The key information provided includes details on four different capital investment proposals that are being evaluated by companies using various methods like accounting rate of return, payback period, net present value and internal rate of return. By analyzing the strengths and weaknesses of these methods, we can better understand which techniques are most suitable for assessing potential investments and maximizing shareholder value. Proper capital allocation is critical as these decisions often involve long-term assets and can determine the future success of a firm. As such, a rigorous analysis framework and selection criteria are essential.
ARR method links to return on capital but ignores time value of money
The accounting rate of return (ARR) approach has the strength of clearly connecting to return on capital employed (ROCE), enhancing credibility. It also uses familiar accounting metrics, easy for accountants to grasp. However, ARR does not factor in the time value of money or allow for proper comparison of competing projects with differing sizes.
Payback period method straightforward but short-sighted
Payback period is easy to understand, calculate and provides a basic risk measure. But it fails to account for cash flows after breakeven is reached and cannot properly rank investments of different scales.
NPV explicitly values time and project lifespan
Net present value (NPV) handles time value and considers lifetime cash flows, making it appealing. But the dollar value return lacks context and NPV alone cannot rank alternatives. Still, positive NPV projects are clearly wealth-creating.
IRR method accentuates percentage returns
Internal rate of return highlights percentage returns, useful for some. But IRR can conflict with NPV on mutually exclusive options of varying size. Multiple IRRs may also arise with irregular cash patterns. And focusing solely on rate of return, IRR fails to properly prioritize among competing projects.
In summary, while simple techniques like ARR and payback period have their places in preliminary analysis, more rigorous methods like NPV and IRR are superior for formal capital allocation decisions. Each approach has particular strengths and limitations that must be weighed against a firm’s objectives, constraints and risk tolerance.