Exercises 3.

T or F

The payback period estimates the length of time for the cash inflows from an
1.
investment to recover the initial project cost.
Investment appraisal is a means of assessing whether an investment project is
2.
worthwhile or not.
The period over which the investment is expected to earn profit is required to
3.
calculate the average rate of return (ARR) for a project.
The formula to calculate the payback period is: Annual cash flow from investment
4.
÷ initial investment cost × 100.
An advantage of the payback period is that it allows a firm to examine if it will
5.
break even on the purchase of an asset before it becomes technologically obsolete.
An advantage of the payback method of investment appraisal is that contribution
6.
per month is likely to be constant during a project.
A disadvantage of the payback period method of investment appraisal is that it
7.
ignores the overall profitability of an investment.
Before pursuing a project, qualitative investment appraisal should also be
8.
considered.
An advantage of the payback period method of investment appraisal is that
9.
managers can easily understand the results.
An advantage of the average rate of return (ARR) investment appraisal method is
10.
that managers can see profitability predictions for projects.
Average annual profit is calculated by: (Total returns – Initial outlay) divided by
11.
the years of usage. This is then used to calculated the ARR.
A disadvantage of the payback period method of investment appraisal is that it
12.
cannot be used to compare different investment projects with different costs.
The average rate of return calculated by the formula: Average annual revenue
13.
divided by the Initial investment cost.
A disadvantage of average rate of return (ARR) is that a project’s useful life span
14.
(or a guess) is needed before any calculations can be made.
15. In an investment appraisal, the acronym NPV stand for Net Present Value.
The payback method of investment appraisal is harder to calculate than the net
16.
present value method.
 Net present value (NPV) indicates the value of the return from an investment
17.
project expressed in today’s value. (HL only)
18. Depreciation doesn’t directly affect the payback period.
The net present value of an investment is calculated using a discount factor (the
19.
opposite to a compound interest rate figure).
Total present values – original cost of investment is used to calculate the net
20.
present value (NPV).

Multiple Choices

1.Liquidity can be defined as:

A. The ability of a business to convert its current assets into cash easily

B. The ability of a business to get loans easily from banks

C. The ability of a business to raise capital from the market

D. All three options

2. Which of the following is a cash inflow?  

A. Wages

B. Utilities

C. Rent

D. Debtors

3.Which of the following is not likely to be a method for reducing cash outflows?

A. Looking for a low-cost supplier overseas

B. Making cash payments only

C. Controlling stock more effectively

D. Reducing expenses
4. A business that is profitable may not necessarily have adequate: 

A. Working capital

B. Investment

C. Cash flow

D. Sales revenue

5. A businesses requires a cash flow forecast in order to:

A. Assess how much profit they are making on a monthly basis

B. Ensure their sales targets are met for bonuses

C. Prepare cash flow statements

D. Not be caught unaware when payments are due

6. What is the term for the amount of cash paid out by the business for core operations such as
raw materials, creditors and electricity and other activities such as legal fees?

Closing balance = opening balance + __________

7. When a company has high liquidity, this means that:

A. The working capital is insufficient to meet current liabilities.

B. The company’s assets can be easily converted into cash.

C. The current liabilities are greater than the current assets.

D. The company has very high overdraft obligations.

Case Studies

Case Study 1.

Supreme Computing Inc. is considering spending $71,500 on new 3D printers. The annual
contribution from this investment is forecast to be $33,000.

Calculate the payback period for Supreme Computing Inc.  [3 marks]

 Months [1 mark]
 Weeks [1 mark]
 Days [1 mark]

Calculate the average rate of return for Supreme Computing Inc.  [2 marks]

Case Study 2.

Rowlands Printing Co. is considering an investment of $380,000 on new printing machines. The
project is expected to generate the following net cash flows in the five years that the machines are
expected to last, before they need replacing and upgrading. Rowlands Printing Co. has suffered
from liquidity problems recently, although remains profitable. The management team would
therefore prefer a shorter payback period for any investment project.

Year Net cash flow

1 $120,000

2 $140,000

3 $180,000

4 $150,000

5 $110,000
(a)     Define the term payback
period.                                                                                                [2 marks]

(b)     Calculate the payback period for Rowlands Printing

Co.                                                           [2 marks]

(c)     Comment on whether Rowlands Printing Co. should invest in the new printing

machines.      [4 marks]
Case Study 3.

Lewis & Co. is considering whether to pay for an annual subscription to an advertising agency at
a total cost of $80,800 for the next 5 years. The advertising agency predicts the net cash inflow
from this will be $28,200 of additional income per year for the company.

Calculate the payback period for Lewis & Co.  [2 marks]

Case Study 4.

