Types of Expenditure

Capital This refers to spending on acquiring, upgrading, or improving non-current

Expenditure assets (also called fixed assets).
Example:
Purchasing a new factory or office building.
Buying machinery, vehicles, or equipment for business use.
Revenue This refers to the spending necessary to maintain existing assets and day-to-
Expenditure day business operations.
Example:
Repairing machinery or vehicles.
Paying salaries, rent, or electricity bills.

Payback Period
Payback period is the time it takes for the operating cash flows from a project to pay back the
initial investment.
It is used as a part of initial screening of projects & the selected projects are further appraised
using techniques like NPV.

Decision Rule:
Payback Period < Target Accept
Payback Period > Target Reject
Target payback is decided by the management, and is subjective.

E.g. 1
Year 0 1 2 3 4 5
Cash Flow -100,000 30,000 40,000 50,000 35,000 15,000
If target payback period is 3 years, will the project be accepted?

Soln:
Year Cash Flow Cumulative
Cash Flow
1 30,000 30,000
2 40,000 70,000
3 50,000 120,000
4 35,000 155,000
5 15,000 170,000
The above table shows that in between Year 2 & 3, the project recovers its initial investment.
$
Cash Flow till Year 2 70,000
Balance Cash Flow to recover initial investment 30,000
Cash Flow in Year 3 50,000
Payback period 2 years 7.20 months
Yes, the project will be accepted as the actual payback period is less than the target.

Discounted Payback Period

Under this method, discounted cash flows are used to calculate Payback Period.
E.g. 1
Year 0 1 2 3 4 5
Cash Flow -100,000 30,000 40,000 50,000 35,000 15,000
Discount Rate 12%
If target payback period is 3 years, will the project be accepted?

Soln:
Year Cash Flow DCF @ PV of Cash Cumulative
12% Flow Cash Flow
1 30,000 0.893 26,786 26,786
2 40,000 0.797 31,888 58,673
3 50,000 0.712 35,589 94,262
4 35,000 0.636 22,243 116,506
5 15,000 0.567 8,511 125,017
The above table shows that in between Year 3 & 4, the project recovers its initial investment.
$
Cash Flow till Year 3 94,262
Balance Cash Flow to recover initial investment 5,738
Cash Flow in Year 4 22,243
Payback period 3 years 3 months
No, the project will be rejected as the actual discounted payback period is more than the
target.

E.g. 2
Brenda and Eddie are worried about the length of time it will take for the cash flows from the
Parkway Diner to repay their total investment of $500,000 ($350,000 to take over the
business and $150,000 to refurbish it).
Cash flow projections from the project are estimated as:
Year Operating Cash Flows ($)
1 70,000
2 70,000
3 80,000
4 100,000
5 100,000
6 120,000
After the sixth year, Brenda and Eddie confidently expect that they could sell the business for
$350,000.
Calculate discounted payback period of the project if discount rate is 9%.

Soln:
Cash Outflow 500,000 $
Year Cash Flow DCF @ PV of Cash Cumulative
9% Flow Cash Flow
1 70,000 0.917 64,220 64,220
2 70,000 0.842 58,918 123,138
3 80,000 0.772 61,775 184,912
4 100,000 0.708 70,843 255,755
5 100,000 0.650 64,993 320,748
6 470,000 0.596 280,246 600,994
The above table shows that in between Year 5 & 6, the project recovers its initial investment.
 $
Cash Flow till Year 5 320,748
Balance Cash Flow to recover initial investment 179,252
Cash Flow in Year 6 280,246
Payback period 5 years 8 months

Return on Capital Employed (ROCE)

ROCE PBIT / Capital Employed
ROCE Operating Margin x Asset Turnover

Decision Rule:
ROCE > Target Accept
ROCE < Target Reject
Target ROCE is decided by the management, and is subjective.

E.g. 1
An asset costing $120,000 is to be depreciated over 5 years to a nil residual value. Profits
after depreciation for the 5 years of the project are as follows:
Year 1 2 3 4 5
Profits ($) 12,000 17,000 28,000 37,000 8,000
Required:
What is the average accounting rate of return for this project?

Soln:
$
Opening Capital Employed 120,000
Closing Capital Employed - The asset has 0 scrap value.
Average Investment 60,000

Year 1 2 3 4 5
Profit 12,000 17,000 28,000 37,000 8,000
Average Profit 20,400 $
Accounting Rate of Return 34%

E.g. 2
Brenda and Eddie are considering expanding their restaurant business through the purchase
of the Parkway Diner, which will cost $350,000 to take over the business and a further
$150,000 to refurbish the premises with new equipment.
Cash flow projections from the project are estimated as:
Year Operating Cash Flows ($)
1 70,000
2 70,000
3 80,000
4 100,000
5 100,000
6 120,000
The equipment will be depreciated to a zero resale value over the same period and, after the
sixth year, Brenda and Eddie confidently expect that they could sell the business for
$350,000.
Calculate ROCE of this investment (using average investment method).

