Stephen Lumby(1981) defined an investment decision as one which made by the investors or the top management, involves the company in a cash outlay with the aim of receiving future cash inflows.
This article will take a look at two traditional methods of investment appraisal, Pay-back and Return on Capital Employed. Before we get to know the methods, we should keep in mind that all investment appraisal methods act as a decision guide, they could not tell investors or decision makers whether to invest or not. However, through investment appraisal, it will help us to communicate information with decision makers. Due to the uncertainty of the future, any investment technique can never replace managerial judgement, nevertheless, it could make the judgement more sound.
- The Payback method
The name of this method neatly describes the operation of the method, referring to how long does it take to ‘pay back’ the initial capital investment from the incremental benefits. Usually, the benefits being defined as after-tax cash flows. Projects could be ranked in terms of the speed of return, the faster paying-back project is, the more preferred it would be.
One of the advantages of the payback is obvious, it is quick and simply to calculate and easy to understand. To calculate the payback period, the method only takes inputs as initial outlay and annual cash flows. Another advantage of the payback is that it concentrates on the speed of return, this factor could be a dominant short-run consideration for companies with tight liquidity. Additionally, a shorter payback period means a lower risk, thus, as management wish to avoid or minimize risk and uncertainty, the project with fastest payback period is preferred.
Let us now turn to the disadvantages of the payback. The first is the problem of ignoring the time value of money. This is a very crucial problem of the method as the fact that the money could be invested so as to earn interest as well. One of the other drawbacks of the payback method is that it only considers the period takes to recover the outlay, it does not consider the cash flows that come in subsequent years. As shown in Example, according to the payback method, Project 1 is more preferred, however, if we take a look at Project 2, actually it would generate lucrative cash flows in later years. This means the payback method might mislead the management to cursory decisions. Another problem arises from the fact that usually capital investments are not just one-time investments, the payback method might be not realistic when applying in these scenarios. Finally, the payback method has the problem of setting the maximum payback period criterion, there is no specific guidelines on how the maximum payback period should be determined.
“The real problem does not stem from the payback concept itself, but more from the way the method is used in the decision making process.”
2. Return on Capital Employed
Return on Capital Employed (ROCE) which usually being known as Accounting Rate of Return (ARR), ROCE is expressed as a percentage ratio of the accounting profit generated by an investment project divided by the required capital outlay. Let us take a look at the formula how to calculate the ROCE ratio:
The decision rule: If the expected ROCE for the investment is greater than the target or hurdle rate which determined by the management, then the project should be accepted. When several projects are mutually exclusive, the one with higher ROCE rate is preferred.
Let us take a look at the advantages of the ROCE method. First, the same as the payback method, it is also easy to calculate and it produces a simple rule in helping the management to accept or reject projects. Another advantage of the ROCE method is that it provides a percentage rate of return which the financial management is very familiar with, unlike the payback method, it considers the profits throughout the whole project life.
However, the ROCE method also suffers from several disadvantages. First, it is the ambiguous nature of the ROCE concept, there is no general agreement in calculating the variants (As shown in the formula, we can use initial capital costs or average capital investment). Second, the method provides a percentage rate, it is unable to compare the financial size between projects. Third, although the method does take into account the profits throughout the whole project life, when comparing between projects, it ignores the difference in the length of life between projects which is crucial when considering the uncertainty, liquidity etc. of the projects. Finally, the same as the payback method, the problem of ignoring the time value of money.
Both the payback method and the ROCE method are widely used in investment decisions, each has its own advantages and disadvantages. It is not easy to tell which one is superior, on the contrary, it is common to find that the methods are usually combined to produce a ‘two-tier’ decision rule, for example, ‘projects may be accepted only if (say) they payback within five years and have a minimum ROCE of 12%’. However, these two traditional methods of investment appraisal still facing the problem of ignoring the time value of money.
Lumby, S. (1981) Investment appraisal and related decisions. Hong Kong: Nelson.