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Investment Evaluation Methods

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Questions and Answers

What is a key limitation of the payback period method?

It disregards the time value of money. (correct)

It prioritizes qualitative data over quantitative data.

It uses complex calculations for cash flow projections.

It considers long-term profitability.

Why might a business overlook a potentially better investment?

It does not yield immediate cash flow.

It has a longer payback period. (correct)

It involves high operational costs.

The investment is too risky.

What does the average rate of return (ARR) allow businesses to do?

Maximize immediate profits.

Ignore opportunity costs.

Estimate cash flows over the long term.

Compare multiple investment options. (correct)

Which investment is likely to carry higher risk according to the content?

Investing in a machine at 27.5% return. Signup and view all the answers

What is a possible approach a business might take when evaluating investment options?

Analyze potential future cash flows. Signup and view all the answers

What might be a reason for businesses to assign different weights to the payback period in decision-making?

Differing organizational priorities. Signup and view all the answers

What is an essential factor to consider alongside the average rate of return?

Opportunity cost. Signup and view all the answers

How does the time value of money affect future cash flows?

It assigns less value to future cash flows compared to present cash flows. Signup and view all the answers

Study Notes

Payback Period Evaluation

The payback period method relies on estimations, which can affect its accuracy.
Despite its simplicity, this method ignores long-term profitability, potentially overlooking valuable investments with longer payback periods.
The payback period method does not account for the time value of money, which reduces the value of future cash flows.
Businesses may assign different weights to the payback period in decision-making, potentially prioritizing social or environmental impacts over payout speed.

Average Rate of Return (ARR) Interpretation

Businesses typically set a minimum ARR threshold for investment consideration.
Comparing investments with the highest rates of return allows businesses to make informed decisions.
Opportunity cost must be considered when analyzing ARR, comparing the investment return to alternative opportunities.
Risk is a crucial factor in ARR assessment, as higher returns are often associated with greater risk.

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Description

Explore the key concepts of the payback period and average rate of return (ARR) in investment evaluations. This quiz will help you understand the limitations and considerations of these financial assessment methods. Get ready to analyze how businesses make investment decisions based on these critical metrics.