Chapter – 2

Basic Investment Appraisal Techniques

 Chapter contents

1. Features of investment appraisal

2. Accounting profits v/s cash flows

3. Relevant cash flows

4. Investment appraisal techniques

- ROCE (which uses profit in its calculation)
- Payback (which uses cash flows, in its calculation)
 Features of investment appraisal

Assessment of the Estimates of future costs

level of expected and benefits over the
returns project’s life
 Accounting profits v/s cash flows

In capital investment appraisal, relevant cash flows are used in all the methods (except ROCE), for evaluation
rather than accounting profits

What are ‘relevant cash flows’ ?

Relevant cash flows are:
 futuristic
 incremental
 cash-based

Accordingly, sunk costs, committed costs, non-cash items and allocated

costs must be ignored in the calculations for investment appraisal.

Point to note: Opportunity cost is relevant. Opportunity costs are the cash
flows in relation to the next best alternative.

‘Note that in the exam, generally, to convert profits to cash flows or vice-
versa, the adjustment for depreciation only will be required.’
 Investment appraisal techniques

ROCE Payback
Return on capital employed (‘ROCE’ or ‘ARR’)
Take after
depreciation

Decision rule: If the expected ROCE > the target

ROCE, then accept the project

The initial capital cost =

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 (ensure this is amortised against profit).
Advantages & disadvantages of ROCE

Advantages
 Simple to calculate
 Links with other
accounting measures

Disadvantages
 Project life is not considered
 Timing of cash flows is also ignored
 Different accounting policies can impact its
value
 It may ignore working capital
 It does not measure absolute gain
 Payback Period

1. In case of constant annual cash flows

2. Uneven annual cash flows

Payback is calculated by working out the cumulative cash flow over the life
of the project

Pay back period = Lower Year + CO – CI of lower year

CI of upper year – CI of lower year

Decision rule: fastest payback project is chosen

Advantages & disadvantages of Payback Period

Advantages
 simple to calculate
 useful in case of rapidly changing technology (a quick payback is
essential, in case of rapidly changing technology)
 useful when investment conditions are expected to improve in
the future
 it gives quick return which helps the company to grow, minimize
its risk and maximize liquidity
 it uses cash flows, not accounting profit

Disadvantages
 it ignores the returns after payback period
 does not consider the timings of cash flows
 it ignores the profitability of the project
 does not give a definitive investment signal
Thank You