Mini-scenario 2

The following information relates to a proposed four-year project which is being financially evaluated by the Board of Directors of Pampass Inc. (Pampass). Pampass is an unlisted company but shareholders include private investors, a venture capital company, an insurance company and a pension fund. The initial investment is $7.8 million, with scrap value of $0.2 million and the following net cash inflows for each of the four years:

Year	2021	2022	2023	2024
Net operating cash flow ($m)	2.40	3.00	3.20	3.16

The Board of Directors believes that this project will increase shareholder wealth if it achieves an accounting rate of return (ARR) greater than 20%. As a matter of policy, the Board requires all investment projects to be evaluated using both ARR and payback period. Shareholders have recently criticised the Board of Directors for using these investment appraisal methods, claiming that Pampass should be using the net present value method. The directors remuneration package includes a financial reward for achieving an ARR greater than 20% but does not include a share option scheme.

Required:

1. What is the payback period of the proposed project?

1. What is the average rate of return (ARR) of the proposed project?

1. Which of the following statements about investment appraisal methods is/are not correct?

1. ARR must be greater than the cost of equity if a project is to be accepted
2. Riskier projects should be evaluated with longer payback periods
3. The ARR method does not consider the time value of money

1. Which of the following statements about Pampass is/are correct?

1. Managerial reward schemes should not encourage the achievement of stakeholderobjectives
2. Requiring investment projects to be evaluated via the ARR method is an example of dysfunctional behaviour encouraged by performance-related pay
3. Pampass does not have an agency problem as the Board of Directors is acting to maximise shareholder wealth

1. Which of the following statements is/are not correct?

1. Introducing a share option scheme in Pampass would help bring directors objectives in line with shareholders objectives
2. By linking their financial rewards to a target ARR, Pampass is encouraging its directors to focus on short-term profitability and discouraging them to make long-term capital investment decisions
3. Directors remuneration in Pampass should be determined by its senior executive directors