Accounting Rate of Return (ARR) Advantages and Disadvantages
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What is a major limitation of the Accounting Rate of Return (ARR) method?

  • It is based on expected cash flows from the project
  • It is a relative measure rather than an absolute measure
  • It is difficult to calculate
  • It ignores the time value of money (correct)

    • What is the main advantage of using the Payback Period method?

  • It is based on expected cash flows from the project
  • It takes into account the time value of money
  • It is more accurate than the NPV method
  • It is simple to calculate and understand (correct)

    • What is the primary purpose of the Payback Period method?

  • To determine the Internal Rate of Return (IRR) of a project
  • To evaluate mutually exclusive projects
  • To determine the Net Present Value (NPV) of a project
  • To calculate the number of years needed to recover the original investment (correct)

    • What is a key difference between the Accounting Rate of Return (ARR) and the Internal Rate of Return (IRR) methods?

    <p>ARR ignores the time value of money, while IRR takes it into account</p> Signup and view all the answers

    What is the main focus of the Payback Period method?

    <p>To measure the time it takes to recover the initial investment</p> Signup and view all the answers

    What is a limitation of the Payback Period method?

    <p>It ignores the cash flows after the payback period</p> Signup and view all the answers

    What is the main advantage of using the Accounting Rate of Return (ARR) method?

    <p>It is simple to calculate and understand</p> Signup and view all the answers

    What is a major difference between the Payback Period and the Net Present Value (NPV) methods?

    <p>Payback Period ignores the cash flows after the payback period, while NPV considers all cash flows</p> Signup and view all the answers

    What is the primary objective of companies making capital investments?

    <p>To generate value for their stakeholders by returning long-term benefits and future cash flows</p> Signup and view all the answers

    What is the main limitation of the Accounting Rate of Return (ARR) method?

    <p>It does not consider the time value of money</p> Signup and view all the answers

    A project has a net present value (NPV) of $100,000. What does this indicate?

    <p>The project is expected to generate a positive return</p> Signup and view all the answers

    What is the main difference between the Net Present Value (NPV) and Internal Rate of Return (IRR) methods?

    <p>NPV provides a dollar value, while IRR provides a percentage</p> Signup and view all the answers

    A project has a payback period of 3 years. What does this indicate?

    <p>The project will recover its initial investment cost in 3 years</p> Signup and view all the answers

    What is the main advantage of the Net Present Value (NPV) method?

    <p>It considers the time value of money</p> Signup and view all the answers

    A project has an Accounting Rate of Return (ARR) of 15%. What does this indicate?

    <p>The project will generate a return of 15% per annum</p> Signup and view all the answers

    What is the main limitation of the Payback Period method?

    <p>It does not consider the time value of money</p> Signup and view all the answers

    What is the scrap value of the plant purchased in the first scenario?

    <p>$20,000</p> Signup and view all the answers

    What is the target ARR of the company in the first scenario?

    <p>25%</p> Signup and view all the answers

    What is the ROCE required by Shevin Inc in the second scenario?

    <p>10% pa</p> Signup and view all the answers

    What is the expected residual value of the equipment after four years in the second scenario?

    <p>$2m</p> Signup and view all the answers

    What is the expected additional sales in 2020 in the second scenario?

    <p>2,000,000 units</p> Signup and view all the answers

    What is the average profit-to-average investment method used to evaluate the project in the second scenario?

    <p>ARR</p> Signup and view all the answers

    Why is the sales volume expected to fall over time in the second scenario?

    <p>Due to emerging competitive pressures</p> Signup and view all the answers

    What is the purpose of the central finance department in the second scenario?

    <p>To set the overhead costs</p> Signup and view all the answers

    What is a limitation of the Payback Period method?

    <p>It ignores cash flows after the payback period</p> Signup and view all the answers

    What is the primary objective of companies making capital investments?

