P4-Non-DCF Methods of Investment Appraisal

ACCA P4考試：Non-DCF Methods of Investment Appraisal

1 Purpose of Investment Appraisal

The purpose of investment appraisal is to determine whether an investment project gives an adequate financial return. This return can be measured in a variety of ways but the most common are either by measuring the profitability of the investment or the cash flows from the investment.

Profits can be distorted by selection of different accounting policies and therefore methods based on cash flows are preferable.

2 Payback Period

Payback period— the time it takes for the operating cash flows from a project to pay back the initial investment.

Advantages

Simple to calculate.

Easy to understand.

Concentrates on earlier flows:

more certain;

more important if firm has liquidity concerns.

Disadvantages

Ignores cash flows after payback period;

Target period is subjective;

Gives little information about change in shareholder wealth;

Ignores the time value of money (although using discounted payback deals with this).

3 Accounting Rate of Return (ARR)

Accounting rate of return (ARR)— The earnings of a project expressed as a percentage of the capital outlay or average investment.

Also referred to as Return on Capital Employed (ROCE) or

Return on Investment (ROI).

This is a financial accounting measure based on the statement of profit or loss and statement of financial position.

It includes:

Sunk costs (money already spent);

Net book values of assets;

Depreciation and amortisation;

Allocated fixed overheads.

Advantages

Uses readily available accounting information;

Simple to calculate and understand;

Often used by financial analysts to appraise performance.

Disadvantages

Different methods of calculation may cause confusion;

Based on profits rather than cash.

Profits are easily manipulated by accounting policy.

Ignores time value of money;

Target rate is subjective;

A relative measure (%)—gives little information about the absolute change in shareholders' wealth.