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Subject P2: Advanced Management Accounting

10.8

ARR fails to take account of project life or the timing of cash flows. A project
with a long life and a high ARR may therefore be accepted over one with a
short life and a low ARR even though the NPV of the second project is higher.

Profit measures are subjective and ARR figures for identical projects could be
different in different companies as a result of the accounting policies applied. It
is not a measure of absolute wealth gain but of relative performance. Without
objective targets, there is no definite investment signal.

10.9

An absolute measure is required – use NPV

The company’s primary objective is to maintain short term liquidity – use
payback

It is essential that all cashflows over the life of the project are taken into account
– use NPV

The company’s cost of capital cannot be readily identified – use payback

Profit estimates cannot readily be converted into cashflows – use ARR

The ARR method calculates a percentage return provided by the accounting
profits of the project and is therefore most useful when estimated cashflows are
not available.

Since Payback focuses on the short term return of invested funds, selecting
projects on the basis of Payback may help reduce the risk of liquidity problems.
It also does not require the use of the company’s cost of capital and may
therefore be useful when it is not available (NPV requires the cost of capital to
carry out the calculations, and although IRR can be found without the use of a
cost of capital, its use is necessary to provide a comparison before an
investment decision can be made.)

NPV (as well as IRR) takes account of all cashflows across the life of the project
– ARR looks at profits not cashflows and payback focuses only on those
cashflows within the payback period. It also provides an absolute measure as
the NPV of a project is equal to the increase in shareholders’ wealth (IRR, ARR
and Payback all provide a measure for comparison).

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