Chapter 12 tutorial suggested solution
12.1 What are the key features of capital investment decisions that distinguish
them from other types of business decisions?
Solution: Capital investments involve outlaying a significant proportion of a
business’ total resources. If mistakes are made with the decision, the effects
on the business could be significant, if not catastrophic.
Typically, they require an initial outlay of one large amount with cash inflows
received over a long-term period.
LO1 Identify the essential features of investment decisions, and state the four
common capital investment appraisal methods
12.3 List and briefly describe two strengths and two weaknesses for the accounting
rate of return evaluation method.
Solution:
Strength—close link between ARR and ROCE enhances credibility and
understanding.
Strength—easy for accountants to understand as uses familiar accounting
measures.
Strength—provides a result in percentage terms as preferred by many
managers.
Weakness—doesn’t recognise the time value of money.
Weakness—doesn’t properly rank investments with competing projects of
different size.
Weakness—subject to manipulation due to use of accounting measures.
LO2 Demonstrate an understanding of the ‘accounting rate of return’ method
with respect to the formula, decision rule, and strengths and weaknesses
12.4 List and briefly describe two strengths and two weaknesses for the payback
evaluation method.
Solution:
Strength—easy to understand.
Strength—easy to calculate.
Strength—good, basic measure of risk.
Weakness—doesn’t recognise the time value of money.
Weakness—doesn’t recognise cash flows after the project pays back.
Weakness—doesn’t properly rank investments with competing projects of
different size.
LO3 Demonstrate an understanding of the ‘payback’ method with respect to
the formula, decision rule, and strengths and weaknesses
12.5 List and briefly describe two strengths and two weaknesses for the net
present value evaluation method.
Solution:
Strength—explicitly recognises the time value of money.
Strength—considers cash flows for the life of the project.
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An Introduction/8e
Weakness—the actual return percentage is unknown since the NPV method
provides an absolute dollar amount as the return.
Weakness—does not provide for ranking of alternative projects. If funds were
unlimited, then all projects with positive (+) NPVs would be selected.
However, funds are normally restricted and ranking alternative projects on the
basis of NPV may not achieve the best investment strategy.
LO4 Demonstrate an understanding of the ‘net present value’ method with
respect to the formula, decision rule, and strengths and weaknesses
12.8 What is meant by the expression ‘the time value of money’?
Solution: On purely economic grounds, a dollar earlier is preferred to a
dollar later because the dollar received earlier can be invested at a risk-free
interest rate to accumulate to a larger future sum. For example, $1.00
invested for one year at 10% p.a. is equal to $1.10 in one year from now.
LO4 Demonstrate an understanding of the ‘net present value’ method with
respect to the formula, decision rule, and strengths and weaknesses
12.11 The payback method has been criticised for not taking into account the time
value of money. Could this limitation be overcome? If so, would this method
then be preferable to the NPV method?
Solution: The 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 companies and
represents an improvement on the original approach described in the chapter.
However, it still retains the other flaws of the original payback approach which
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.
LO3 Demonstrate an understanding of the ‘payback’ method with respect to
the formula, decision rule, and strengths and weaknesses
LO4 Demonstrate an understanding of the ‘net present value’ method with
respect to the formula, decision rule, and strengths and weaknesses
AE12.1
Solution:
Average investment for A = 10
Check $000’s
Year 1 Beginning 20
End 16
End year 2 12
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An Introduction/8e
End year 3 8
End year 4 4
End year 5 0
60 divided by 6 = 10,000
Average profit = sum of inflows less annual depreciation of $4,000, divided by 5, so
(4 + 2 + 2 + 2 + 0)/5 = 2,000
So ARR = 2,000/10,000 x 100 = 20%
For B
Average investment is 25
Average profits are (10 + 5 + 5 + 5 + 0)/5 = 5,000 so ARR = 5/25 x 100 = 20%
For C
Average investment is 25
Average profits are (− 10 − 5 + 0 + 5 + 35)/5 = 5,000 so ARR = 5/25 x 100 = 20%
Clearly, the ARR is not very effective at differentiating between projects, because it
ignores the initial investment size, plus the complete lack of adjustment for the time
value of money.
LO2 Demonstrate an understanding of the ‘accounting rate of return’ method
with respect to the formula, decision rule, and strengths and weaknesses
AE12.2
Solution:
(a) Payback A B C
3 years 3 years Just under 4.5 years
Accept Accept Reject
(b) NPV at 10%
A Discount factor Discounted value
Outflows (20,000) 1 (20,000)
Inflows
1 8,000 .909 7,272
2 6,000 .826 4,956
3 6,000 .751 4,506
4 6,000 .683 4,098
5 4,000 .621 2,484
Net present value 3,316
So accept
B Discount factor Discounted value
Outflows (50,000) 1 (50,000)
Inflows
1 20,000 .909 18,180
2 15,000 .826 12,390
3 15,000 .751 11,265
4 15,000 .683 10,245
5 10,000 .621 6,210
Net present value 8,290
Copyright ©2021 Pearson Australia (a division of Pearson Australia Group Pty Ltd) –ISBN9781488625695 /Atrill/Accounting
An Introduction/8e
So accept
C Discount factor Discounted value
Outflows (50,000) 1 (50,000)
Inflows
1 - .909 -
2 5,000 .826 4,130
3 10,000 .751 7,510
4 15,000 .683 10,245
5 45,000 .621 27,945
Net present value (170)
So reject
(c) Need to re-do NPV at a different rate. Suggest 20% for illustration purposes.
NPV at 20%
A Discount factor Discounted value
Outflows (20,000) 1 (20,000)
Inflows
1 8,000 .833 6,664
2 6,000 .694 4,164
3 6,000 .579 3,474
4 6,000 .482 2,892
5 4,000 .402 1,608
Net present value (1,198)
B Discount factor Discounted value
Outflows (50,000) 1 (50,000)
Inflows
1 20,000 .833 16,660
2 15,000 .694 10,410
3 15,000 .579 8.685
4 15,000 .482 7,230
5 10,000 .402 4,020
Net present value (2,995)
C Discount factor Discounted value
Outflows (50,000) 1 (50,000)
Inflows
1 - .833 -
2 5,000 .694 3,470
3 10,000 .579 5,790
4 15,000 .482 7,230
5 45,000 .402 18,090
Net present value (15,420)
By interpolation
Project NPV at 10% NPV at 20% difference diff for 1%
A 3,316 (1,198) 4,514 451
B 8,290 (2,995) 11,292 1,129
C (170) (15,240) 15,070 1,507
Therefore the IRR is as follows:
A 10% + (3,316/4,514)/10 = 17.3%
B 10% + (8,297/11,292)/10 = 17.3%
C Obviously less than 10%. Given that a change in discount rate of 1% is
associated with a reduction in NPV of 1,507, the IRR is only
just under 10%.
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An Introduction/8e
If the required IRR is 10% A and B would be accepted but C would be
rejected. If the required rate of return is 20% all would be rejected.
LO3 Demonstrate an understanding of the ‘payback’ method with respect to
the formula, decision rule, and strengths and weaknesses
LO4 Demonstrate an understanding of the ‘net present value’ method with
respect to the formula, decision rule, and strengths and weaknesses
LO5 Demonstrate an understanding of the ‘internal rate of return’ method with
respect to the formula, decision rule, and strengths and weaknesses
Copyright ©2021 Pearson Australia (a division of Pearson Australia Group Pty Ltd) –ISBN9781488625695 /Atrill/Accounting
An Introduction/8e