Question 1 (a)

Traditional methods of evaluating long-term projects

4 marks

Time to write: About 8 minutes

From an older CBCS paper

Question

Question 1 (a) · 4 marks

Explain the traditional methods for evaluating long term projects.

Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.

Before you write

Read off the question and its marks

8 minfor 4 marks

Read from the question

ExplainEach point stated, then explained in a line or two.

Write it in this order

Read; underline the asks; jot your points 1 min
1 Payback period: method, rule, merits and demerits 2 marks 3 min
2 ARR: method, rule, merits and demerits 2 marks 3 min
Check: every ask answered, key terms underlined 1 min

Short on time? Trim steps 1 and 2 evenly rather than skip one: each is capped at its own marks.

Try it first. About 8 minutes for 4 marks. Write it out, then open the solution.

Solution

Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.

The traditional (non-discounting) methods are the payback period and the accounting (average) rate of return. Neither discounts future cash flows.

1. Payback period. The number of years a project takes to recover its investment from its cash inflows; with unequal inflows the inflows are cumulated, the fraction of the last year found by interpolation. A project is accepted if its payback is within the cut-off period set by management.

Merits: simple; stresses early recovery, so it shows the project's liquidity and screens out risky projects.
Demerits: it ignores the time value of money and the inflows after the payback period, and its cut-off is arbitrary, so it is not a measure of profitability.

2. Accounting (average) rate of return (ARR). The annual net income earned on the average funds invested: ARR = average annual profit after tax ÷ average investment × 100. A project is accepted if its ARR is above the minimum rate set by management, and projects are ranked by ARR.

Merits: simple; uses accounting data; considers profits over the whole life.
Demerits: it uses accounting profit, not cash flows, and ignores the timing of the returns (time value of money).

Where the 4 marks sit

#	Component	Marks
1	Payback period: method, rule, merits and demerits	2
2	ARR: method, rule, merits and demerits	2
	Total	4

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