Solutions to Review Questions

Atrill, McLaney: Accounting and Finance for Non-Specialists, 4th edition

Chapter 10

10.1NPV is usually considered the best method of assessing investment opportunities because it takes account of:

The timing of the cash flows. By discounting the various cash flows associated with each project according to when it is expected to arise, it recognises the fact that cash flows do not all occur simultaneously. Associated with this is the fact that, by discounting, using the opportunity cost of finance (that is, the return which the next best alternative opportunity would generate), the net benefit after financing costs have been met is identified (as the NPV).
The whole of the relevant cash flows. NPV includes all of the relevant cash flows irrespective of when they are expected to occur. It treats them differently according to their date of occurrence, but they are all taken account of in the NPV and they all have, or can have, an influence on the decision.
The objectives of the business. NPV is the only method of appraisal where the output of the analysis has a direct bearing on the wealth of the business. (Positive NPVs enhance wealth, negative ones reduce it). Since most private sector businesses seek to increase their value and wealth, NPV clearly is the best approach to use, at least out of the methods we have considered so far.

NPV provides clear decision rules concerning acceptance/rejection of projects and the ranking of projects. It is fairly simple to use, particularly with the availability of modern computer software that takes away the need for routine calculations to be done manually.

10.2The payback method, in its original form, does not take account of the time value of money. However, it would be possible to modify the payback method to accommodate this requirement. Cash flows arising from a project could be discounted, using the cost of finance as the appropriate discount rate, in the same way as the NPV and IRR methods. The discounted payback approach is used by some businesses and represents an improvement on the original approach described in the chapter. However, it still retains the other flaws of the original payback approach that were discussed. For example it ignores relevant data after the payback period. Thus, even in its modified form, the PP method cannot be regarded as superior to NPV

10.3The IRR method does appear to be preferred to the NPV method among practising managers. The main reasons for this appear to be as follows:

A preference for a percentage return ratio rather than an absolute figure as a means of expressing the outcome of a project. This preference for a ratio may reflect the fact that other financial goals of the business are often set in terms of ratios for example, return on capital employed.
A preference for ranking projects in terms of their percentage return. Managers feel it is easier to rank projects on the basis of percentage returns (though NPV outcomes should be just as easy for them). We saw in the chapter that the IRR method could provide misleading advice on the ranking of projects and the NPV method was preferable for this purpose.

10.4Cash flows are preferred to profit flows because cash is the ultimate measure of economic wealth. Cash is used to acquire resources and for distribution to shareholders. When cash is invested in an investment project an opportunity cost is incurred, as the cash cannot be used in other investment projects. Similarly, when positive cash flows are generated by the project it can be used to re-invest in other investment projects.

Profit, on the other hand, is relevant to reporting the productive effort for a period This measure of effort may have only a tenuous relationship to cash flows for a period. The conventions of accounting may lead to the recognition of gains and losses in one period and the relevant cash inflows and outflows occurring in another period.