Chapter 2 - Basic Investment Appraisal Techniques

Question 0

Advantages and disadvantages of ROCE

Answer 0

Advantages:
1. Simplicity - Based on widely reported measures of return (profits) and asset (balance sheets values), it is easily understood and easily calculated.

2. Links with other accounting measures - Annual ROCE, calculated to assess a business or sector of a business is widely used. Expressed in % terms which managers and accountants are familiar with.

Disadvantages:
1. Fails to take account of the project life or the timing of cash flows. This ignores time value for money.

2. Varies with different accounting policies and the extent to which project costs are capitalised.
3. Might ignore working capital requirements.
4. Not a measurement of absolute gain in wealth for the business owners.
5. No definite investment signal.

Question 1

ROCE (ARR)

Answer 1

ROCE = Average annual profits before interest and tax/ Initial capital costs x 100%

Or

ROCE = Average annual profits before interest and tax/ Average capital investment x 100%

The average investment can be calculated as:

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

If the ROCE > Target or hurdle rate then the project should be accepted.

Question 2

Payback method of appraisal

Answer 2

The payback period is 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.

Payback period = Initial investment/ Annual cash flow

Question 3

Advantages and disadvantages of payback

Answer 3

Advantages:
1. Simplicity.

2. Rapidly changing technology - If a new plant is scrapped in a short period then a quick payback is essential.
3. Improving investment conditions - When investment conditions are expected to improve in the near future, attention is directed to those projects which will release funds soonest to take advantage.
4. Payback favours project with a quick return.
   - Rapid project payback leads to rapid company growth.
   - Rapid payback minimises risk.
   - Rapid payback maximises liquidity.
5. Uses cash flows rather than profits.

Disadvantages:
1. Project returns may be ignored - Payback ignores profitability and concentrates on cash flows and liquidity.

2. Timing ignored - Time VFM is ignored.
3. Lack of objectivity - No length of time set as minimum payback period.
4. Project profitability is ignored - Takes no account of the effects on business profits and periodic performance.

Question 4

Net Present Value (NPV)

Answer 4

1. NPV considers cash flows.
   - This is the reason why NPV is preferred to ROCE since ROCE compares average annual accounting profit with initial or average capital.
2. NPV considers the whole of an investment project.
   - In this respect, NPV is superior to Payback which measures the time it takes for an investment to repay the initial capital invested.
   - Payback considers cash flows within the payback period and ignores cash flows outside of the payback.
3. NPV considers the time value for money.
   - NPV and IRR are both discounted cash flow (DCF) models which consider value of money whereas ROCE and Payback do not.
4. NPV is an absolute measure of return.
   - NPV is seen as being superior to IRR and ROCE as these only offer a relative measure of return and therefore fail to reflect the amount of the initial investment or the increase in corporate value.
5. NPV links directly to the objective of maximising shareholder wealth.
   - The NPV of an investment project represents the change in total market value that will occur if the investment project is accepted.
   - Therefore the increase in wealth of each shareholder can be measured by the increase in the value of their shareholding as a percentage of the overall issued share capital of the company.