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What limits the usefulness of the average rate of return and cash payback methods?
AThey need cash flows to be equal in every year
BThey cannot be applied to equipment purchases
CThey take no account of the time value of money
DThey rely on a discount rate set by management
Answer & Solution
Correct answer: C. They take no account of the time value of money
1. Both methods are quick to compute but give rather general results.
2. Neither discounts a future cash flow back to what it is worth today.
3. That makes them more reliable for shorter term investments than for long ones.
4. They serve as an initial screen, disqualifying weak proposals before a fuller analysis begins.
5. Cash payback copes perfectly well with uneven annual cash flows, so unevenness is not the limitation.
_Source: Jonick, Principles of Managerial Accounting (UNG Press, CC BY-SA 4.0), section 9.8 Capital Investment Analysis_
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