Chapter # 2

Basic Investment Appraisal Techniques

Class Lecture Notes

Importance of this part

1. Exam perspective 2. Real life/practlcal

It is the main function of a financial manager

FM AFM

One 20 marks 50 Marks question

high chances of coming
in section C

Investment decisions
Decision regarding the utilisation of finance.

Long term investing decisions

Main focus in chapter 2-6

Short term investment decsions

Working capital management Chapter 7-10

Long term investing decisions

It is also known as capital budgeting decisions

Capital- Money raised and utilised for long term purpose

Budgeting - It is performed because we are answerable to other for their money
(shareholders and debt providers)
Decisions is taken only when there is more than one choice

Evaluate all the choices based on some grounds (appraise), and choose the best alternative

Questions to be answers:
1. What are the alternatives ?
2. How to appraise them ? Main focus is here in all the chapters

One concept and 2 techniques in this chapter

Techniques to appraise investments

1. ROCE

ROCE = Average annual PBIT

Capital emplyeed/Investment

Average annual PBIT - If the PBIT for 4 years is given, just average it

We do cost benefit analysis

For the money that I investment, how much do I get in return

Average annual PBIT This is benefit

Capital emplyeed/Investment This is cost, the resources given up (opportunity cost)

Capital employeed includes all long term finances - debt and equity
ROCE is the ratio which tells how much return is earned for all fund providers

ROCE using Initial investment

It shows how much is the yearly return for the initial investments.

ROCE using average investment

Over a period of time, investmet made in the first year will be decreasing.
Because investments like plant and machinery have depreciation
This is better because both in the numerator and denominator is average.

Limitations of ROCE

1. Time value of money is not considered

2. PBIT is a weak metric to use it to make decisions, as it is affected by accounting estimates.
Also it has non-cash items
3. In this way cash flows is a better metric to take decisions.

In order to accept a project , the ROCE should be greater than the cost of capital.

Disadvantages include:

1. no account is taken of project life

2. no account is taken of timing of cash flows
3. it varies depending on accounting policies
4. it may ignore working capital
5. It does not measure absolute gain
6. There is no definite investment signal.

2. Relevant cash flows

Relavant Cash Flow

Relevant cash flow is a future increamental cash flow
1.Future : ●Only future cash flows are considered
●Sunk cost are ignoerd (past cost)

2.Incremental ●Only extra cashflows that occur as a result of the decision

should be considered,
●Fixed cost should be ignored unless it is incremental
fixed cost
●Committed cost should be ignored as it does not effect
the decision
●Opportunity cost should be included

3.Cahflow ●It includes both inflow and outflow

●Only cash items are included - Depreciation is excluded.

Sunk cost- Fees given for survey of the banking classes

Cost incurred in the past are ignored in relevant costing
Relevant cost- Rent cost ie, it is paid only when the project is started
Committed cost - Committed cost that are unavoidable in the future

3. Payback period

Payback - when will we get back the cost of investment

Limitations
1. Doesn't consider the time value of money
2. It gives undue importance to payback period instead of % of return
3. It does not consider the cash flow after the payback period. What if there is a huge negatve
cash flow after payback period ?

Example -

Year A B
0 -1,000 -1000
1 800 200
2 300 300
3 400 400
4 -2000 500
5 600

Payback 2.3 3.6 Years

If we use payback to select the investment, A should be selected but it will incur a loss
of 2,000.
Chapter # 2

Basic Investment Appraisal Techniques

Homework Notes

Investment Appraisal Techniques

●Accounting Profits & Cash flows
●Cash flow & Relevant cost
●Basic Appraisal Techniques
-ROCE
-Payback

Importance of this part

1. Exam perspective 2. Real life/practlcal

It is the main function of a finance

manager
FM AFM

One 20 marks 50 Marks question

high chances of coming
in section C

●Investment decisions
Decision regarding the utilisation of finance.

●Long term investing decisions

Main focus in chapter 2-6

●Short term investment decsions

Working capital management Chapter 7-10

●Long term investing decisions is also known as capital budgeting decisions.

●Capital- Money raised and utilised for long term purpose
●Budgeting - It is performed because we are answerable to other for their money
(shareholders and debt providers)

●Decisions is taken only when there is more than one choice

●Evaluate all the choices based on some grounds (appraise), and choose the best alternative

●Questions to be answers:
1. What are the alternatives ?
2. How to appraise them ? Main focus is here in all the chapters

One concept and 2 techniques in this chapter

●ROCE
●Payback

1. ROCE (Return on Capital Employeed)

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

ROCE = Average annual profits before interest and tax x 100

Average capital investment

Average capital investment = Initial investment + Scrap value

2
Average annual PBIT - If the PBIT for 4 years is given, just average it

●We do cost benefit analysis

●For the money that I investment, how much do I get in return

●Average annual PBIT : This is benefit

●Capital emplyeed/Investment : This is cost, the resources given up (opportunity cost)

●Capital employeed includes all long term finances - debt and equity
●ROCE is the ratio which tells how much return is earned for all fund providers

ROCE using Initial investment

●It shows how much is the yearly return for the initial investments.

ROCE using average investment

●Over a period of time, investmet made in the first year will be decreasing.
Because investments like plant and machinery have depreciation
This is better because both in the numerator and denominator is average.

