Question

Your company needs to replace a substantial piece of equipment and is considering three different options. You want to make a good decision and will have to justify your choice by explaining to your manager how you made the decision. He doesn't have much background in finance so you want to limit it to one decision criteria. You will therefore choose:

• Accounting rate of return because you know your manager likes to work with percentages.

• Net present value because you know it will ensure that you choose the option that will add the most value to the company.

• Payback because it is so quick and easy to calculate.

• Internal rate of return your manager understands percentages.

• Profitability index because it will ensure you choose the most profitable option.

Answer 1

The answer is

Net present value because you know it will ensure that you choose the option that will add the most value to the company.

Net present value is the best decision criteria for capitak budgeting decisions.

Payback period does not take into account time value of money and cash flows after payback period and hence should not be used

Accounting rate of return does not take into account the time value of money

IRR assumes reinvestment at IRR which is not a reasonable assumption

Profitability index nullifies the impact of investment, and hence, the most profitable investment might not add maximum value