictive short-term finance policy.
6. “Net Present Value (NPV) is just a tool, and as with any tool, it can be dangerous in the wrong
hands.”

a) Discuss this statement. (8 marks)

b) In what way do sensitivity analysis and scenario analysis improve the application of NPV?

(7 marks)

Though NPV is the best capital budgeting approach conceptually, it has been criticized in practice for
giving managers a false sense of security. Sensitivity analysis, break even analysis, and scenario
analysis shows NPV under varying assumptions, giving managers a better feel for the project’s risks.
Unfortunately each methodology has its own drawbacks. Sensitivity analysis modifies only one
variable at a time, but many variables are likely to vary together in the real world. Scenario analysis
examines a project’s performance under different scenarios but not all scenarios. Break-even
analysis calculates the sales figure at which the project breaks even. Though break-even analysis is
frequently performed on an accounting profit basis, we suggest that a net present value basis is
more appropriate. In essence, all capital budgeting techniques are tools and any tool in the wrong
hands can cause damage.