Question

Describe the unique features of Residual Income, Return on Investment, Payback, Net Present Value and Internal Rate of Return in measuring financial performance.

Critically analyse the strengths and weaknesses of each measure.

Comment on the problem that may be involved in comparing divisional performance.

Discuss the approaches that can be used to avoid dysfunctional behavior which is motivated by accounting-based performance targets.

Explain the return and risk relationship concept in finance.

Describe a situation whereby a department’s attitude is: Risk neutral, risk averse or risk seeking.

Explain and critically analyse the distinction between decision tree, expected value and maximax, maximin and regret criterion can be used for decision-making under conditions of risk and uncertainty. The managing director of Bounce Ltd has asked you to explain how each method of the above can be applied in decision-making and comment on the strengths and limitations of each method.

Answer 1

Pay-Back Method

Introduction: - This method based on the principle that every capital expenditure pays itself back within a certain period out of the additional earning generated from the capital asset. This represent the period in which the total investment in permanent assets pay back itself. In other word it measures the period of time for the original cost of a project to be recovered from the additional earning of the project itself. Under this method various investments are ranked according to the length of their payback period in such a manner that the investment with a shorter payback period is preferred.

Strengths: - (a) The main advantage of this method is that it is simple to understand, easy to calculate, requires less time and labor.

(b) In this method, as a project with a shorter payback period is preferred to the one having a longer payback period, it reduces the loss through obsolescence and is more suited to the developing countries, like India, which are in process of development and have quick obsolescence.

(c) Due to its short term approach, this method particularly suited to a firm which has shortage of cash or whole liquidity position is not particularly good.

Weaknesses: - (a) The main disadvantage of this method is that it ignores the time value of money and does not consider the magnitude and timing of cash inflow. It treats all cash flows are equal through they occur in different periods. It ignores the fact that cash received today is more important than the same amount received after.

(b) It does not take into account the cash inflows earned after the payback period. Hence the true profitability of the projects cannot be correctly assessed.

Return on Investment

Introduction: - According to this method, it takes into account the earning expected from the investment over their whole life or various projects are ranked in order of the rate of earnings or rate of return. The project with the higher rate of return is selected as compared to the lower rate of return. In this method concept of profit (the profit after tax and depreciation) is used rather than cash inflows.

Strengths: - (a) Like payback method it is simple to understand, easy to calculate.

(b) It uses the entire earning of a project in calculating the rate of return and not only the earnings up to payback period and hence give a better view of profitability as compared to payback period method.

(c) As this method based on profit concept, it can be readily calculated from the financial data.

Weaknesses: - (a) This method also like payback method ignore the time value of money as the profits earned at different points of time are given equal weight by averaging the profits. It ignores the fact that cash received today is more important than the same amount received after.

(b) It ignores the period in which the profits are earned as a 20% rate of return in 2.5 years may be considered to be better than 18% rate of return for 12 years. This is not proper because longer the period of the project greater is the risk involved.

Net Present Value

Introduction: - The NPV method is a modern method of evaluating capital budgeting. This method takes into consideration time value of money concept. The NPV of all inflows and outflows of cash occurring during the entire life of the project is determined separately for each year by discounting these flows by the firm’s cost of capital or pre-determined rate. If the present value is positive or zero, when present value of cash inflows either exceeds or is equal to the present values of cash outflows, the proposal may be accepted. But in case the present value of inflows is less than the present value of cash outflows, the proposal should be rejected.

Strengths: - (a) It recognizes the time value of money and is suitable to be applied ina situation with uniform cash outflows and uneven cash inflows or cash flows at different periods of time.

(b) It takes into account the earnings over the entire life of the project and the true profitability of the investment proposal can be evaluated.

Weaknesses: - (a) It is difficult to understand and operate.

(b) It may not give good results while comparing projects with unequal lives as the project having higher net present value but realized in a longer life span may not be as desirable as a project having something lesser net present value achieved in a much shorter span of life of the asset.

Internal Rate of Return

Introduction: - Under this method the cash flows of a project are discounted at a suitable rate by hit and trial method, which equates the net present value so calculated to the amount of the investment. In this method discount rate is determined internally, so the method known as internal rate of return method. The internal rate of return can be defined as that rate of discount at which the present value of cash inflows is equal to the present value of cash outflows. Accept the proposal if the internal rate of return is higher than or equal to the minimum required rate of return and reject the proposal if the internal rate of return is lower than the minimum required rate of return.

Strengths: - (a) Like NPV method it takes into account the time value of money and can be usefully applied in situation with even as well as uneven cash flow at different periods of time.

(b) It considers the profitability of the project for its entire economic life and hence enables evaluation of true profitability.

(c) It provides for uniform ranking of various proposals due to the percentage rate of return.

Weaknesses: - (a) It is difficult to understand and is most difficult method of evaluation of investment proposal.

(b) This method is based upon the assumption that the earnings are reinvested at the internal rate of return for the remaining life of the project, which is not justified assumption particularly when the average rate of return earned by the firm is not close to the internal rate of return. In this sense, NPV method seems to be better as it assumes that the earnings are reinvested at the rate of firm’s cost of capital.

Residual Income

Introduction: - Residual income method is a equity valuation method. Under this method company’s stock equals the present value of future residual incomes discounted at the appropriate cost of equity. It is calculated by the cost of equity multiplied by equity capital then subtracted from net income of the company.

Strengths: - (a) It is better than return on investment approach because it accepts any investment that exceeds the minimum required return on investment.

(b) It is easy to calculate because it is make use of data readily available from a firm's financial statements.

Weaknesses: - (a) This method relies heavily on forward looking estimates of firm’s financial statements; it ignores the historical misrepresentation of firm’s financial statement.

(b)