Question

EXPLAIN the following appraisal methods; payback period, return on capital employed and net present value. Stating and explaining advantages and disadvantages. (50)

Answer 1

1]	SIMPLE PAYBACK PERIOD:
	The simple payback period indicates the time within
	which the cash flows from the investment would
	recover the initial investment. It is measured in years.
	It is based on after tax cash flows but does not take
	into account the time value of money.
	Where the cash inflows are in the form of an annuity,
	the payback is calculated as:
	Initial investment/Annual cash inflow.
	Where the cash inflows are uneven, they are cumula-
	ted year wise, and the year in which the last dollar is
	recovered is the year in which the payback occurs.
	The payback is then expressed as a combination of
	complete years and, if required, fraction of the year
	in which the last dollar is recovered.
	Thus, payback may be say 3 years or 3.5 years.
	A project will be accepted if, its payback is within the
	maximum payback period prescribed by management.
	While choosing from different alternatives, the
	alternative with the shortest payback is preferred.
	Advantages:
	*Easy to calculate and understand.
	*Prefers projects with shorter durations and hence
	considers and minimizes risk.
	Disadvantages:
	*Ignores time value of money.
	*Ignores the cash flows after the payback period.
	*Does not give the addition to shareholders' wealth.
2]	ROCE [Return on capital employed]:
	The return on capital employed [ROCE] is a popular profitability
	ratio that, helps in measuring the ability of a firm to generate
	profits. It can also be used to evaluate proposed projects.
	ROCE is given by:
	EBIT/Capital employed, Capital employed being 'Total asssets-
	Current liabilities'.
	Some analysts recommend using net operating profit in place of
	EBIT.
	The ROCE obtained can be compared with industry standards of
	other benchmark.
	Advantages:
	*It can be easily worked out and understood
	*Projections can be compared with actuals easily, as it is
	a measure calculated from accounting records.
	Disadvantages:
	*Does not help in capital budgeting as it does not consider time
	value of money.
	*It does not give the net addition to shareholders' wealth.
	*It is based on accounting profits and not cash flows. Hence, it
	is far moved away from reality.
3]	NET PRESENT VALUE:
	This is a discounted cash flow method. It is given by
	the formula:
	NPV = PV of cash inflows-PV of cash outflows.
	Here, the discount rate used is the WACC of the firm
	adjusted for the variation in risk of the project when
	compared with the existing projects.
	The NPV represents the addition to shareholders'
	wealth in absolute dollars. From this, it follows that
	projects with positive NPVs are to be accepted and
	those with negative NPVs are to be rejected.
	When considering mutually exclusive alternatives,
	the alternative with the greatest NPV is to be
	preferred.
	Advantages:
	*Considers time value of money
	*Considers the cash flows during the entire life
	*Risk can be built-in by adjusting the discount rate to
	suit the risk.
	*Gives the addition to shareholders' wealth in dollar
	terms.
	Disadvantages:
	*Dfficult to calculate as it involves finding the cost of
	various components of capital, then combining them
	to get the WACC. The WACC is then used to discount
	the cash inflows
	*It is difficult to understand for laymen.