Question 4.6: In what respect is PP not a complete answer as a means of as...
In what respect is PP not a complete answer as a means of assessing investment opportunities? Consider the cash flows arising from three competing projects:
| Time | Project A £000 |
Project B £000 |
Project C £000 |
|
| Immediately | Cost of machine | (200) | (200) | (200) |
| 1 year’s time | Operating profit after depreciation | 70 | 20 | 70 |
| 2 year’s time | Operating profit after depreciation | 60 | 20 | 100 |
| 3 year’s time | Operating profit after depreciation | 70 | 160 | 30 |
| 4 year’s time | Operating profit after depreciation | 80 | 30 | 200 |
| 5 year’s time | Operating profit after depreciation | 50 | 20 | 440 |
| 5 year’s time | Disposal proceeds | 40 | 10 | 20 |
(Hint: Again, the defect is not concerned with the ability of the manager to forecast future events. This is a problem, but it is a problem whatever approach we take.)
The PP for each project is three years and so the PP method would regard the projects as being equally acceptable. It cannot distinguish between those projects that pay back a significant amount early within the three-year payback period and those that do not.
In addition, this method ignores cash flows after the payback period. A decision maker concerned with increasing owners’ wealth would prefer Project 3 because the cash inflows are received earlier. In fact, most of the initial cost of making the investment has been repaid by the end of the second year. Furthermore, the cash inflows are greater in total.