Accounting Based Exam: Payback Period Calculation, Evaluation and Investment Appraisal Decisions
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Added on 2023/06/12
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This exam includes multiple choice questions related to accounting, payback period calculation for Edinburgh and Newcastle, critical evaluation of payback technique, benefits and drawbacks of IRR, and advising team regarding the characteristics of investment appraisal decisions.
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Accounting Based Exam
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a. Computing payback period for both Edinburgh and Newcastle Initial investment EdinburghNewcastle Franchise fee (year 0)87007950 New buses (year 041203890 Total initial investment1282011840 Payback period EdinburghNewcastle Year Cash inflows Cumulative cash inflows Cash inflows Cumulative cash inflows 13780378035003500 24150793038507350 3455012480420011550 4512017600515016700 5501022610504521745 Payback period3 + (12820 – 12480) / 5120 = 3.07 years 3 + (11840 – 11550) / 5150 = 3.06 years With the help of the payback calculation it is clear that in case of Edinburgh it is 3.07 years and for Newcastle it is 3.06 years. Both the project is having a very slight difference and as a result of this selection of any project will not make huge difference. In case of Edinburgh the company will recover the invested amount in time frame of 3.07 year and for Newcastle they will be start earning the profit after the time of 3.06 years. b. Critically evaluating payback technique Benefits of payback period
Use For Small Investments:The payback period is beneficial for the companies that prefer toinvest insmall projectsandalso doesnot want toengage incomplex calculations by taking factors like discount rates and the effect on the output into account.Simplicity:The concept involved in payback period is very easy to understand and perform calculation. It can be calculated without the help calculator or spreadsheet.Risk Focus:The payback period analysis is based on focus over the fastness of money being returned from an investment. It is beneficial in knowing the comparison of the risk related to projects with their differential payback periods. Liquidity Focus:The analysis made through payback period focuses the projects that quickly returns the money, thus project selection decisions are inclined towards the higher degree in context of short term liquidity. The concept is highly advantageous in case of long-term investments with uncertainty. DrawbacksTime value of money is ignored:This is the major drawback of payback period is that time value of money is not taken into account. The concept does not consider the fact that money that comes earlier is worth more.Not all Cash Flows Covered:Cash flows in calculation of payback period are calculated only till the period initial investment is paid back. The concepts fail in calculating sash flows for the subsequent years.Unrealistic:The concept of payback period is so simple that it does not even consider the circumstances in a normal business. Capital investments are not one time investments generally and also most projects have irregular cash inflows. Profitability gets ignored:There is no guarantee that project with shorter payback period will be profitable. It may that cash flow after payback period stops or decreases. The project would become incapable for returns in both the scenarios after payback period.
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c. Advising team regarding the characteristics of investment appraisal decisions along with the benefits & drawbacks of IRR With the help of the above calculation it is clear that company must go with the option of Newcastle. The reason underlying this fact is that the payback period is less in comparison to the other project. Although both the project is having only slight different within the payback period but Newcastle is having one month less. Hence, in this case the company will be start recovering the amount and after that they can start earning profits. Investment appraisal decisions are made based on the results of techniques of investment appraisal that are payback period, accounting rate of return, net present value, internal rate of return, profitabilityindex and discountedpayback period. These techniqueshighlightthe rationale justification for spending the company's limited resources. Advantages and disadvantages of IRR enumerated below: AdvantagesDisadvantages Time Value Of Money:It considers the time value of money.Simplicity:The method is very simple to interpret.HurdleRateofReturnisNot Required:In calculation of IRR hurdle rate is not required.Required Rate of Return is a Rough Estimate:Themanagersmakethe roughestimateofrequiredrateof return. Economiestoscaleignored:One drawbackofIRRisthattheactual value of benefits are ignored. AssumptionofReinvestmentRate: Theimplicitassumptionof reinvestment rate is impractical. DependentProjects:Sometimes situations arise in which a compulsion of investing in other projects is created during evaluation of a project. MutuallyExclusiveProjects: Calculation of IRR is not sufficient in mutually exclusive projects.