Question

5. Explain why the NPV method is considered superior to the payback period and accounting rate of return methods of appraising potential capital investments.

(10 marks)

6. Explain the effect of non-financial/non-quantitative factors on project appraisal by using relevant examples.

Answer 1

The NPV calculation is one of the several methods which is used to determine the present value of the project's projected future income. In computation of NPV, the present value of the project's cost is subtracted from the present value of future income. Although the payback period method is easier and simpler in the computation for small, repetitive investment and factors in depreciation and tax rates; however NPV is more efficient and accurate as it uses cash flow (and not earnings) and gives the investment decisions which adds value. The payback method doesn’t assess properly the time value of money, financial risks, inflation, etc. while NPV measures accurately an investment’s profitability. Moreover payback method indicates the investment's maximum acceptable period, ignores any probabilities that can occur after the payback period, and nor does it measure total incomes. It would not indicate whether over time the purchases will yield positive profits. Thus compared to payback method and IRR NPV gives provides better decisions when making capital investments

As per policy we have to answer first question