Chislehurst Garden Centre (CGC) is investigating the feasibility of replacing its fleet of delivery
vehicles. The new vehicles would cost $560,000. The investment would increase CGC’s annual
sales revenue by $150,000 but raise costs by $50,000 a year. The estimated useful life of the new
vehicles is 8 years with no scrap (second-hand) value. The management at CGC prefer all
investment projects to have an average rate of return (ARR) of no less than 5%.

(a)  Calculate the average rate of return (ARR) of the new delivery vehicles for
CGC.                     [2 marks]

(b)  Based on the above answer, comment on whether CGC should purchase the new vehicles.  
[2 marks]

Case Study 5.

Sparks Education Company (SEC) is considering whether to replace its photocopiers and printers
for a total cost of $95,000. The expected net cash flow or total contribution per year are shown
below. The expected useful life of these equipment is 5 years.

Year Contribution ($)

1 28,000
2 32,000
3 35,000
4 25,000
5 22,000
Calculate the average rate of return and comment on whether Sparks Education
Company (SEC) should replace its photocopiers and printers.  [4 marks]
Case Study 6.

Juke’s Retro Arcade Games (J-RAG) is a partnership owned by brothers Jake and Luke that
trades second-hand games, including popular games consoles and arcade games from the 1980s.
The business has a single store in a popular location, and hires 15 part-time workers, most of
whom attend the local university. Whilst this creates great flexibility, J-RAG struggles with staff
retention, especially during the spring each year as the students who work at the business need
time to prepare for their exams.

The business also has an outdated computer system so struggles with accurate stock control
management. J-RAG’s accountant has also advised that the business needs to improve its
financial and human resources record keeping, such as a secure database of employee details and
payment records. Therefore, the brothers are considering whether to invest in a new computerized
system to improve its operational efficiency. The cost of the investment is forecast to be $140,000
with an expected lifespan of five years. Alternatively, they could use the money to hire two full
time workers which is expected to minimize disruptions caused by high labor turnover.

The forecasted net cash flows from the investment in the computerized system are given below.
The partnership uses a 4% discount factor (HL only).

Net cash
Year Discount factor
flow ($)
1 45,000 0.9615
2 50,000 0.9246
3 55,000 0.8890
4 45,000 0.8548
5 40,000 0.8219

[2
(a) (i) Define the term partnership.
marks]
[2
(a) (ii) Define the term labour turnover.
marks]
[2
(b) (i) Calculate the payback period for the proposed investment project.
marks]

Calculate the average rate of return (ARR) for the proposed

(b) (ii) [2
investment project.
marks]
 [2
(b)(iii) Calculate the net present value for the proposed investment project.
marks]

Evaluate whether J-RAG should invest in the new computerized

(c) system. Use information from the case study and both quantitative
[10
and qualitative considers in your answer.
marks]

Case Study 7.

Politooth is a manufacturing facility in Thailand that produces custom made dental implants
through the 3D printing process. Politooth has been contracted recently by the Thai government,
which has been outsourcingthe dental care it provides for its staff to private companies. 

Politooth is deciding whether to invest in additional 3D printers. The printers cost 3 million THB
and should provide at least five years of active use. 

The net cash flows are as follows: 

Year 1 2 3 4 5
Forecast annual net cash flow 650 000 790 000 650 000 800 000 400 000
(in THB)
Questions

1. Calculate
●    the payback period
●    the average rate of return (ARR)
●    NPV at a discount rate of 4%
2. Comment on your answer from one of the calculations in question 1. 
3. What qualitative data might Politooth use in conjunction with the investment appraisals
above in order to make an investment decision?

Case Study 8.

Proposal X and proposal Y both require an initial investment of $10,000 and both are expected to
generate a cash inflow of $20,000 over their four years lives. The net cash inflow for each year of
life of two proposals is given below:
 1. Compute the present value of cash inflows generated by both the proposals assuming a
discount rate of 18%. [2 marks]
2. Which of the two proposals is better if compared using net present value (NPV) method?
3. [4 marks]

Case Study 9.

Rahat Manufacturing Company uses average rate of return (ARR) to analyze investment in plant

assets. The company wants to reduce its total annual cost by purchasing a new equipment to be
installed in the factory. The relevant information about investment in new equipment is presented
to you:

 Amount required to purchase the equipment: $90,000

 Useful life of the equipment: 4 years
 Straight line depreciation per year: $5,625
 Residual value of the equipment at the end of 16-year period: $0
 Required rate of return: 16%
 Cost savings below

Year 1 $-1,000
Year 2 $15,000
Year 3 $25,000
Year 4 $36,000

 Required:

1. Compute accounting rate of return of the equipment. [2 marks]

2. Is this investment desirable according to ARR analysis? [4 marks]