Question

Which one of the following statements is correct (true)?

• When a company is cash rich, a project with a short payback period but a low rate of return may be preferred to a project with a long payback period and a high rate of return.

• The required rate of return is the maximum rate of return that an investment project must yield to the acceptable.

• In preference decisions, the profitability index and internal rate of return methods may rank projects in a different order of preference.

• The minimum required rate of return is the discount rate that makes the net present value of the project equal to zero.

Answer 1

1. FALSE
Payback period is the period to achieve breakeven of the initial expenditure made by using the cash inflows i.e the period to recover the initial expenditure.
When the company is cash rich it is least bothered about recovery of initial expenditure, therefore a long payback period will be acceptable to the company. The purpose of company in that case is to maximize returns.

When a company is cash rich, a project with a long payback period and a high rate of return will be preferred instead of a project with a short payback period but a low rate of return.

2. FALSE
The required rate of return is the MINIMUM rate of return that an investment project must yield to the acceptable. If the product is yield higher than the required rate of return it will have higher NPV and vice versa.

3. TRUE
Profitability index is calculated by dividing the PV of Cash Inflows by Initial Outflow.

Hence a Profitability Index will rank the project from higher to lower Ratio. The Higher the Profitability index the better the project. This means project with ratio of higher PV of cash inflows to PV of cash outflows will be selected first.

However IRR ranks project on the basis of project’s internal rate of return. The higher a project IRR the better it ranks the project. The IRR method will not always give correct preference between projects having different life or different stream of cash flows.

In preference decisions, the profitability index and internal rate of return methods may rank projects in a different order of preference.

4. FALSE
Minimum Required rate of return is the minimum return that an investor expects to earn. Internal rate of return is the discount rate that makes the net present value of the project equal to zero.