Question

(a) Explain why investment appraisal methods based on project cash flows are regarded as superior to earnings-based measures such as forecasted return on assets. (120 words) (b) Compare the merits of the net present value (NPV), internal rate of return (IRR) and discounted payback period methods of capital investment project appraisal, assuming the firm’s objective is to maximise the wealth of its equityholders. What conditions must apply for the net present value (NPV) and internal rate of return (IRR) methods to always give the same signal to accept or reject a capital investment project? (210 words) (c) A firm may be unable to undertake all of its wealth-creating projects due to insufficient available funds for investment. What market imperfections might cause this problem? How should the firm identify its optimal capital investment strategy if it faces this problem? (150 words) (8 ma

Answer 1

a). Investment appraisal methods based on cash flows are considered superior to earnings based measures because 1). cash flows allow accounting for time value of money and riskiness of the project (in the discount rate) 2). cash flows are more certain and easier to forecast than earnings for which accounting rules would have to be factored in so accuracy may be an issue 3). accounting rules are based on conservative assumptions whereas for project analysis, best estimates are used (as risk can be adjusted for, in the discount rate). This is the reason why Net Present Value (NPV) is considered a better criteria for deciding upon projections than ROI etc.