Recall that an introduction to this article was given in the part one of this series. Hence, no further introduction would be made here. Our aim here is to explore the various investment technique needed by everyone in a simple manner that you will have no difficulty comprehending the concepts. BINGO!!!
Payback period of a project involves rough estimate of the period of time it will take to recoup the initial investment made in that project. There are two variants of it. The simple payback period and discounted payback period.
Both variants are calculated based on the incremental cash flows of a project. The number of years calculated based on this rough estimate is compared with the company’s already defined accepted period.
If the payback period is less than that already defined by the company as acceptable, and provided that there are no other constraints- e.g. capital rationing (both soft and hard), then the project will be accepted.
This method of investment appraisal has a number of drawbacks which include the following:
- It ignores the timing of cash flows. It places the same weight on the cash flows that are generated at the beginning of the project with those that are generated at the middle end of the project.
- It ignores the time value of money. It does not recognize the fact that N1 (One Naira) today is not the same as N1 in the future.
- Decision based on it is biased. Projects with short-term outlook are favoured over projects that has long-term prospect.
- Managers find it difficult to make decision when there are projects with similar payback period.
- It only takes care of the risks associated with the timing of cash-flows but not the risks associated with the variability of cash-flows.
Payback method of investment seems to have more popularity in practice despite the above drawbacks for the following reason:
- Simplicity. It is simple to calculate and understand. In a world of limited resources, this feature is invaluable. Managers with non-finance or accounting background end not to have difficulty understanding and communicating payback information.
- Usefulness in early stage of projects. Payback is highly valuable in screening projects at the initial stage. This helps to filter out projects that would other wise waste useful resources in the form of further analysis.
- Reduce risk. The fact that it tend to favour short-term projects makes it really helpful in eliminating risk that is associated with long-term projects.
- It is handy in time of capital rationing. Payback quickly identifies those projects that generate cash-flow in the immediate future. This helps to alleviate the harsh effects of capital rationing – especially soft capital rationing.
Return On Capital Employed (ROCE) method
This method is also called the accounting rate of return (ARR) or Return On Investment (ROI) method. ROCE method of investment appraisal is to estimate the accounting rate of return that a project should yield. If it exceeds the target rate of return, the project will be undertaken.
To get the ROCE, you divide average annual accounting profit by average investment. Notice that profit and not cash-flow is used here. One aspect of ROCE that accountants don’t so much like is the absence of an accepted definition of ‘Return on Investment’.
However, being consistent in which ever definition you choose takes care of this worrying situation.
Advantages of ROCE
- It is a quick and simple calculation to make. This is one of its strongest hold – especially for non-finance managers.
- Returns from entire project are taken care of. Even though this is fairly an estimate.
- Its interpretation in not a problem as it is based on a familiar concept of percentage.
Disadvantages of ROCE
- It is based on accounting profit instead of cash-flow. Accounting profit suffers from the problem of treating the same item differently by different accountants.
- It takes account of the size of the investment. This is because it is a relative measure and not an absolute measure.
- The length of the project is not taken into account.
- It ignores the concept of time value of money just like the payback period.
Additionally, ROCE suffers a serious of drawback of not taking into account the timing of the profits from an investment.
Managers using this method of appraisal technique should know that monies tied up in an investment could still be invested in other investment opportunities. This is one area where payback period method of investment appraisal is good at.
Nevertheless, payback period and ROCE still enjoy the largest number of vote from the non-financial managers.