Investment Appraisal: Evaluating Payback Period & IRR in Accounting

This assignment provides a detailed solution to an accounting exam question focusing on investment appraisal techniques, specifically the payback period method and internal rate of return (IRR). It begins by calculating the payback period for two investment options, Edinburgh and Newcastle, determining that Newcastle has a slightly shorter payback period. The solution then critically evaluates the payback period technique, outlining its benefits such as simplicity and liquidity focus, while also addressing its drawbacks like ignoring the time value of money and profitability. Furthermore, the assignment advises a team on the characteristics of investment appraisal decisions, highlighting the advantages and disadvantages of using IRR, including its consideration of the time value of money but also its potential for unrealistic reinvestment rate assumptions. Ultimately, the assignment recommends choosing the Newcastle project based on its shorter payback period, emphasizing the importance of recovering initial investments quickly. Desklib offers a wealth of similar solved assignments and study resources for students.

Accounting Based Exam

Multiple choice question
Question
no Answer
1 a
2 d
3 a
4 b
5 a
6 d
7 b
8 d
9 d
10 b
11 b
12 a & b
13 d
14 b
15 a
16 d
17 d
18 d
19 b
20 c
21 b
22 b
23 c
24 a
25 d
26 d
27 a
28 c
29 c
30 d

a. Computing payback period for both Edinburgh and Newcastle
Initial investment
Edinburgh Newcastle
Franchise fee (year 0) 8700 7950
New buses (year 0 4120 3890
Total initial
investment 12820 11840
Payback period
Edinburgh Newcastle
Year
Cash
inflows
Cumulative cash
inflows
Cash
inflows
Cumulative cash
inflows
1 3780 3780 3500 3500
2 4150 7930 3850 7350
3 4550 12480 4200 11550
4 5120 17600 5150 16700
5 5010 22610 5045 21745
Payback
period 3 + (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 to invest in small projects and also does not want to engage in complex
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.
Drawbacks Time 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.

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, profitability index and discounted payback period. These techniques highlight the
rationale justification for spending the company's limited resources.
Advantages and disadvantages of IRR enumerated below:
Advantages Disadvantages
 Time Value Of Money: It considers the
time value of money. Simplicity: The method is very simple
to interpret. Hurdle Rate of Return is Not
Required: In calculation of IRR hurdle
rate is not required. Required Rate of Return is a Rough
Estimate: The managers make the
rough estimate of required rate of
return.
 Economies to scale ignored: One
drawback of IRR is that the actual
value of benefits are ignored.
 Assumption of Reinvestment Rate:
The implicit assumption of
reinvestment rate is impractical.
 Dependent Projects: Sometimes
situations arise in which a compulsion
of investing in other projects is created
during evaluation of a project.
 Mutually Exclusive Projects:
Calculation of IRR is not sufficient in
mutually exclusive projects.