c It ignores the time value of money a concept incorporated into more

C it ignores the time value of money a concept

This preview shows page 10 - 13 out of 13 pages.

c) It ignores the time value of money (a concept incorporated into more sophisticated appraisal methods). This means that it does not take account of the fact that $1 today is worth more than $1 in one year's time. An investor who has $1 today can either consume it immediately or alternatively can invest it at the prevailing interest rate, say 10%, to get a return of $1.10 in a year's time. d) Payback is unable to distinguish between projects with the same payback period. e) The choice of any cut-off payback period by an organisation is arbitrary. f) It may lead to excessive investment in short-term projects. g) It takes account of the risk of the timing of cash flows but not the variability of those cash flows. (7) Advantages of the payback method a) It is simple to calculate and simple to understand. This may be important when management resources are limited. It is similarly helpful in communicating information about minimum requirements to managers responsible for submitting projects. b) It uses cash flows rather than accounting profits. c) It can be used as a screening device as a first stage in eliminating obviously inappropriate projects prior to more detailed evaluation. d) The fact that it tends to bias in favour of short-term projects means that it tends to minimise both financial and business risk. e) It can be used when there is a capital rationing situation to identify those projects which generate additional cash for investment quickly.
Image of page 10

Subscribe to view the full document.

___________________________________________________________________________________________________________________ Page 11 of 13 IPK COLLEGE 1664, JALAN KULIM, 14202 BUKIT MERTAJAM, PENANG TEL : 012-5203212 / 0125113212 / 04-5512588 Subject: Financial Management (DFM1) Prepared by Susan Lim Email : [email protected] Part 5: The return on capital employed ROCE= Estimated average annual accounting profits x 100% Estimated average investment Average investment= Initial investment + Scrap value 2 (1) The return on capital employed method (ROCE) (also called the accounting rate of return method or the return on investment (ROI) method) of appraising a capital project is to estimate the accounting rate of return that the project should yield. (2) Accounting profit will be calculated after deducting depreciation from the cash profits. (3) The investment at the beginning of the project is the initial cost. The investment at the end of the project is the disposable value or scrap value. (4) If it exceeds a target rate of return, the project will be undertaken. In (5) In RATIO ANALYSIS, we discussed how return on capital employed is measured for financial accounting purposes. (6) Here the measure is calculated in relation to investments. Example A company has a target return on capital employed of 20% for its capital investments (using the first definition from the paragraph above), and is now considering the following project. Capital cost of asset $80,000 Estimated life 4 years Estimated profit before depreciation Year 1 $20,000 Year 2 $25,000 Year 3 $35,000 Year 4 $25,000 The capital asset would be depreciated by 25% of its cost each year, and will have no residual value. You are required to assess whether the project should be undertaken.
Image of page 11
___________________________________________________________________________________________________________________ Page 12 of 13 IPK COLLEGE 1664, JALAN KULIM, 14202 BUKIT MERTAJAM, PENANG TEL : 012-5203212 / 0125113212 / 04-5512588 Subject: Financial Management (DFM1) Prepared by Susan Lim Email : [email protected] (7) Disadvantages It is based on accounting profits and not cash flows. Accounting profits are subject to a number of different accounting treatments.
Image of page 12

Subscribe to view the full document.

Image of page 13
  • Spring '17
  • JANE KDAL

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern

Ask Expert Tutors You can ask You can ask ( soon) You can ask (will expire )
Answers in as fast as 15 minutes