Basic Investment Appraisal Techniques – ARR and Payback

CIMA-P2 · Chapter 10

Basic Investment Appraisal Techniques – ARR and Payback

1 Introduction

This section of the syllabus considers the techniques used to support long-term decision making — above all the selection of capital investment projects. Capital investment is the primary means by which an organisation allocates resources between competing needs, so the quality of these decisions largely determines whether a strategy is actually delivered.

This chapter covers two things. First, the process a proposal travels through, from the idea to the post-completion audit. Second, the two basic, non-discounted appraisal techniques — payback and the accounting rate of return (ARR).

The next chapter turns to the technically superior method, net present value (NPV), and its related measure, the internal rate of return (IRR). Chapters 12 to 13 then deal with the cash flows that go into a discounted appraisal, and with capital rationing, replacement and real options.

You need to be able to calculate each method, explain it, and discuss its strengths and weaknesses. All of them support accept/reject decisions, and all of them can be used to rank mutually exclusive projects — but they do not always rank them in the same order, which is itself examinable.

2 Capital investment decisions

A capital investment decision commits cash now in the expectation of returns over several future years. Typical examples are the purchase, improvement or replacement of a non-current asset, the launch of a new product, or the acquisition of another business.

Capital investment decisions

Required

What do we mean by a capital investment decision?
What are the features of this type of decision that increase the risk attaching to it?

Capital investment decisions

(a) What they are

Capital investment decisions — sometimes called capital budgeting decisions — relate to funds spent by the business to further its long-term objectives. They usually involve acquiring, improving or replacing a non-current asset, such as new machinery, or acquiring another business.

(b) Why they carry more risk than routine decisions

They are long-term commitments with a large initial outlay: the cash goes out now and the benefits arrive over future years.
They are to a large extent irreversible — an asset bought and installed cannot usually be unwound at cost.
They often need new finance, so they change the capital structure of the business, increasing gearing or diluting equity.
Most of the figures in the appraisal are estimates, and some of them are estimates for many years ahead, which increases both risk and uncertainty.
Because of all of the above, they normally require authorisation at the most senior level.

It is that last point — that these are board-level, largely irreversible commitments made on estimated data — that explains why organisations put a formal process round them, which is the subject of the next section.

3 The investment decision-making process

A technique is only the middle of the story. The syllabus asks you to explain the steps and pertinent issues in the decision-making process: where proposals come from, how a capital budget is created, and how a go/no-go decision is actually taken. The process below is the normal shape for a medium-sized or large organisation.

3.1 Origination of proposals

Proposals do not originate in the finance function. They come from the operating parts of the business — a production manager who can see a bottleneck, a sales director who wants a new channel, an IT function replacing a system that is out of support. Two things follow:

The organisation must actively encourage proposals, because a business whose managers have learned that capital requests are always refused simply stops making them, and its asset base quietly ages.
Proposals must be presented on a common basis — a standard capital request form, a stated cost, a stated set of benefits, and the assumptions behind them — or they cannot be compared.

The management accountant's contribution at this stage is not to have the ideas. It is to supply the data and the format that make somebody else's idea appraisable.

3.2 Screening

Proposals are first filtered against strategic fit and against simple financial hurdles, commonly a maximum payback period. Screening is deliberately crude: its purpose is to stop the organisation spending appraisal effort on proposals that will plainly fail. This is the main practical role of payback (section 6) and of ARR (section 5).

3.3 Creation of the capital budget

The capital budget is the amount of money the organisation is prepared to commit to capital projects for the coming period, together with the projects it expects to spend it on. It is prepared alongside the operating budgets and approved by the board.

Two points matter for the exam:

The capital budget is where capital rationing comes from.
A limit set by the board itself is soft capital rationing; a limit set by the lenders is hard capital rationing. Selecting projects under such a limit is dealt with in chapter 13.
An approved capital budget is not authority to spend.
Inclusion in the budget reserves the funds; each project still needs its own authorisation when the detailed appraisal is complete.

3.4 Appraisal and the go/no-go decision

The surviving proposals are appraised in full — normally on a discounted cash flow basis (chapters 11 and 12) — and a recommendation is put to whoever holds the authority limit. The decision is a go/no-go decision: the project either proceeds or it does not.

The decision is not taken on the number alone. The appraisal is supported by the qualitative and non-financial factors the numbers cannot carry (chapter 13, section 3), and by an assessment of how sensitive the conclusion is to the estimates it rests on (chapter 15).