Initial capital cost

It comprises of :
●Cost of new assets bought
●Net book value (NBV) of existing assets to be used in the project
●Investment in working capital
●Capitalised R&D expenditure

Advantages of ROCE
●Simplicity
●Links with other accounting measures

Disadvantages of ROCE
Limitations of ROCE

●Time value of money is not considered

●PBIT is a weak metric to use it to make decisions, as it is affected by accounting estimates.
Also it has non-cash items
●In this way cash flows is a better metric to take decisions.
●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 definite investment signal.

●In order to accept a project , the ROCE should be greater than the cost of capital.

2. Accounting profits and cash flows

●In capital investment appraisal it is more appropriate to evaluate future cash flows than
accounting profits because :
1. Profits cannot be spent
2. Profits are subjects
3. Cash is required to pay dividents

Profits vs cash flows

●Cash is what ultimately counts - profits are only a guide to cash availability : they cannot
actually be spent.

●Profit measures is subjective : the time period in which income and expenses are recorded,
and so on, are a matter of judgement.

●Cash is used to pay dividents : dividents are the ultimate method of transferring wealth to
equity shareholders.

●Major changes in cash and profit flows will be linked to the following :
1. Changes in working capital
2. Asset purchased and depreciation
3. Deferred taxation
4. Capitalisation of R&D expenditure

3. Cash flows and relevant costs

●For all methods of investment appraisal, with the expectation of ROCE, only relevant cash
flows should be considered.

Relavant Cash Flow

Relevant cash flow is a future increamental cash flow
1.Future : ●Only future cash flows are considered
●Sunk cost are ignoerd (past cost)

2.Incremental ●Only extra cashflows that occur as a result of the decision

should be considered,
●Fixed cost should be ignored unless it is incremental
fixed cost
●Committed cost should be ignored as it does not effect
the decision
●Opportunity cost should be included

3.Cahflow ●It includes both inflow and outflow

●Only cash items are included - Depreciation is excluded.

Sunk cost- Fees given for survey of the banking classes

Cost incurred in the past are ignored in relevant costing
Relevant cost- Rent cost ie, it is paid only when the project is started
Committed cost - Committed cost that are unavoidable in the future
Ignore
●Sunk costs
●Commited costs
●Non-cash items
●Allocated costs

●Opportunity costs are the cash flows in relation to the next best alternative, eg. If a
machine that was to be sold is used on a project, the lost sale value is an opportunity cost
and is relevant.

4. Payback method of appraising

●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

Constant annual cash flows

Payback period = Initial investment

Annual cash flow

Proforma
Year A B
0 -1,000 -1000
1 800 200
2 300 300
3 400 400
4 -2000 500
5 600

Payback 2.3 3.6 Years

●A payback period may not be for an exact number of years. To calculate the payback in years
and months you should multiply the decimal fraction of a year by 12 to get the number of
months.

●In practice, cash flows from a project are unlikely to be constant. Where cash flows are
uneven, payback is calculated by working out the cumilative cash flow over the life of the
project.
Advantages of payback period
●It is simple

●It useful in certain situations:

-Rapidly changing technology - if plant is to be scraped within short period, quick payback is
is essential
-Improving investment conditions

●It favours quick return:

-Helps company growth
-Minimises risk
-Maximises liquidity

●It uses cash flows, not accounting profits

Disadvantages of payback period

●It ignores returns after the payback period
●It ignores the timing of the cash flows
●It is subjective - no definitive investment signal
●It ignores project profitability
●It does not consider the cash flow after the payback period. What if there is a huge negatve
cash flow after payback period ?
●It ignores time value of money.
●It gives undue importance to payback period instead of % of return

Example -

Year A B
0 -1,000 -1000
1 800 200
2 300 300
3 400 400
4 -2000 500
5 600
Payback 2.3 3.6 Years

●If we use payback to select the investment, A should be selected but it will incur a loss
of 2,000.
Chapter # 2

Basic Investment Appraisal Techniques

Illustrations
Chapter # 2

Basic Investment Appraisal Techniques

Test Your Undestandings

TYU - 2

ROCE = Average annual PBIT

Capital emplyeed/Investment

(a) ROCE using initial capital cost

Year Cashflows Depreciation PBIT

1 100,000 (100,000) -
2 200,000 (100,000) 100,000
3 400,000 (100,000) 300,000
4 400,000 (100,000) 300,000
5 300,000 (100,000) 200,000
6 200,000 (100,000) 100,000
7 150,000 (100,000) 50,000 Average annual PBIT 150000

Depreciation for each year = 100000

ROCE = Average annual PBIT

Capital emplyeed/Investment

=150,000
800,000

18.75%

(b) ROCE using average capital

ROCE = Average annual PBIT
Average Investment

Average investment = Initial investment + Savage investment

2

=800000+100000
2
450,000

ROCE = 33.33%

TYU - 3

Relevant cash flows

Supervisor's salary 15,000

TYU -9

80,000 Not relevant as sunk cost

5,000 Scrap value relevant as it is opportunity cost
1,500 Disposat cost of machine after using it in the project

Relevant cost of Machine for using it in the new contract = 6,500

TYU - 6

Year Cash flow Cumilative cash flow

0 (1,900,000) (1,900,000)
1 300,000 (1,600,000)
2 500,000 (1,100,000)
3 600,000 (500,000)
4 800,000 300,000
5 500,000 800,000

Interpolation =
1 year 800000
0.625 500000
3.625 years
Chapter # 2

Basic Investment Appraisal Techniques

Revision Kit