One stage in the capital budgeting process is

investment appraisal. This appraisal has the following

features:
§ assessment of the level of expected returns earned for
the level of expenditure made – ROCE appraisal
technique
§ estimates of future costs and benefits over the project’s
life – Payback appraisal technique
If the expected ROCE for the
investment is greater than the
target or hurdle rate (as decided
by management) then the project
should be accepted.
A project involves the immediate purchase of an item
of plant costing $110,000. It would generate annual
cash flows of $24,400 for five years, starting in Year 1.
The plant purchased would have a scrap value of
$10,000 in five years, when the project terminates.
Depreciation is on a straight-line basis.

Determine the project's ROCE using:

(a) initial capital costs
(b) average capital investment
A project requires an initial investment of $800,000 and then earns
net cash inflows as follows:
Year 1 2 3 4 5 6 7
Cash inflows ($000) 100 200 400 400 300 200 150

In addition, at the end of the seven-year project the assets initially

purchased will be sold for $100,000.

Determine the project’s ROCE using:

(a) initial capital costs
(b) average capital investment.
✓ simplicity
✓ links with other accounting measures.
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
In capital investment appraisal it is more
appropriate to evaluate future cash flows than
accounting profits, because:
§ profits cannot be spent
§ profits are subjective
§ cash is required to pay dividends
For all methods of investment appraisal, with the
exception of ROCE, only relevant cash flows
should be considered. These are:
§ future Ignore:
§ incremental § sunk costs
§ cash-based. § committed costs
§ non-cash items
§ allocated costs.
A company is evaluating a proposed expenditure on an item of
equipment that would cost $160,000.

A technical feasibility study has been carried out by consultants,

at a cost of $15,000, into benefits from investing in the equipment.

It has been estimated that the equipment would have a life of four
years, and annual profits would be $8,000, after deducting annual
depreciation of $40,000 and an annual charge of $25,000 for a
share of the existing fixed cost of the company.

What are the relevant cash flows for this?

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.
Decision rule:
§ only select projects which pay back within the
specified time period
§ choose between options on the basis of the
fastest payback
An expenditure of $2 million is expected to
generate net cash inflows of $500,000 each year for
the next seven years.
What is the payback period for the project?
§ it is simple
§ it is useful in certain situations:
ürapidly changing technology
üimproving investment conditions
§ it favors quick return:
ühelps company growth
üminimizes risk
ümaximizes liquidity
üit uses cash flows, not accounting profit.
§ 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.
Which of the following is an example of a relevant cash
flow to be considered in an investment appraisal
process for a new project?
A. Market research expenditure already incurred
B. Additional tax that will be paid on extra profits
generated
C. Centrally-allocated overheads that are not a
consequence of undertaking the project
D. Tax-allowable depreciation
Garfield plc is considering whether to enter into a new project. The machinery
which would be used to produce the goods for the contract was purchased seven
years ago at a cost of $80,000, with an estimated life of ten years. Depreciation is
on a straight-line basis. The machinery has been idle for some time, and if not
used on this contract would be scrapped and sold immediately for an estimated
$5,000. After use on this contract the machinery would have no value, and would
have to be dismantled and disposed of at a cost of $1,500.
Ignoring the time value of money, what is the relevant cost of the machine to
the new contract?
A. $3,500
B. $5,000
C. $6,500
D. 24,500
Which of the following is an advantage of the payback
method of investment appraisal?
A. It takes account of the timing of the cash flows within the
payback period
B. It uses accounting profits rather than cash flows
C. It takes account of the cash flows after the end of the
payback period and therefore the total project return
D. It can be used as a screening device as a first stage in
eliminating obviously inappropriate projects prior to
more detailed evaluation
Which of the following statements is not true?
A. The return on capital employed method of
investment appraisal takes account of the
length of the project
B. Focus on an early payback period can enhance
liquidity
C. Investment risk is increased if the payback
period is longer
D. Shorter term forecasts are likely to be more
reliable
§ Read the chapter 2 “Basic investment appraisal
techniques”
§ Do all test your understandings at the end of the
chapter 2
§ Do the tasks in the next slides
A project will involve spending $1.8 million now.
Annual cash flows from the project would be
$350,000.
What is the expected payback period?