Question 4: Answer the following questions: (12 Marks) 1

1). NPV - Primary strength is that it takes time value of money into consideration and assumes that the cash flows are reinvested at the cost of capital which is a conservative estimate. Weakness of NPV is that forecasting of future cash flows and cost of capital is required. Estimating cost of capital can be especially challenging.

IRR - Primary strength of IRR is that it does not require cost of capital and includes time value of money in its calculation. Weakness is that it assumes that cash flows are reinvested at the IRR (and not at the hurdle rate or cost of capital) which is an aggresive assumption to make and may not always be feasible.

Payback period - Primary strength is that it is very simple to calculate and provides a rough back-of-the-envelope idea about whether the investment should be considered or not. Weakness is that it does not take the time value of money into account.

Accounting rate of return - Primary strength is that ARR is based on accounting information only so it is easy to calculate. Weakness is that it does not take into account, the time value of money and also, cash flows from investments.

2). IRR is the rate of return at which NPV of the investment is zero or, in other words, the rate at which the investment breaks even. If the IRR is r, then

-26,300 + 8,400/(1+r) + 11,300/(1+r)^2 + 16,500/(1+r)^3 = 0

Using a financial calculator or excel, IRR comes out to be 15.81%. (By hand, it can only be done via trial and error method, as it is a polynomial equation.)