Capital Investment Appraisal Methods

Capital Investment Appraisal Methods

Return on Capital Employed (ROCE)

This method calculates the profits that will be earned by a project and expresses this as a percentage of the capital invested in it. The higher the ROCE the higher a project will be ranked. There may be a hurdle rate required by the company in order to make a project viable. This method is based on profit rather than cash flows. One problem is in consistency of measurement as there are several possibilities for definitions of the appropriate profit and capital figures figure to use.

Payback

This method calculates the length of time a project will take to recoup the initial investment, in other words how long a project will take to pay for itself. It gives the time taken for the cash inflows to exactly equal the initial cash outflow. The technique may use either actual or discounted cash flows. It is often used as a supplementary evaluation to more complex techniques.

Discounted Cash Flow (DCF)

Present Value (NPV)

This method considers all relevant cash flows associated with a project over the whole of its life and adjusts those occurring in future years to their present value by discounting at a rate called the cost of capital. The NPV is therefore the current cash equivalent of a stream of future cashflows. A positive NPV indicates surplus cash in current terms as a result of accepting the project. It exceeds the required return.

2. Internal Rate of Return (IRR)

This method involves comparing the rate of return expected from the project calculated on a discounted cashflow basis with the rate used a s the cost of capital. It is the actual discounted return achieved by the project. Projects with an IRR higher than the cost of capital are worth undertaking.