Session 3

Investment Decisions

FOCUS
This session covers the following content from the ACCA Study Guide.

D. Investment Appraisal
1. Investment appraisal process techniques
b) Calculate payback period and discuss the usefulness of payback as an
investment appraisal method.
d) Calculate return on capital employed (accounting rate of return) and
discuss its usefulness as an investment appraisal method.

Session 3 Guidance
Read section 1 to familiarise yourself with the capital expenditure decision-making process.
Read through section 2 on payback period and work through Illustration 1. Be sure to understand
the payback period decision rule and its advantages and disadvantages.

(continued on next page)

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VISUAL OVERVIEW
Objective: To appreciate the stages in the investment decision-making process
and to assess an investment using the payback period and the return on capital
employed methods.

INVESTMENTS

DECISION-MAKING PROCESS
APPRAISAL
Expenditure Types METHODS
Investment Appraisal's Role

PAYBACK PERIOD RETURN ON CAPITAL EMPLOYED

Methodology Terminology
Advantages Calculation
Disadvantages Advantages
Possible Improvements Disadvantages

Session 3 Guidance
Understand how to calculate return on capital employed (ROCE), the ROCE decision rule and
its advantages and disadvantages.
Attempt Examples 1 and 2 to test your understanding of ROCE and payback period.

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Session 3 Investment Decisions F9 Financial Management

1 Decision-Making Process

1.1 Expenditure Types

Capital expenditurethe acquisition of non-current assets
or their improvement.
Revenue expenditureincurred to maintain non-current
assets (e.g. repairs).

1.2 Investment Appraisal's Role

Investment appraisal plays a key role at the stage of analysing
and evaluating investment proposals.
< If the firm's main financial objective is to maximise (or at
least produce satisfactory) shareholder wealth, then the key
investment appraisal technique should be net present value
(NPV). This is because NPV shows the theoretical absolute
change in shareholder wealth due to a project.
< Managers may also require other measures as part of their
decision-making process (e.g. payback as a liquidity measure
and return on capital employed [ROCE] to judge the effect on
published financial statements).
< Providers of finance may wish to know the project's internal
rate of return (IRR). In particular, banks compare project IRR
to the interest rate on proposed loans in order to measure the
"headroom" on the project, and hence the risk of default on
the debt.

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F9 Financial Management Session 3 Investment Decisions

2 Payback Period

2.1 Methodology
Payback period is the amount of time it takes for the
undiscounted operating cash flows from a project to pay
back the initial investment.

The decision rule for payback period is:

< If payback period < target ACCEPT
< If payback period > target REJECT

Illustration 1 Payback Period

Investment $1.4m
Annual cash flows (before depreciation but after tax) $0.3m
Project life 10 yrs

Solution
1.4
Payback period = = 4.7 years
0.3
(or five years if cash flows are assumed to be received at year ends.)

2.2 Advantages and Disadvantages

of Payback Period
Advantages Disadvantages
Simple to calculate. Ignores cash flows after payback period.
Easy to understand. Target period is subjective.
Concentrates on earlier flows, Ignores time value of money.
which are: Gives no information about the change
more certain; and in shareholder wealth.
more important if the firm has
liquidity concerns.

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Session 3 Investment Decisions F9 Financial Management

2.3 Possible Improvements

Discounted payback: this method requires that cash flows first
be discounted to present value and then a discounted payback
period is calculated. This approach takes into account the time
value of money (see Session 7).
Payback with bail-out: this variation of payback takes into
account the estimated scrap/disposal value of the asset if the
project is abandoned early.

3 Return on Capital Employed (ROCE)

3.1 Methodology
Return on capital employed (ROCE) is the average annual
operating profit expressed as a percentage of the initial (or
average) investment.
ROCE is also referred to as accounting rate of return (ARR) or
return on investment (ROI).

The decision rule for ROCE is:

< If ROCE > target ACCEPT
< If ROCE < target REJECT

3.2 Calculation
ROCE is a financial accounting measure based on the income
statement and statement of financial position. Therefore,
it includes:
< Sunk costs (money already spent);
< Net book values of assets;
< Depreciation and amortisation; and
< Allocated fixed overheads.

It is calculated as:

Average annual operating profit

ROCE = 100
Initial investment
OR

Average annual operating profit

= 100
Average investment

Where:
Initial investment + scrap value
Average investment =
2

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F9 Financial Management Session 3 Investment Decisions

Example 1 ROCE

Initial investment $200m

Scrap value $20m
Operating cash flows:
Year 1 $100m
Year 2 $50m
Year 3 $50m
Year 4 $50m

Required:
Calculate ROCE on:
(i) initial investment
(ii) average investment

Solution

(i) ROCE using initial investment

ROCE =

(ii) ROCE using average investment

ROCE =

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Session 3 Investment Decisions F9 Financial Management

3.3 Advantages and Disadvantages of ROCE

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
flow. Profits are easily manipulated by
accounting policy.
Ignores time value of money.
Target rate is subjective.
As a relative (percentage) measure, it
gives no information about the absolute
dollar change in shareholders' wealth.