A positive NPV is a reason to accept a project, not an instruction to. Authorisation limits, the funds actually available, the risk appetite of the board and the fit with strategy can all defeat a positive appraisal — and an examiner asking you to "advise" wants that said.

3.5 Implementation and monitoring

Once authorised, the project is implemented and its spend is monitored against the authorised figure. Material overspend normally has to be re-authorised, which is the control that stops a project being approved on an optimistic cost and then quietly growing.

3.6 Post-completion audit

A post-completion audit compares what the project actually cost and actually delivered with what was forecast when it was authorised, and asks why the two differ.

Post-completion audit

A review, carried out after a capital project has been completed and has been running long enough to produce results, comparing actual outcomes with the forecasts on which the project was authorised.

Its purpose is not to punish. It is to improve the next forecast — and the fact that it will happen improves the current one, because managers who know their estimates will be revisited make more honest estimates.

The benefits and the costs of the exercise are worth stating separately:

Benefits	Limitations
Improves the quality of future forecasts, because estimating biases become visible.	It is expensive in management time, so it is normally applied only to large or unusual projects.
Discourages deliberately optimistic proposals, because the proposer knows the outcome will be checked.	The outcome cannot be reversed — the cash is spent, so the audit changes nothing about this project.
Identifies projects that should be abandoned or extended, and so feeds the real options discussed in chapter 13.	Separating the project's effect from everything else that changed in the business is often difficult.
Identifies weaknesses in the process itself, such as a screening hurdle that is set at the wrong level.	It can make managers risk-averse, and so discourage exactly the innovative proposals the business needs.

Chapter 9 returns to the post-completion audit in the setting where it matters most — digital transformation projects, whose benefits are largely intangible and therefore have to be measured after the event or not at all.

4 Investment appraisal techniques

Investment appraisal techniques evaluate the financial viability of a long-term project. All of them compare the returns the project is expected to generate against the initial outlay and the other relevant costs it causes.

They are applied before the project is accepted, so most of the costs and revenues in the analysis are estimates rather than guaranteed outcomes. Estimates should nevertheless be defensible and reasonable in the circumstances, and any assumption management has made in forecasting them should be stated explicitly before the decision is taken.

The four techniques in the syllabus divide as follows:

Technique	Basis	Time value of money	Where it is covered
Payback	Cash flows	Ignored (unless discounted payback is used)	This chapter, section 6
Accounting rate of return (ARR)	Accounting profits	Ignored	This chapter, section 5
Net present value (NPV)	Cash flows	Recognised	Chapter 11
Internal rate of return (IRR)	Cash flows	Recognised	Chapter 11

The two in this chapter are the basic techniques. They are quick, they are widely used in practice as screening filters, and they are examinable in their own right — but neither of them accounts for the time value of money, which is why chapter 11's methods are technically superior.

5 The accounting rate of return (ARR)

This recording covers sections 5 and 6 — ARR and payback — and works Examples 2 and 3. Two notices.

One: the tutor reads the machine's cost as "£80,000" in Example 2. The notes are in dollars throughout; the figure is $80,000 and nothing else changes.

Two: the recording does not cover section 3, the investment decision-making process. Read section 3 from the notes.

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The accounting rate of return is an accounting-based measure: it looks at the profitability of an investment rather than at its cash flows. You should be able to calculate it, interpret it, and discuss its strengths and weaknesses against the other methods.

Several formulae for ARR are in use. CIMA's preferred version, and the one used in this text, is the average investment method:

ARR = (Average annual profit ÷ Average investment) × 100%

where Average investment = (Initial cost + Scrap proceeds) ÷ 2

The average investment is the initial cost plus the scrap proceeds, divided by two — not minus. The asset appears in the statement of financial position at $80,000 on day one and is depreciated down to its $10,000 residual value, so the average carrying amount over the life is the average of those two figures, $45,000. Taking (80,000 − 10,000) ÷ 2 = $35,000 would be the answer to a different question.

Take care if you are given cash flows rather than profits. Cash flows have to be adjusted before they can be used in this formula — normally by deducting depreciation, which converts them into the profits the formula requires.

The ARR percentage is then compared with a target rate of return in order to decide whether the investment is worthwhile. The target is often the company's target return on capital employed (ROCE), which makes the comparison consistent with the measure on which the division or the business as a whole is judged.

Accounting rate of return

A machine will cost $80,000. It has an expected life of 4 years with an anticipated scrap value of $10,000.

Expected profits for each year of the project are as follows:

Year	Profit $
1	20,000
2	30,000
3	40,000
4	10,000

Required

Calculate the accounting rate of return of the project.

