Basic investment appraisal techniques

Question 1

One stage in the capital budgeting process is investment appraisal. This
appraisal has the following features:

Answer 1

 assessment of the level of expected returns earned for the level of
expenditure made
 estimates of future costs and benefits over the project’s life

Question 2

ROCE =

Answer 2

Average annual profits before interest and tax /
Average capital investment ×100%

Question 3

Average capital investment =

Answer 3

Initial investment + scrap value / 2

Question 4

Advantages and disadvantages of ROCE

Answer 4

Advantages include:
 simplicity
 links with other accounting measures.
Disadvantages include:
 no account is taken of project life
 no account is taken of timing of cash flows
 it varies depending on accounting policies
 it may ignore working capital
 it does not measure absolute gain
 there is no definitive investment signal

Question 5

In capital investment appraisal it is more appropriate to evaluate future
cash flows than accounting profits, because:

Answer 5

 profits cannot be spent
 profits are subjective
 cash is required to pay dividends

Question 6

Cash flows are a better measure of the suitability of a capital
investment because:

Answer 6

 cash is what ultimately counts – profits are only a guide to cash
availability: they cannot actually be spent
 profit measurement is subjective – the time period in which
income and expenses are recorded, and so on, are a matter of
judgement
 cash is used to pay dividends – dividends are the ultimate method
of transferring wealth to equity shareholders

Question 7

The payback period is

Answer 7

the time a project will take to pay back the money spent on it. It is based on expected cash flows and provides a measure of liquidity

Question 8

Payback period =

Answer 8

initial investment / annual cash flow

Question 9

Advantages and disadvantages of payback

Answer 9

Advantages include:
 it is simple
 it is useful in certain situations:
– rapidly changing technology
– improving investment conditions
 it favours quick return:
– helps company growth
– minimises risk
– maximises liquidity
 it uses cash flows, not accounting profit.
Disadvantages include:
 it ignores returns after the payback period
 it ignores the timings of the cash flows
 it is subjective – no definitive investment signal
 it ignores project profitability