Soln:
$
Opening CE 500,000
Closing CE 350,000 The asset was reduced to 0 in accounting books, but was sold for 350,000.
Hence, this is the closing value of CE.
Average Investment 425,000

Year 1 2 3 4 5
Cash Flow 70,000 70,000 80,000 100,000 100,000
Depreciation (Note 1) -25,000 -25,000 -25,000 -25,000 -25,000
Profit on Sale of Asset (Note 2)
Profit 45,000 45,000 55,000 75,000 75,000
Average Profit 65,000 $
Accounting Rate of Return 15.3%

Note 1: Depreciation
Initial Investment 150,000 $
Scrap Value - $
Useful Life 6 years
Depreciation p.a. (Cost - Scrap Value) / Useful Life
25,000 $

Note 2: Profit on Sale of Asset

Book Value at the end of Year 6 350,000

Sale Proceeds 350,000
Profit on Sale of Asset -
 6
120,000
-25,000
-
95,000
Investment 1.40 $m
Annual Cash Flow 0.30 $m
Payback Period 4.67 years

Note 1: Depreciation
Deprecation is a non-cash expense. Therefore, it is not deucted while calcualting annual cash
flow.
 $m
Year 1 2 3 4
Cash Flow 100 50 50 50
Avg Cash Flow 62.50 $m

Initial Investment 200 $m

Scrap Value 20 $m
Useful Life 4 years
Depreciation p.a. (Cost - Scrap Value) / Useful Life
45 $m

$m
Operating Cash Flow 62.50
Depreciation p.a. -45.00
Operating Profit 17.50

ROCE on Initial Investment 8.75%

Avg Investment 110.0 $m

ROCE on Avg Investment 15.91%

Self Note: $m
Asset A/C
Year 1 To Bank 200 Year 1 By Depreciation 45
Year 1 By Balance c/d 155
200 200

Year 2 To Balance b/d 155 Year 2 By Depreciation 45

Year 2 By Balance c/d 110
155 155

Year 3 To Balance b/d 110 Year 3 By Depreciation 45

Year 3 By Balance c/d 65
110 110

Year 4 To Balance b/d 65 Year 4 By Depreciation 45

Year 4 By Balance c/d 20
65 65

Average Investment 110 $m

Year 1 2 3 4 5
Cash Flow 20,000 20,000 20,000 15,000 15,000
Cumulative Cash Flow 20,000 40,000 60,000 75,000 90,000
Avg Cash Flow 17,500 $

$
Cost of Machine 80,000
Cost of Market Research (capitalised) 8,000
Opening Investment 88,000
Scrap Value 4,000
Average Investment 46,000

$
Operating Cash Flow 17,500
Depreciation 14,000
Operating Profit 3,500

(i) ROCE on Opening Investment 4.0%

(ii) ROCE on Average Investment 7.6%

(iii) Payback Period

The above table shows that in between Year 4 & 5, the project recovers its initial investment.
$
Cash Flow till Year 4 75,000
Balance Cash Flow to recover initial investment 13,000
Cash Flow in Year 5 15,000
Payback period 4 years 10 months
 $
6
15,000
105,000
Investment 500,000.00 $
Annual Cash Flow 200,000.00 $
Payback Period 2.50 years

Note 1: Depreciation
Deprecation is a non-cash expense. Therefore, it is not deucted while calcualting annual cash
flow.
 Year Cash Flow Cumulative
Cash Flow
1 200 200
2 200 400
3 400 800
4 400 1,200
The above table shows that in between Year 3 & 4, the project recovers its initial investment.
$
Cash Flow till Year 3 800
Balance Cash Flow to recover initial investment 200
Cash Flow in Year 4 400
Payback period 3.5 years
(1) FALSE
Opportunity costs are relevant in investment decision-making as they
represent the benefits foregone by choosing one alternative over another.

(2) FALSE
ROCE is a profit-based accounting measure and does not account for the
time value of money.

(3) FALSE
Payback period is a cash-flow based investment appraisal method, which
focuses on how quickly a project recovers its initial investment.

(4) TRUE
Capital budgeting involves forecasting future cash flows, costs, and benefits,
all of which are inherently uncertain.
Initial Investment 100,000 $
Year Cash Flow Cumulative
Cash Flow
1 35,000 35,000
2 38,000 73,000
3 25,000 98,000
4 20,000 118,000
5 10,000 128,000
The above table shows that in between Year 3 & 4, the project recovers its initial investment.
$
Cash Flow till Year 3 98,000
Balance Cash Flow to recover initial investment 2,000
Cash Flow in Year 4 20,000
Payback period 3.1 years
ROCE PBIT / CE
Payback Period No of years in which initial investment is recovered from the
project cash flows.
Payback Period Initial Investment / Annual Cash Flow
10 100,000 / Annual Cash Flow
Annual Cash Flow 10,000 $

Initial Investment 100,000 $

Scrap Value 10,000 $
Useful Life 20 years
Depreciation 4,500 $

$
Annual Cash Flow 10,000
Depreciation -4,500
PBIT 5,500 $
Avg Investment 55,000 $
ROCE 10%
Initial Investment 9,000 $
Useful Life 5 years
Depreciation 1,800 $

$
Cash Flow 3,000
Depreciation -1,800
Profit 1,200
ROCE 13%
Target ROCE 15%
Since ROCE < Target, the project would be rejected.

Payback Period 3.0 years

Target Payback 2.5 years
Since Payback > Target, the project would be rejected.
(1) FALSE
Accounting profits are based on accounting policies which are subject to
manipulation. Using cash flows is generally preferred in investment appraisal.

(2) FALSE
Investments which have an ROCE greater than the target ROCE decided by the
management are selected.

(3) FALSE
Rejecting all such projects might prevent potentially beneficial investments if
the current ROCE is unusually high.

(4) TRUE
ROCE is calculated using average profit and average capital employed, which
reflects the performance over the project’s entire life.