Example 2 ROCE and Payback

A project being considered would require a machine costing $80,000. Market
research of $8,000 has already been carried out and has been capitalised. The
result is that the project is expected to last for six years and produce net cash
earnings of $20,000 for each of the first three years, and then $15,000 for
each of the last three years. The anticipated scrap proceeds of the machine at
various stages in its life are as follows:

After year 1 $40,000

After year 2 $30,000
After year 3 $20,000
After year 4 $13,000
After year 5 $10,000
After year 6 $4,000

Assume that cash flows arise evenly during the year.

Required:
Evaluate the project using:
(i) ROCE
(ii) ROCE using the average investment approach
(iii) Payback period
(iv) Payback period incorporating the bail-out factor

Solution
(i) ROCE

ROCE =

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F9 Financial Management Session 3 Investment Decisions

Example 2 ROCE and Payback (continued)

(ii) ROCE using average investment

ROCE =

(iii) Payback period

Time Flow Cumulative flow

0 (88,000)

1 20,000

2 20,000

3 20,000

4 15,000

5 15,000
6 15,000

Payback period = years

(iv) Payback period incorporating the bail-out factor

Net cumulative
Time Flow Cumulative flow Scrap flow
0 (88,000)

1 20,000

2 20,000

3 20,000

4 15,000

5 15,000
6 15,000
Payback period with bail-out = years

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 Summary
< Payback period and return on capital employed (ROCE) are commonly used in practice.
However, neither method informs management of the absolute change in shareholders'
wealth due to a particular project.
< The decision rule for payback period is if the payback period is less than the target, then
accept the project. If the payback period is larger than the target, then reject the project.
< Discount payback period (see Session 7) and payback with bail-out offer potential
improvement over payback period.
< ROCE is also referred to as accounting rate of return (ARR) or return on investment (ROI).
< The decision rule for ROCE is if the ROCE is greater than target, then accept the project.
If the ROCE is less than the target, then reject the project.
< Because ROCE is a financial accounting measure based on the income statement
and statement of financial position, it includes sunk costs, net book values of assets,
depreciation and amortisation and allocated fixed overheads.

Session 3 Quiz
Estimated time: 15 minutes

1. State when and why net present value should be the main investment appraisal
technique. (1.2)

2. Describe how payback period is calculated. (2)

3. List TWO advantages of payback period. (2)

4. List THREE disadvantages of payback period. (2)

5. Describe the TWO methods of calculating ROCE. (3.1)

6. List TWO advantages and TWO disadvantages of ROCE. (3.3)

Study Question Bank

Estimated time: 40 minutes

Priority Estimated Time Completed

MCQs - Session 3 25 minutes

Q4 Elvira (a) and (b) 15 minutes

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 Session 3

EXAMPLE SOLUTIONS
Solution 1ROCE

Average Total cash flows Total depreciation

=
annual profit Number of project years

$250m $180m
= = $17.5m
4

(i) ROCE using initial investment

$17.5m
ROCE = 100 = 8.75%
$200m

(ii) ROCE using average investment

Average Initial investment + Scrap value

=
investment 2
$200m + $20m
= = $110m
2

$17.5m
ROCE = 100 = 15.91%
$110m

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Solution 2ROCE and Payback
(i) ROCE
(3 $20, 000 + 3 $15, 000)
Average annual earnings = = $17, 500
6
$80, 000 + $8, 000 $4, 000
Average annual depreciation = = $14, 000
6

$17,500 $14, 000

ROCE = 100 = 4.0%
$88, 000

(ii) ROCE using the average investment

$88,000 + $4, 000

Average investment = = $46, 000
2

$17,500 $14, 000

ROCE = 100 = 7.6%
$46, 000

(iii) Payback period

Time Flow Cumulative

flow
0 (88,000) (88,000)
1 20,000 (68,000)
2 20,000 (48,000)
3 20,000 (28,000)
4 15,000 (13,000)
5 15,000 2,000
6 15,000 17,000

$13, 000
Payback period = 4 years + = 4.9 years
$15, 000

(iv) Payback period incorporating the bail-out factor

Time Flow Cumulative Scrap Net cumulative

flow flow
0 (88,000) (88,000) (88,000)
1 20,000 (68,000) 40,000 (28,000)
2 20,000 (48,000) 30,000 (18,000)
3 20,000 (28,000) 20,000 (8,000)
4 15,000 (13,000) 13,000
5 15,000 2,000 10,000 12,000
6 15,000 17,000 4,000 21,000

Payback period with bail-out = 4.0 years

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NOTES

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