S

Solutions to these questions can be found in Appendix C .

8.1 Why is the net present value method of investment appraisal considered to be theoretically

superior to other methods that are found in practice?

8.2 The payback period method has been criticised for not taking the time value of money into

account. Could this limitation be overcome? If so, would this method then be preferable

to the NPV method?

8.3 Research indicates that the IRR method is extremely popular even though it has shortcomings when compared to the NPV method. Why might managers prefer to use IRR

rather than NPV when carrying out discounted cash flow evaluations?

8.4 Why are cash flows rather than profit flows used in the IRR, NPV and PP methods of

investment appraisal?

REVIEW QUESTIONS

EXERCISES

Exercises 8.1 and 8.2 are basic level, 8.3 and 8.4 are intermediate level and 8.5 to 8.8 are

advanced level. Those with coloured numbers have solutions given in Appendix D .

8.1 The directors of Mylo Ltd are currently considering two mutually exclusive investment

projects. Both projects are concerned with the purchase of new plant. The following data

are available for each project:

Project 1 Project 2

000 000

Cost (immediate outlay) 100 60

Expected annual operating profit (loss):

Year 1 29 18

2 (1) (2)

3 2 4

Estimated residual value of the plant after 3 years 7 6

The business has an estimated cost of capital of 10 per cent. It uses the straight-line

method of depreciation for all non-current (fixed) assets when calculating operating profit.

Neither project would increase the working capital of the business. The business has sufficient funds to meet all investment expenditure requirements.

Required:

(a) Calculate for each project:

(i) the net present value;

(ii) the approximate internal rate of return;

(iii) the payback period.

(b) State, with reasons, which, if any, of the two investment projects the directors of Mylo

Ltd should accept.