    <p>To maximize shareholder wealth</p> Signup and view all the answers

    What is the main advantage of using the Net Present Value (NPV) method?

    <p>It takes into account the time value of money</p> Signup and view all the answers

    What is the main difference between the Internal Rate of Return (IRR) and the Accounting Rate of Return (ARR) methods?

    <p>IRR considers the time value of money, while ARR does not</p> Signup and view all the answers

    What is the main focus of the Payback Period method?

    <p>To determine the time it takes to recover an investment</p> Signup and view all the answers

    What is a disadvantage of the Accounting Rate of Return (ARR) method?

    <p>It ignores the time value of money</p> Signup and view all the answers

    What is the main advantage of using the Internal Rate of Return (IRR) method?

    <p>It takes into account the time value of money</p> Signup and view all the answers

    What is the main difference between the Payback Period and the Net Present Value (NPV) methods?

    <p>NPV takes into account the time value of money, while Payback Period does not</p> Signup and view all the answers

    Which of the following is a key limitation of the Payback Period method?

    <p>It is not able to consider the time value of money</p> Signup and view all the answers

    What is the primary goal of capital budgeting decisions?

    <p>To maximize shareholder wealth</p> Signup and view all the answers

    Which of the following methods is able to consider the time value of money?

    <p>Net Present Value</p> Signup and view all the answers

    Which of the following is a key advantage of the Net Present Value (NPV) method?

    <p>It is able to consider the time value of money</p> Signup and view all the answers

    What is the primary difference between the Internal Rate of Return (IRR) and the Net Present Value (NPV) methods?

    <p>The IRR method is used to calculate the rate of return, while the NPV method is used to calculate the value of the project</p> Signup and view all the answers

    Which of the following is a key limitation of the Accounting Rate of Return (ARR) method?

    <p>It is affected by the accounting conventions used</p> Signup and view all the answers

    What is the primary purpose of the Payback Period method?

    <p>To determine the time it takes for a project to recover its initial investment</p> Signup and view all the answers

    Which of the following methods is most suitable for evaluating projects with different cash flow patterns?

    <p>Net Present Value</p> Signup and view all the answers

    Study Notes

    Investment Appraisal Methods

    • Capital investments are made to generate value for stakeholders by returning long-term benefits and future cash flows greater than the associated funding cost of the capital invested.

    Accounting Rate of Return (ARR)

    • ARR is a financial metric used to evaluate the profitability of an investment or project.
    • ARR calculates the average annual profit or return generated by an investment as a percentage of the initial investment cost.
    • Advantages of ARR:
      • Simple to calculate
      • Uses profits which may be seen in the financial accounts
      • Gives a percentage measure which may be more readily understood by management
      • Can be used to compare mutually exclusive projects
    • Disadvantages of ARR:
      • Ignores the time value of money
      • Profits are arrived at after taking accruals and provisions into account
      • It is a relative measure rather than absolute measure

    Payback Period

    • This investment appraisal method calculates the number of years needed to recover the original investment.
    • Measures the time that a project will take to earn the cash that was invested in it.
    • Based on expected cash flows from the project, not accounting profits.
    • Advantages of Payback Period:
      • Simple concept to understand
      • Easy to calculate (provided future cash flows have been calculated)
      • Uses cash, not accounting profit
      • Takes risk into account (in the sense that earlier cash flows are more certain)
    • Disadvantages of Payback Period:
      • Considers cash flows within the payback period only, ignoring size and timing of cash flows
      • Ignores time value of money (although discounted payback can be used)
      • It does not really take account of risk

    Practice Questions

    • Calculate the payback period of a project with given cash flows
    • Calculate the ARR of a project with given cash flows and initial investment
    • Determine whether a proposed capital investment is attractive using the ARR method

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    Lecture 6 Investment Appraisal Part A.pptx

    Description

    This quiz covers the advantages and disadvantages of Accounting Rate of Return (ARR) in investment decision making, including its calculation and limitations.

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