The Dilemma at Day-Pro
1. Payback Period of each project
Tim can show that the payback period is not appropriate in the analysis of the projects for the following reasons. First, it does not properly account for the time value of money, risk financing and other important considerations such as opportunity cost and it does not consider the cost of capital. It does not specify any required comparison to other investments or even to not making an investment. The method is an indication of both the risk and the liquidity without considering the terms to maturity. Second, it ignores cash flows occurring after the payback period. An implicit assumption in the use of method is that returns to the investment continue after the payback period. Cash flows occurring within the payback period should not be weighted equally as they are. It violates the principle that investors desire more in the way of benefits rather than less. Lastly, the selection of maximum acceptable payback period is arbitrary.
2. Discounted Payback Period using 10% as the discount rate
Though Discounted Payback Period is more appropriate way of measuring the payback period since it considers the time value of money, Tim should not ask the Board to use DPP as the deciding factor because it produces conflicting rankings. With the Discounted Payback Period, investments that have a Positive Net Present Value (NPV) over the longer term will be rejected because of the fact that we have to set an arbitrary cut-off point. Since we determine a cut-off point, we are ignoring the possibility of growing cash flows thereafter. Thus, we are ignoring cash flows that are paid or received after the payback period.
3. 40% Accounting Rate of Returns
• If the ARR of a project is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. Since Synthetic
Tim can show that the payback period is not appropriate in the analysis of the projects for the following reasons. First, it does not properly account for the time value of money, risk financing and other important considerations such as opportunity cost and it does not consider the cost of capital. It does not specify any required comparison to other investments or even to not making an investment. The method is an indication of both the risk and the liquidity without considering the terms to maturity. Second, it ignores cash flows occurring after the payback period. An implicit assumption in the use of method is that returns to the investment continue after the payback period. Cash flows occurring within the payback period should not be weighted equally as they are. It violates the principle that investors desire more in the way of benefits rather than less. Lastly, the selection of maximum acceptable payback period is arbitrary.
2. Discounted Payback Period using 10% as the discount rate
Though Discounted Payback Period is more appropriate way of measuring the payback period since it considers the time value of money, Tim should not ask the Board to use DPP as the deciding factor because it produces conflicting rankings. With the Discounted Payback Period, investments that have a Positive Net Present Value (NPV) over the longer term will be rejected because of the fact that we have to set an arbitrary cut-off point. Since we determine a cut-off point, we are ignoring the possibility of growing cash flows thereafter. Thus, we are ignoring cash flows that are paid or received after the payback period.
3. 40% Accounting Rate of Returns
• If the ARR of a project is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. Since Synthetic