Management Accounting

Introduction

Project appraisal techniques are a useful tool to assess the potential benefits and impacts of undertaking a project or a new development.

Three widely used and accepted methods used by finance and project managers are:

Payback Method

Accounting Rate of Return

Net Value & Net Present Value

This paper will exemplify and evaluate each of the three project appraisal techniques and highlight validity as an aid to decision making.

The following example will be used to illustrate each technique:

Initial Capital Cost Ј500,000

Lifespan 6 years

Cost of Capital 6 %

Residual Value 4 % of the initial capital cost

Additional Net Cash Flows:

Year 1 Ј50,000

Ј75,000

Ј100,000

Ј120,000

Ј90,000

Ј80,000

Discount Factors based on a 6% cost of capital:

Year 1 0.943

0.890

0.840

0.792

0.747

0.705

Payback Method

This is the simplest method of looking at one or more investments projects or ideas.

The payback method calculates the length of time it will take for the net cash flows to recover the initial capital costs. When comparing projects this technique holds that, all other things being equal, the better project is the one with the shorter payback.

A company may also compare the payback period of a project with the company's average or target when deciding whether to undertake a project.

This technique has been illustrated in Example 1.

Example 1

Initial capital Ј500,000

Year Net Cash Flow (Ј) Cumulative Net cash flow (Ј) Remainder (Ј)

1 50,000 50,000 450,000

2 75,000 125,000 375,000

3 100,000 225,000 275,000

4 120,000 345,000 155,000

5 90,000 435,000 65,000

6 80,000 515,000

1. payback is after 5 years.

The number of months is calculated as below:

Payback period = 65,000 x 12 = 9.75

80,000

Payback period is 5 years + 9.75 months.

Payback period = 5 years 10 months

2. Payback period = 65,000 x 365 = 296.56 days

80,000

Payback period = 297 days

From the table in example 1 it can be seen that the project earns the initial investment of Ј500, 000 in year 6.

Calculation 1 shows the actual period is approximately 5 years and 10 months or 296 days (calculation 2).

Standing alone this information does conclude whether the project is viable or not.

Where there are two or more projects the one with the shorter payback is considered the better project. For example if another project had a payback of 10 years, and all other factors were constant, then using payback this project should be accepted.

In the case of just one project being appraised then the payback period needs to be compared with the company's target requirement the current average.

Benefits of Payback.

The main benefit of the payback method is that it is a very simplistic and easily understood model.

It is very simple to understand, so even non-financial departments can calculate and understand the what the payback calculation shows.

The outcome also gives a simple measure of risk, where if the payback period is long there is more risk and if the payback period is short there is less risk. This may be particularly important for high risk projects or for high capital investment projects.

Selecting projects based upon the payback period may avoid problems with liquidity and aid cashflow forecasting and control. Payback uses actual cash flows not subjective accounting profits, and emphasises the cash flows in the earlier years of the project, usually the most critical for a company having paid out a large initial capital outlay. A company may raise finance for the project using a bank loan and therefore it is important they know the amount of time they will be able to repay the loan and the implications in its cashflow.

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Drawbacks of Payback Method

Payback has the virtue easy to compute and easily understood by financial and non-financial managers. However, the simplicity of the method carries weaknesses with it.

The main criticism of payback method is that it ignores the time value of money ie Ј1000 today is not the same as Ј1000 in 3 years time. External factors like inflation will affect the value of money. E.g. if inflation is 6% then your money would halve every 12 years.

Cashflows will have a different value in the future depending on political, social environmental and economical factors which all affect the financial climate.

There