Investment appraisal is normally undertaken by a company before committing to any form of high-level capital spending. The appraisal has two main features including the assessment of the level of returns expected that could be earned from the investment made and an estimate of the future benefits and costs in the span of the project (Ross et al. 2010). In this regard, long-term forecasting is important for estimates of future benefits and costs especially in the purchase of the non-current asset. There are several techniques for investment appraisal, but the two most basic include the payback and return on capital employed (ROCE).
ROCE follows the same principle with the accounting rate of returns as they both relate the investment and the accounting profits (Lumby & Jones 2001). It is computed by getting the percentage of average pre-tax annual profits to the initial capital costs. The method has the advantages of simplicity, especially in the computation. This is because it gives a percentage that indicates the rate of return expected from an investment that is familiar to the management. Also, the technique can be easily linked to other accounting measures (Lumby& Jones 2001). However, the method has disadvantages in that it cannot account for project life, the timing of cash flows and mostly varies depending on policies of accounting employed. Additionally, the method ignores working capital and fails to measure the absolute gain attained while it still lack definitive signal for investment (Watson & Head 2010).
Examples
The ROCE technique is quite popular in the assessment of the business performance after the investments are completed (Haka 2006). This technique is widely used as a measure of the business performance as well as to measure the performance of the management (Lumby & Jones 2001). It is most commonly used in the privately owned businesses as it depicts an increase of wealth for the owner. Also, it can be applied in the expression of the financial goals of a business (Watson & Head 2010). Both independent and mutually exclusive projects can employ the ROCE technique. For example, if a project needs an investment of $800,000 and earns cash inflows of 100, 200, 400, 400, 300,300, 200 and 150 in terms of thousand dollars in a span of seven years.
In addition the assets will be sold at $100,000 at the end of the seven years. The ROCE for this project will be 18.75%. The decision rule as to accept the project or not is determined by looking at the expected ROCE and the hurdle rate from the management. If the expected ROCE is more than the target rate, then the project is accepted (Haka 2006). The popularity of this techniques has however been declining most probably due to the inflation rates that have led to higher interests rates making the decision-making process difficult. In this case, the method is best suited for short-term business approaches (Haka 2006).
Payback period, by definition, is the rough estimate of the time taken to recoup the investments made in a project (Lefley 1996). This technique has two variants: discounted and simple payback periods. The periods are calculated by computing the quotient of initial investment divided by annual cash flow (Lefley 1996). This investment appraisal method has the advantages of simplicity and can use the cash flows and not the accounting profits. This is because the profits in the company cannot be sent and are subjective (Watson & Head 2010). Also, cash is used as the dividends have to be paid. For instance, an expenditure of $2million to get cash inflows of $500,000 per year for some seven years can be assessed using payback. The estimated period will be 4 years and the cumulative cash flow would change over the years. The decision rule in using payback is that the objects that pay up to the specified target payback should be accepted (Wambach 2000). Also, the fastest paying option is always considered.
Also, payback has proven to be very useful in some conditions such as in the improvement of the investment conditions and adaptation to the rapidly changing technology (Lefley 1996). Additionally, the technique maximizes the liquidity, increases company growth while still minimizing the risk.
Comparison of the Two Methods
Despite the numerous advantages, the payback method also has some limitations (Wambach 2000). It does not take into consideration the returns that occur after the period and also disregards the cash flow timings although this can be done by the discounted payback period. In the same regard, it does not provide a definitive investment signal making the method subjective (Lefley 1996). Lastly, the payback method does not take into account the profitability of the project.
The best of the methods in this case would be the payback. This is especially because of the cash flows involved in the projects. The method puts into consideration the time as well as the value for money. Payback is also invaluable especially in the world of unlimited resources and the information provided is understandable (Lefley 1996). ROCE and payback period are both classical techniques in investment appraisal (Wambach 2000). Industries are divided among the two methods although it is possible to utilize both although the non-finance managers prefer to use ROCE (Ross et al. 2010). In this regard, two decisions could be made. For instance, a project could be accepted if the ROCE is below 13% and it can payback within four years (Watson & Head 2010).
Conclusion
The forecasts are important for any business before embankment of any project. Although the investment appraisal may but produce accurate results, it would be important to use as many techniques to avoid losses. Spending on too much on current assets is unrealistic, and the forecasts need to be very careful in order for the best possible value to be gotten. Although several methods for the investment appraisal exist, the return on capital employed and payback remains the most popular one especially with the managers with low skills on finances.
References
Lefley, F 1996, ‘The payback method of investment appraisal: a review and synthesis’, International Journal of Production Economics, 44(3), 207-224.
Wambach, A 2000, ‘Payback criterion, hurdle rates and the gain of waiting’, International Review of Financial Analysis, 9(3), 247-258.
Lumby, S, & Jones, C 2001, Fundamentals of investment appraisal, Cengage Learning Business Press.
Haka, S F 2006,‘A review of the literature on capital budgeting and investment appraisal: past, present, and future musings’ ,Handbooks of Management Accounting Research, 2, 697-728.
Ross, S, Hillier, D, Westerfield, R, Jaffe, J, & Jordan, B2010,‘Corporate Finance’, Second Edition.
Watson, D, & Head, A 2010,Corporate finance: principles and practice, Pearson Education.
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