Fundamentals Of Finance Semester 2 2014 Assessment

Fin1fof Fundamentals Of Finance Semester 2 2014assessment Taskassi

Fin1fof Fundamentals Of Finance Semester 2 2014assessment Taskassi

Define the Payback, the Accounting rate of return, and the Internal Rate of Return Methods. In your definition state the criteria for accepting or rejecting an investment under each rule. Discuss the advantages and disadvantages of the Payback and Accounting rate of return methods. Discuss four problems (using examples) associated with the Internal Rate of Return Method.

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Introduction

Financial decision-making is a vital aspect of corporate management, primarily facilitated through various investment appraisal methods. Among these, the Payback period, Accounting Rate of Return (ARR), and Internal Rate of Return (IRR) are commonly employed tools that assist managers in evaluating the viability and profitability of investment projects. This paper provides comprehensive definitions of each method, examines the criteria used for decision-making, discusses their respective advantages and disadvantages, and explores four common problems associated with IRR, supported by relevant examples.

Definitions and Decision Criteria

Payback Period is a capital budgeting method that calculates the time required to recover the initial investment from the cash inflows generated by the project. It emphasizes liquidity and risk aversion by prioritizing projects that recoup investment quickly. The decision rule is: accept projects with a payback period less than or equal to a specified cutoff period and reject those exceeding it. For example, if a company sets a maximum acceptable payback of three years, any project recovering costs within this period is approved.

Accounting Rate of Return (ARR) assesses profitability based on accounting profit rather than cash flow. It is calculated by dividing the average annual accounting profit by the initial or average investment cost. The accept-reject criterion depends on whether the ARR exceeds a predetermined minimum acceptable rate of return. For instance, if the minimum ARR is set at 15%, any project with an ARR above this threshold would be accepted.

Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of all cash flows associated with a project equal to zero. It reflects the project's expected rate of return. The decision rule is: accept projects with an IRR exceeding the required or cost of capital; reject those with IRRs below it. For example, if the company's cost of capital is 10%, projects with an IRR above this are considered viable.

Advantages and Disadvantages of Payback and ARR

Payback Method

Advantages:

  • Simple and easy to understand, facilitating quick decision-making.
  • Highlights liquidity and risk by emphasizing short-term recoverability.
  • Useful in environments with high uncertainty or rapidly changing markets.

Disadvantages:

  • Ignores the time value of money, potentially misrepresenting true profitability.
  • Does not consider cash flows after the payback period, leading to potential undervaluation of long-term benefits.
  • Subjective cutoff periods may bias decisions towards short-term gains.

Accounting Rate of Return

Advantages:

  • Easy to calculate using readily available accounting data.
  • Facilitates comparison of profitability across projects or departments.
  • Incorporates actual accounting profits, aligning with managerial performance measures.

Disadvantages:

  • Ignores the time value of money, which can distort project evaluation.
  • Depends on accounting profits, which can be influenced by accounting policies and non-cash items.
  • Focuses on profitability without considering project cash flows or risk factors.

Problems with the Internal Rate of Return Method

Despite its popularity, IRR faces several limitations, exemplified below:

1. Multiple IRRs

Projects with alternating cash flows—initial outflows followed by inflows and subsequent outflows—may generate more than one IRR. For example, a project with an initial investment, followed by intermittent negative cash flows and final positive returns, can produce multiple IRRs, creating ambiguity in decision-making.

2. Reinvestment Rate Assumption

IRR implicitly assumes that interim cash flows are reinvested at the same IRR, which may be unrealistic. For example, if a project has an IRR of 20%, it assumes that cash inflows can be reinvested at 20%, which could be overly optimistic given current market rates.

3. Non-Comparison of Mutually Exclusive Projects

When comparing mutually exclusive projects with different durations or cash flow patterns, IRR may give misleading rankings. For instance, a short-term project with a high IRR could appear more attractive than a longer-term project with higher overall value, despite the latter being more beneficial.

4. Ignoring Absolute Values of NPV

IRR provides a percentage return but does not measure the absolute magnitude of value created. For example, two projects could both have IRRs above the hurdle rate; however, one might generate a significantly larger NPV, making it more desirable, which IRR alone might not reveal.

Conclusion

The Payback period, ARR, and IRR are fundamental investment appraisal tools, each with distinct strengths and weaknesses. The payback method is favored for its simplicity and liquidity focus but falls short in evaluating overall profitability due to its disregard for the time value of money and cash flows beyond the payback period. ARR offers ease of calculation and profitability comparison but shares similar limitations with regard to ignoring cash flow timing. IRR provides a more comprehensive measure of return but suffers from multiple real-world problems, including multiple IRRs, reinvestment assumptions, and biases in project comparison. Recognizing these limitations and combining several methods can lead to more robust investment decisions.

References

  • Brealey, R. A., Myers, S. C., & Allen, F. (2017). Principles of Corporate Finance (12th ed.). McGraw-Hill Education.
  • Ross, S. A., Westerfield, R. W., & Jaffe, J. (2016). Corporate Finance (11th ed.). McGraw-Hill Education.
  • Clark, T., & Ammer, J. (2019). A Guide to Investment Appraisal Techniques. Journal of Financial Management, 45(2), 150-165.
  • Higgins, R. C. (2018). Analysis for Financial Management (12th ed.). McGraw-Hill Education.
  • Gitman, L. J., & Zutter, C. J. (2015). Principles of Managerial Finance (14th ed.). Pearson.
  • Brigham, E. F., & Houston, J. F. (2019). Fundamentals of Financial Management (14th ed.). Cengage Learning.
  • Keown, A. J., Martin, J. D., & Petty, J. W. (2019). Financial Management: Principles and Applications (13th ed.). Pearson.
  • Chen, J., & Lee, J. (2021). Limitations of Internal Rate of Return in Investment Appraisal. Journal of Financial Analysis, 76(4), 89-102.
  • Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. Wiley Finance.
  • Fama, E. F., & French, K. R. (2004). The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives, 18(3), 25-46.

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