Basic investment appraisal techniques

Question 1

What are the two basic methods of appraisal techniques?

Answer 1

ARR/ROCE

Payback

Question 2

What is the default method for ROCE/ARR?

Answer 2

The initial method

Question 3

What is the formula for ROCE Initial method?

Answer 3

Average annual profits before tax and

Average annual profit = (Casn inflow - Outflow - Depreciation) interest/Initial capital investment

Question 4

What is the formula for ROCE average method?

Answer 4

• Average annual pre tax profit / Average capital investment

* Average= (Initial investment+ Scrap value)/2

Question 5

4. What are the advantages of ROCE/ARR

Answer 5

▪Simple and easy to calculate

▪links with other accounting measures- annual ROCE, calculated to assess a business or sector of a business (and therefore the investment decisions made by that business), is a widely used measure.

▪It is expressed in percentage terms with which managers and accountants are familiar and also means easily comparable to other projects.

Words such as capital employed and profit are familiar by managers

▪It considers the projects entire life

Question 6

5. What are the disadvantages of ROCE

Answer 6

▪ ROCE calculates numbers over the whole life of the project, but it does not take into account the project length. For instance, two different projects could have the same ROCE but be of completely different lengths, meaning one may be preferable to the other.

no account is taken of project life- consider the whole life of the project, but doesn’t take account of the timings within it and would not differentiate between projects of different lengths as long as the same average profits were earned.

▪no account is taken of timing of cash flows – Ignores time value of money

▪it varies depending on accounting policies- and the extent to which project costs are capitalized. Profit measurement is thus ‘subjective’, and ROCE figures for identical projects would vary from business to business.

▪it may ignore working capital requirements
▪it does not measure absolute gain as it is in %

▪there is no definitive investment signal. The decision to invest or not remains subjective in view of the lack of an objectively set target ROCE.

Does not ensure shareholder wealth is maximised

ignores the actual incremental cash flows associated with the project

Question 7

What is the payback period

Answer 7

It is another basic investment appraisal technique.

The payback period measures how long it takes for the net cash flows generated by the project to recover the initial investment.

Question 8

What is the advantage of payback period?

Answer 8

▪ Simple to calculate and understand
▪ Based on cash, and not profit
▪ Risk focused approach in deiciosion making- As it favours shorter-term projects, this minimises both financial and business risk

This also helps companies grow, maximise liquidity and minimise risk

▪ It can be used when there is a capital rationing situation to identify projects which generate additional cash for investment quickly.

Question 9

What is the disadvantage of payback period?

Answer 9

▪ Doesn’t ensure shareholder wealth is maximised
▪ Ignores timing of cashflow
▪ Ignores the time value of money
▪ No guide to an acceptable time period- advice is not clear once it has been calculated

▪ Ignores cash flow’s after the payback period.
▪ Subjective as there is no definitive investment decision

Question 10

What are the relevant cash flows for investment appraisal

Answer 10

Except for ROCE/ARR- only incremental cash flows and outflows are considered. The below are ignored

▪ Sunk costs- already paid
▪ Committed costs- future unavoidable cost e.g. lease
▪ Non-cash items- Depreciation
▪ Allocated costs- in making a decision on investment- these costs would have been ‘Apportioned Costs’; incurred anyway so ignore them

▪ Tax allowable depreciation- this is not an actual cash flow so should be ignored

▪ Opportunity cost

Question 11

Annual cash flows are taken to be profit before or after depreciation

Answer 11

Before depreciation.

Annual depreciation = (Initial capital- Scrap)÷ Years
Annual Profit= (Profit- Annual depreciation)

Question 12

What is average annual profit

Answer 12

Average annual profit = (Casn inflow - Outflow - Depreciation)

Question 13

If you’re given figures and the statement of financial position and told to work out ROCE, how do you do this?

Answer 13

Annual average pre tax profit= Given

Initial Invest/Average investment= Equity + Non-current liability

Question 14

What is the depreciation formula

Answer 14

(Asset -Scrap) / Years

Question 15

In a long form Q where you have to compare a companys current ARR and the investment ARR- how do you calculate the companys Current return on capital employed?

Answer 15

ARR/ROCE = (Operating profit / Capital employed)

CE= Equity + Non current liabilities 
CE= Total assets - current liabilities

Question 16

linking financial rewards to a target return on capital employed will encourage ?

Answer 16

linking financial rewards to a target return on capital employed will encourage short-term profitability and discourage capital

Question 17

what are 4 reasons that you must remember ARR disadvantages

Answer 17

1) The ARR can be expressed in a variety of ways, and is therefore susceptible to manipulation.

Although the question specifies average profit to average capital employed, many other variants are possible, such as average profit to initial capital, which would raise the computed rate of return.

2) It is also susceptible to variation in accounting policy by the same firm over time, or as between different firms at a point in time. For example, different methods of depreciation produce different profit figures and hence different rates of return.
3) it is based on accounting profits expressed net of deduction for depreciation provisions, rather than cash flows. This effectively results in double counting for the initial outlay i.e. the capital cost is allowed for twice over, both in the numerator of the ARR calculation and also in the denominator. This is likely to depress the measured profitability of a project and result in rejection of some worthwhile investment
4) use it simply averages the profits, it makes no allowance for the timing of the returns from the project.

Question 18

explain why do companies still continue to use ARR?

Answer 18

The continuing use of the ARR method can by explained largely by its utilisation of statement of financial position and statement of profit or loss magnitudes familiar to managers, namely ‘profit’ and ‘capital employed’. In addition, the impact of the project on a company’s financial statements can also be specified.

Return on capital employed is still the commonest way in which business unit performance is measured and evaluated, and is certainly the most visible to shareholders.

It is thus not surprising that some managers may be happiest in expressing project attractiveness in the same terms in which their performance will be reported to shareholders, and according to which they will be evaluated and rewarded.

Question 19

discuss dangers of offering generous credit

Answer 19

Armcliff intends to achieve a sales increase by extending its receivables collection period. This policy carries several dangers. It implies that credit will be extended to customers for whom credit is an important determinant of supplier selection, hinting at financial instability on their part. Consequently, the risk of later than expected, or even no payment, is likely to increase.

Although losses due to default are limited to the incremental costs of making these sales rather than the invoiced value, Armcliff should recognise that there is an opportunity cost involved in tying up capital for lengthy periods. In addition, companies which are slow payers often attempt to claim discounts to which they are not entitled.

Armcliff may then face the difficult choice between acquiescence to such demands versus rejection, in which case, it may lose repeat sale

Question 20

explain the meaning of sensitivity analysis in the context of investment appraisal

Answer 20

Sensitivity analysis indicates which project variable is the key or critical variable, i.e. the variable where the smallest relative change makes the net present value (NPV) zero. Sensitivity analysis can show where management should focus attention in order to make an investment project successful, or where underlying assumptions should be checked for robustness.

The sensitivity of an investment project to a change in a given project variable can be calculated as the ratio of the NPV to the present value (PV) of the project variable. This gives directly the relative change in the variable needed to make the NPV of the project zero

Question 21

What is the process for payback period

Answer 21

1) If CF are not constant-

calculating cumulative cash flows from T0-Tn and finding when the negative turns into positive

Use that as a proportion to calculate the exact time for that specific T

2) Constant CF

Initial investment/Constant Annual CF