Common appraisal measures

Non-discounted methods - accounting rate of return, ROCE or ROI

This is the ratio of the year-by-year accounting profit of a business divided by the capital employed or invested in the business and used to generate the profit. For example, with the cash flows shown in Table 11.8, year 1 has a very poor return as profit for that year is the cash flows less depreciation (14,000 divided by 5 years' life of the project), a mere 1 per cent of the investment.

TABLE 11.8 Cash flows

Cash flows

ROI is a measure of year-by-year past performance. If accounting profit is consistently calculated, the figure for accounting rate of return (also known as return on capital employed or return on investment) is useful as a measure of historic performance. It is not an acceptable appraisal measure as it assesses only one year of accounting profit and does not take account of the time value of money.

Non-discounted methods - payback

The payback period for a project is the length of time (normally years) required for the initial outlay on the project to be repaid from the annual cash inflows of the project:

If cash inflows vary year to year, the payback date is more easily found using a spreadsheet. With the cash flows as above, payback is two-thirds of the way through year 3, assuming that cash flows accrue evenly throughout the year (Table 11.9).

Payback is simple to calculate and easily understood. Where investments or projects clearly give high returns, payback may be an acceptable measure. Payback does, however, have two fundamental flaws:

1 No account is taken of the fact that later cash flows are worth less in today's terms compared with earlier cash flows - no account is taken of the time value of money.

2 No account is taken of the cash flows received after the date of payback.

TABLE 11.9 Payback

Payback

The time value of money can be recognized by calculating the discounted payback (Table 11.10). Discounted payback is at a later date as there is recognition of the time value of money.

TABLE 11.10 Calculating the discounted payback

Calculating the discounted payback

If the reasons for appraising expenditure are primarily to ration cash and ensure as risk free as possible an investment, using payback as the appraisal measure may be acceptable.

Both accounting rate of return and payback are too simplistic in approach and a fundamental weakness in both methods is the fact that they ignore the effect of the timing of investment outflows and related inflows.

 
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