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- 7 Marks
Question
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:
i) State TWO justifications of Payback Period and ONE justification of ARR for their popularity in practice as investment appraisal techniques.
(3 marks)
ii) Outline TWO limitations each for Payback Period and ARR as investment appraisal techniques.
(4 marks)
Answer
i) Justifications for the popularity of Payback Period:
- Liquidity Constraints: The Payback Period is considered useful when firms face liquidity constraints and require a fast return on their investments.
- Simple Screening Device: It serves as a simple first-level screening device that identifies projects that should be subjected to more rigorous investigations.
Justification for the popularity of ARR:
- Managerial Performance Measure: 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 unit’s overall accounting rate of return.
ii) Limitations of Payback Period:
- Ignores Time Value of Money: The Payback Period method ignores the time value of money, making it less accurate for long-term investments.
- Ignores Cash Flows After Payback: It also ignores any cash flows that are earned after the payback period, potentially missing out on the overall profitability of the investment.
Limitations of ARR:
- Ignores Time Value of Money: Similar to the Payback Period, ARR fails to take into consideration the time value of money.
- Relies on Percentage Return: ARR relies on a percentage return rather than an absolute value, which may not accurately reflect the true profitability of an investment.
- Topic: Decision making techniques, Discounted cash flow
- Series: MAY 2016
- Uploader: Dotse