The traditional approach to investment appraisal is return on capital employed (ROCE). In its basic form, it is calculated as the ratio of the accounting profit generated by an investment project to the required capital outlay, expressed as a percentage.
There are many variations in the way the two figures accounting profit and capital outlay are actually calculated. The normal practice for investment appraisal is to calculate profit after depreciation but before any allowance for taxation, and to include in capital employed any increases in working capital that would be required if the project were accepted.
There are two common ways of expressing ROCE in practice. One is the ratio of the average annual profit generated over the life of the project, to its average capital value (i.e. the average capital employed). The other approach is to take the average annual profit as a ratio of the initial outlay (see the example at end of this extract).
ROCE can be employed in the investment appraisal of both independent projects and mutually exclusive projects. First, a decision criterion is set in terms of a minimum acceptable level of ROCE. (The figure used here often reflects the firm's overall return on capital.) Then, for an independent project to be acceptable, its ROCE must at least equal the 'hurdle' or criterion return specified. In a situation of mutually exclusive projects, the best of the alternatives is the project with the highest ROCE. However, this 'best' project will only be accepted by the firm if it, too, meets the set criterion.
Advantages Of ROCE
The ROCE investment appraisal technique is widely used in practice, although it is probably declining in popularity. It has three main advantages.
The first is that by evaluating the project on the basis of a percentage rate of return it is using a concept with which all management are familiar. For example, being told that a project has a four year payback would not immediately convey whether that was good or bad; but being told that a project is expected to produce a 35% return on capital would appear obviously desirable (given that we know the going rate of return on, say, the overall company).
The second advantage is connected to the first. It is the fact that the method evaluates the project on the basis of its profitability, which many managers believe should be the focus of the appraisal.
Finally, a third advantage is that of logic. Managers' own performance is often evaluated by shareholders in terms of the company's overall return on capital employed. Therefore there does seem to be a certain logic in evaluating individual capital investment opportunities on a similar basis. (This line of thinking then often leads to the specification of the ROCE criterion being set equal to the company's actual or desired overall return on capital.)
Disadvantages of ROCE
To set against these advantages, there are a number of major disadvantages, the first of which is the ambiguous nature of the ROCE concept.
There are so many variants that no general agreement exists on how capital employed should be calculated, on whether initial or average capital employed should be used or on how profit should be defined. As a result, the method lays itself open to abuse as a technique of investment appraisal by allowing the decision maker to select a definition of ROCE that best suits their preconception of a project's desirability.
Secondly, because the method measures a potential investment's worth in percentage terms it is unable - in an unadjusted form - to take into account the financial size of a project when alternatives are compared. For example, suppose a company was considering whether to build a large factory at a cost of £10 million, or a small factory at a cost of £3 million. If the large factory turned out to have an ROCE of 20% while the small factory's ROCE was 24%, then the latter investment would be the one chosen (assuming 24% exceeded the ROCE criterion). However, it is not at all certain that the small factory would be a wise choice. While the small factory would result in an aggregate profit of £720 000 (24% of £3 million), the large factory would produce a profit of £2 million for the firm.
However, these two criticisms are relatively insignificant when compared to two further difficulties. The first concerns the fact that accounting profit rather than cash flow is used as the basis of evaluation. This is an entirely incorrect concept to use in a decision-making context. Accounting profit is a reporting concept; it is a creation of accountants. A capital investment decision is an economic or resource allocation decision and the economic unit of account is cash, because it is cash that gives power over resources.
The other major criticism of ROCE is that it also ignores the time value of money.
Furthermore, unlike payback, where discounted payback can be used, there is no way that ROCE can be modified to take the time value of money into account.
Is it being used much?
Despite its criticisms, the method is still widely applied to investment decisions in industry and it may be fair to say that, like payback, although there are many problems associated with its application, it may give acceptable decision advice when applied to relatively minor, short-run investment projects.
Nevertheless, there is survey evidence that does indicate a decline in the technique's popularity. There are perhaps two reasons for this, both of which arise from the high rates of inflation suffered by the economy in the late 1970s and the 1980s. The first is that high rates of inflation led to high interest rates and this high time value of money sharply brought home to management the importance of taking it into account in decision making. With interest rates of around 20% it becomes obvious that the timing of cash flows is important. A second reason for ROCE's decline in popularity could be that the high rates of inflation - and the failure of the inflation accounting debate - taught management about the doubtful validity of the accounting profit number. Thus a method that uses accounting profit and ignores the time value of money has little to recommend it as a decision-making tool.
The use of ROCE tends to result in the adoption of short-term approaches to decision making; so-called 'short-termism'. This is related to its use for measuring the performance of managers and the fact that it emphasizes the effects of the investment on reported earnings rather than long-term cash flows.
The Beta Company wished to evaluate an investment proposal using the ROCE technique. The project requires an initial capital expenditure of £10 000, together with £ 3000 of working capital. The project will have a 4-year life, at the end of which time the working capital will be fully recovered and the project will have a scrap value of £ 2000.
The project's net pre-tax cash flows are as follows, and the company uses straight-line depreciation:
- Year 1 the net cash flow was +£4 000
- Year 2 the net cash flow was +£6 000
- Year 3 the net cash flow was +£3 500
- Year 4 the net cash flow was +£1 500
Depreciation is (£10 000 - £2 000)/4 = £2 000 a year
Annual profit a year (cash flow minus depreciation) is as follows:
- Year 1 £4 000 - £2 000 = £2 000
- Year 2 £6,000 - £2,000 = £4,000
- Year 3 £3 500 - £2,000 = £1 500
- Year 3 £1 500 - £2 000 = -£500
Total profit = £7 000 and average profit = £1 750
Initial capital employed= £13 000 (capital expenditure plus working capital). Average capital employed = (Capital expenditure - scrap value)/2 + scrap value = working capital
(£10 000 - £2 000)/2 = £2 000 = £3 000 = £9 000
Hence return on initial capital employed equals £1 750/£13 000 = 0.135 or 13.5%
and return on average capital employed equals £1 750 / £9 000 = 0.194 or 19.4%
- Why does money have a time value?
- What are the two most serious disadvantages of ROCE?
- Calculate ROCE for the business given that:
Capital expenditure = £11 000; working capital = £4 000; scrap value = £1 000 and the project has a life = 5 years.
- Year 1 the net cash flow was +£4 000
- Year 2 the net cash flow was +£4 000
- Year 3 the net cash flow was +£4 000
- Year 4 the net cash flow was +£3 000
- year 5 the net cash flow was +£2 000
Compare and contrast the use of the payback method with ROCE.
This is an extract from a chapter in Corporate Finance, Theory and Practice by Steve Lumby and Chris Jones. To find out more about this book, to purchase it as a hardcopy or as an e-book or to buy eChapters please select Cengage Brain