B-154 SOLUTIONS
b. The primary disadvantage to using the discounted payback method is that it ignores all cash flows
that occur after the cutoff date, thus biasing this criterion towards short-term projects. As a result,
c. Discounted payback is an improvement on regular payback because it takes into account the time
value of money. For conventional cash flows and strictly positive discount rates, the discounted
payback will always be greater than the regular payback period.
5. a. The average accounting return is interpreted as an average measure of the accounting performance
of a project over time, computed as some average profit measure attributable to the project divided
projects.
b. AAR is not a measure of cash flows and market value, but a measure of financial statement
accounts that often bear little resemblance to the relevant value of a project. In addition, the
selection of a cutoff is arbitrary, and the time value of money is ignored. For a financial manager,
6. a. NPV is simply the present value of a project’s cash flows. NPV specifically measures, after
considering the time value of money, the net increase or decrease in firm wealth due to the project.
NPV.
b. NPV is superior to the other methods of analysis presented in the text because it has no serious
flaws. The method unambiguously ranks mutually exclusive projects, and can differentiate
between projects of different scale and time horizon. The only drawback to NPV is that it relies on
7. a. The IRR is the discount rate that causes the NPV of a series of cash flows to be exactly zero. IRR
can thus be interpreted as a financial break-even rate of return; at the IRR, the net value of the
b. IRR is the interest rate that causes NPV for a series of cash flows to be zero. NPV is preferred in
all situations to IRR; IRR can lead to ambiguous results if there are non-conventional cash flows,
c. IRR is frequently used because it is easier for many financial managers and analysts to rate
performance in relative terms, such as “12%”, than in absolute terms, such as “$46,000.” IRR may