BUSF_A01.qxd

Chapter 4 • Investment appraisal methods

4.1 Is the objective of discounting to take account of inflation? Explain.

4.2 When we say that future cash flows should be discounted at a rate that takes account

of the opportunitycost of finance, what do we mean by opportunity?

4.3 What is the key point about the net present value approach to investment decision

making that makes it the most correct method, in theory?

4.4 The payback period method of assessing potential investment projects is badly flawed,

but it is widely used nonetheless. Why is it so widely used?

4.5 What is the fundamental flaw of using the internal rate of return method? Is it a prob-

lem in practice?

4.6 Evidence shows that many businesses use more than one of the four methods of

investment appraisal found in practice. What could be the reason for this?

Review questions

Suggested answers to

Review questions

in Appendix 3.

(Problems 4.1 to 4.4 are basic-level problems, whereas problems 4.5 and 4.6 are more

advanced and may contain some practical complications.)

4.1*Barclay plc is assessing an investment project. The estimated cash flows are as follows:

Year £m

0 10 Outflow

1 5 Inflow

2 4 Inflow

3 3 Inflow

4 2 Inflow

The business’s cost of finance is 15 per cent p.a. and it seeks projects with a three-

year maximum discounted payback period.

Should the project be undertaken on the basis of NPV and discounted PBP?

4.2 Branton & Co. Ltd is choosing between two mutually exclusive investment opportunities,

Project A and Project B. The estimated cash flows for the two projects are as follows:

Project A Project B

£000 £000

Investment (immediate cash outflow) 50 36

Net annual cash inflows:

Year 1 39 28

298

31214

Cash inflow from residual value Year 3 7 6

The business’s cost of finance is estimated at 10 per cent.

Problems

Sample answers to

problems marked with

an asterisk appear in

Appendix 4.