In capital budgeting process every company needs to assess investments to compare them and then choose which one is beneficial for the company. There are different methods to do that but In this article, we will discuss two of them which are easy to understand and require fewer efforts to implement in real life. These are methods, which helps us to avoid complex calculations and make decisions about relatively small investments. Let us discuss them separately.
ROCE: Return on capital employed
The formula to calculate ROCE is
ROCE =
Where EBIT is Earnings before tax and interest paid and average capital employed is calculated as
. The decision rule is simple, it says that if ROCE is higher than target or benchmarked set by management it should be accepted. The meaning of this ratio is also pretty simple, it shows how much operational profit is available for each unit of capital employed.
There are some advantages and disadvantages of this method:
Advantages:
It is simple and easy to calculate as there are two variables EBIT, which is available in an Income statement, and Capital employed in a balance sheet. The other advantage is the measure is in percentage terms and easy to compare with historical data or with alternatives.
It ignores a lifetime of project and timing of cash flows that is to say it ignores the time value of money. Another disadvantage is it can vary because of accounting policies and will cause not accurate decisions while comparing investment opportunities. It also may ignore capital requirements
Example: A wood processing company wants to buy a machine which costs 100 000$ and will generate for a company 25 000$ each year for 5 years. There is no scrap value and the depreciation is on straight-line bases.
First, we need to calculate EBIT of a project so we should deduct from cash inflows depreciation, which is an expense. Therefore, depreciation is equal 100 000/5 = 20 000. EBIT for each year is equal to 5000 (25000-20000), total is 5*5000=25000$.
ROCE = 25000$/ 100000$ = 0.25 or 25% as there is no scarp value.
Payback assessment method:
It is a method, which measures when the project will pay all investments that you have made on it. It counts liquidity and easy to calculate. The formula to do that is:
Pay Back = initial investment / annual cash flow
But cash flows can be uneven or may not much exactly with investment. For example, we have to cover 200 dollars yet and in the coming year will have 300$ cash inflow, we need do divide 200/300 = 0,66 year or 0,66*12 month = 8 months.
The rule is simple: chose the one which offers less payback period which is more liquid.
Advantages:
It is simple and effective in certain situations like rapidly changing technology or improving investment conditions.
Disadvantages:
It ignores cash flows after payback period and fails to count time value of money.
Example:
Year
|
Cash Flow
|
Cumulative cash flow
|
Payback
|
0
|
(100 000)
|
-100 000
|
0
|
1
|
35 000
|
-65 000
|
1
|
2
|
50 000
|
-15 000
|
2
|
3
|
40 000
|
15 000/40 000
|
0,375 or 4,5 month
|
