- 8 Marks
FM – L2 – Q51 – Introduction to investment appraisal
Question
ZESTA VENTURES
It is said that of all the capital investment evaluation approaches, the Payback (PB) and Accounting rate of return (ARR) methods are widely used in practice. But these methods are not without limitations.
Required:
(a) State TWO justifications of payback period and ONE justification of ARR for their popularity in practice as investment appraisal techniques.
(b) Outline TWO limitations each for payback and ARR, as investment appraisal techniques.
Answer
(a) Justifications for the use of payback method
- It is considered useful when firms face liquidity constraints and require a fast payment of their investments.
- It serves as a simple first level screening device that identifies projects that should be subjected to more rigorous investigations.
(b) Justification for the use of ARR - ARR is a widely used financial measure of managerial performance. So managers are likely to be interested in how any new investment contributes to the business units’ overall accounting rate of return.
(b). Limitations of payback method
- It ignores the time value of money
- It ignores cash flows that are earned after the payback period
Limitations of ARR - The ARR fails to take into consideration the time value of money
- It relies on a percentage return rather than an absolute value
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