- 20 Marks
Question
Management decisions regarding the acquisition of non-current assets and other long-term investments involve huge capital outlay, and they are critical to the future profitability and success of the company.
Gboza Limited proposed to buy a plant costing N2,000,000 which is expected to generate annual net cash flow of N600,000 for six years at a cost of capital of 10%.
Required:
a. Appraise the project using the internal rate of return. (13 Marks)
b. Should the plant be purchased? (2 Marks)
c. State TWO advantages and THREE disadvantages of accounting rate of return (ARR) as an investment appraisal technique. (5 Marks)
(Total 20 Marks)
Answer
Appraise the project using the Internal Rate of Return (IRR):
b. Should the plant be purchased?: Yes, the plant should be purchased because the IRR of 19.92% is higher than the cost of capital of 10%, indicating that the project will generate a return greater than the required rate of return.
c. Advantages and Disadvantages of Accounting Rate of Return (ARR):
Advantages:
- Simplicity: ARR is easy to calculate and understand, making it useful for managers who prefer straightforward techniques.
- Focus on Accounting Profit: It uses accounting profit rather than cash flows, which aligns with how companies report financial performance.
Disadvantages:
- Ignores Time Value of Money: ARR does not take into account the time value of money, which can lead to inaccurate appraisals of long-term projects.
- Focus on Accounting Profits: It relies on accounting profits rather than actual cash flows, which can be manipulated through accounting policies.
- Inconsistent Results: ARR can sometimes give conflicting results when compared to other methods like NPV and IRR, leading to suboptimal decisions.
- Topic: Investment Decisions
- Series: NOV 2014
- Uploader: Dotse