Examples of Investment Appraisals:
Investment Appraisal Methods
Introduction
Investment appraisal is a crucial aspect of financial management, enabling businesses to evaluate the profitability and feasibility of their investments. This article delves into three key types of investment appraisals: the payback period (PP), return on capital employed (ROCE), and break-even point (BEP), outlining their advantages, disadvantages, and applications.
- Payback Period (PP)
- Return on Capital Employed (ROCE)
- Break-Even Point (BEP).
What are they, and what do they do for investment besides appraisals?
What are they?!
1) The payback period is the time it takes for an investment to generate enough cash flows to recover the initial investment. It is simple to calculate and easily understood, making it a popular choice among managers. Its focus on short-term returns helps avoid the uncertainties of long-term forecasting and emphasizes liquidity. However, the PP method has its limitations. It ignores the time value of money within the payback period and is not a suitable measure to deal with risk. Disregard both the size and timing of cash flows beyond the payback period.
2) ROCE is a fundamental measure of business performance. It illustrates the relationship between the operating profit generated during a period and the average long-term capital invested in the business. A profitability ratio measures how efficiently a company utilizes its available capital. It is calculated by dividing earnings before interest and taxes (EBIT) by capital employed (total assets minus current liabilities). Many consider ROCE a primary measure of profitability due to its quick and simple calculation and easy comprehension by non-financial managers. It also presents results as a percentage, which is easier to understand. However, ROCE focuses on accounting profitability rather than cash flows, takes no account of the length of the project, and ignores the time value of money. It measures return against the book value of assets in the business, which may not reflect their current market value.
3) The BEP analysis determines when total sales revenue equals total cost. It is a useful tool for evaluating how long it will take (or how many customers a new business would need) to make a profit. The BEP method is simple, quickly calculated, and easily understood by non-financial managers. It helps assess risk (margin of safety) and predicts the effect of sales price changes. However, it assumes that sales prices are constant at all output levels. It also assumes that everything produced is sold and that all output is sold at the same price.
Each method has its benefits and drawbacks; therefore, businesses must consider which is a good fit. In conjunction with other methods, get the most accurate ones for effectiveness, efficiency of goals, and profitability.
Examples for each of these investment appraisal methods:
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- Payback Period (PP): Suppose a company invests $10,000 in a new piece of equipment that is expected to generate $2,000 per year in additional profit. The payback period would be $10,000 / $2,000,0 = 5 years. This means the company would recover its initial investment after 5 years.
- Return on Capital Employed (ROCE): Let’s say a company has an operating profit (EBIT) of $50,000 and the capital employed (total assets minus current liabilities) is $200,000. The ROCE would be 50,000/$200,000 = 25%. This means that for every dollar of capital employed, the company generates a return of 25 cents.
- Break-Even Point (BEP): If a company sells a product for $20 (selling price per unit), the variable cost per unit is $5, and the total fixed cost is $30,000, the break-even point in units would be $30,000 / ($20—$5) = 2,000 units. This means the company needs to sell 2,000 units to cover its costs and start making a profit.
These are simplified examples, and business scenarios can be much more complex. Also, these methods should not be used in isolation but in conjunction with other financial metrics and considerations to make informed investment decisions.
Conclusion
While each of these investment appraisal methods has its strengths and weaknesses, the choice often depends on the specific context and objectives of the business. Businesses focused on liquidity prefer the payback period method, while others are looking at long-term profitability and might find the return on capital employed more useful.
Understanding these methods can significantly aid in effective and efficient business management.
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