Basic Investment appraisal Techniques

Question 1

What is a relevant cash flow and how does this differ from accounting profit?

Answer 1

A relevant cash flow for investment appraisal is essentially one which relates to and will be affected by the investment going ahead. In accounting terms this is:

• Future - the cost has yet to be incurred/agreed. SO even if it relates to the investment if it has been agreed it is not relevant.
• Incremental - The cost relates to the investment e.g. An apportionment of overheads is not relevant as the cost would be incurred even if the investment did not go ahead.
• A cash flow - there are accounting transactions which do not actually relate to a cash flow, depreciation, so are not relevant.

Relevant cash flow will differ from accounting profit because:

• Accounting profit includes non cash transactions, accruals/prepayments/depreciation.
  
  • Accounting profit will vary from business to business depending on accounting policies.

Question 2

What is payback period and how is this used to appraise and investment?

Answer 2

Payback period = how long a project will take to return investment.

This is a good technique to use where liquidity is an important factor for a company.

How it is calculated will depend on if there are constant or varying cash flows.

• Constant - Payback = Initial investment/annual cash flow
• Varying - Set out as a table and calculate cumulative cash position Year by year, this may result in a part year.Multiply decimal fraction of year by 12 to get no. of months and always round up.

Question 3

How useful is the payback method when used for investment appraisal?

Answer 3

• Simple - stakeholders/managers without accounting backgrounds will likely find the concept behind this method easier to understand and relate to objectives. However it does not give a level of profitability for the project.
• Where there are changing conditions this method indicates where investment will be returned soonest, such as:
  
  • Advancing technology resulting in obsolescence of machinery
  • Investment conditions improving resulting in the business wanting to be in a position to reinvest capital quickly.
• This method looks at cash flows, which are more useful as a measure than accounting profits (think statement of cashflows). From the perspective of increasing shareholder wealth this is important, however the cash flows are not discounted to take in to account time value of money. Not taking into account the impacts of cost of capital may result in the payback period being understated giving a falsely positive result, and a distorted indicator of risk as timings are not taken in to account.
• There is not bench mark for what a “good” payback period is, it is subjective and can change as a result of economic conditions such as changes in interest rates and changes to fiscal policy impacting economic growth.

Question 4

What is ROCE (return on capital employed), what might it also be known as and how is it used to appraise an investment?

Answer 4

ROCE, also known as ARR (Accounting rate of return)

Calculated as either:

• Average annual PBIT/initial capital costs x 100%
• Average PBIT/Average capital costs x 100% - where Ave capital costs are (initial investment+scrap value)/2

Appraisal - A target ROCE will have been set by management, for an investment to be approved it should acheive above the target rate.

Question 5

What are the benefits and shortcomings of using ROCE to appraise an investment

Answer 5

• Profit - this figure can vary from company to company based on differing accounting policies, for example where a company has recognised a fall in their Fair value properties profit in a year may be considerably lower, this however is not a cash movement so should have no impact on liquidity.
• Timings - the scrap value is not discounted to present value distorting the average value of the investment.
• It is a fairly simple method to calculate and links well to other accounting ratio’s.
• There is no indication or impact of how long the return will take, and as there is no allowance for the timing of cash flows the return may be over or understated due to inflation and/or cost of capital.

Question 6

When calculating ROCE (ARR) what would be included as initial capital investment?

Answer 6

• NBV of any fixed assets being used in the project.
• The cost of new assets acquired for the project
• Investment in working capital
• Capitalised R&D expenditure (this should be amortised against profit)