Accounting rate of return

Workings

Average annual profit	(20,000 + 30,000 + 40,000 + 10,000) ÷ 4	$25,000
Average investment	(80,000 + 10,000) ÷ 2	$45,000

Accounting rate of return

ARR = (25,000 ÷ 45,000) × 100% = 55.56%

The project would be accepted if the company's target rate of return is below 55.56%, and rejected if it is above it.

5.1 Strengths and weaknesses of ARR

Strengths	Weaknesses
Quick and simple to calculate from data the accounting system already produces.	It ignores the time value of money — a profit earned in year 4 is treated as worth the same as one earned in year 1.
The result is a percentage, so it is a relative measure and can be compared directly across projects of different sizes.	It uses profits rather than cash flows, and profit is subjective: two acceptable accounting treatments give two different ARRs for the same project.
It includes all the returns and costs over the project's whole life, so it reflects total profitability — unlike payback.	The target rate against which the answer is judged is arbitrary.
It is expressed in the same terms as ROCE, on which managers are often appraised, so it is consistent with how performance is actually measured.	That same consistency is a hazard: a project with a positive NPV can depress a division's ROCE in its early years, and a manager judged on ROCE may reject it (chapter 5).

6 Payback

The payback period is the length of time a project must run before it recoups its original investment in cash terms.

The payback period, stated in years, is compared with a target payback period. If the project pays back within the target period it is accepted; if not, it is rejected.

Payback therefore favours projects with high cash flows early in their lives. That is not simply a bias: the further into the future a forecast reaches, the less reliable it is, so a short payback is a genuine reduction in the risk that the project never recovers its cost at all. This is why so many businesses use payback as a first screening filter (section 3.2) before passing a project on for a full discounted appraisal.

Payback

A machine will cost $1.2 million and has a life of 4 years. Its estimated scrap value is nil.

It is expected to produce cash savings as follows:

	$000
Year 0 (now)	(1,200)
Year 1	300
Year 2	500
Year 3	800
Year 4	850

Required

Calculate the payback period.

Payback

	Cash flow $000	Cumulative cash flow $000
Year 0 (now)	(1,200)	(1,200)
Year 1	300	(900)
Year 2	500	(400)
Year 3	800	400
Year 4	850	1,250

The cumulative cash flow turns positive during year 3. At the end of year 2 the project is still $400,000 short, and year 3 brings in $800,000, so — assuming the cash arrives evenly through the year — a further 400 ÷ 800 = 0.5 of a year is needed.

Payback period = 2 + (400 ÷ 800) = 2.5 years (2 years 6 months)

6.1 Discounted payback

A variant that answers the main criticism of the method: the cash flows are discounted first, and the payback period is then read off the cumulative present values. Discounted payback is always longer than ordinary payback, and it tells you when the project recovers its cost including the cost of the money tied up in it. It still ignores everything that happens after that date.

6.2 Strengths and weaknesses of payback

Strengths	Weaknesses
Quick to calculate and easy to explain, which makes it a good first screen and one that non-financial managers understand.	It ignores the time value of money — unless discounted payback is used.
It uses cash flows rather than profits, which are less subjective.	It ignores the total return: every cash flow after the payback date is disregarded, so a project earning $850,000 in year 4 and one earning $8 million rank equally here.
It reduces exposure to forecasting risk by favouring projects that recover their cost early, and so improves liquidity.	The target payback period is arbitrary — there is no rule that says four years.
It is a useful measure where cash is scarce or the business environment is genuinely unpredictable.	It can lead to systematic under-investment in longer-term projects, which is exactly the kind of investment a digital transformation programme requires (chapter 9).

7 Using the techniques together

No business should make a capital investment decision on one measure. In practice a proposal is screened on payback, appraised on NPV, and its IRR is calculated to show how much room there is for the cost of capital to be wrong. ARR is reported because it is the measure the project's eventual results will be judged on.

The techniques can disagree, and where they do the reason is always one of the three weaknesses above — the treatment of time, the choice between profit and cash, or what happens after the cut-off. Say which method you are relying on and why.

Payback and ARR are the basic techniques: quick, widely used, and both blind to the time value of money. ARR = average annual profit ÷ average investment, where average investment is (cost + scrap) ÷ 2. Payback is the time taken to recover the outlay in cash. Both sit inside a wider process — origination, screening, capital budget, go/no-go, implementation, post-completion audit — which is itself examinable.

8 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.

Answer the questions one at a time. Your progress is saved so you can leave and come back.

Open chapter practice