Return on Initial Capital Employed
The four main techniques adopted to evaluate capital projects like Kips and Queens Projects are considered in this report. This return on initial capital employed ratio examines the return derived in percentage terms on the capital gain of the project at hand. Its simplicity to determine and to understand is particularly popular especially for organizations keen on diminishing administrative expenditure. In addition people that lack finance know how often tend to favour such model. To add caviar to such benefit this ratio can be easily computed by utilising already present accounting data (RAI Foundation Colleges, p 3).
There are two critical disadvantages the hinder the utility of such technique. By resting its computation on accounting profit and not cash flows, serious weaknesses arise. The determination of profits is often criticize because it holds arbitrary assumptions that involve subjectivity and thus fails to provide a clear picture of the financial benefits. Typical examples of such elements are depreciation and goodwill amortisation. Further more, this method does not take into consideration the time value of money principle (RAI Foundation Colleges, p 3). Payback Period
As its name entails, this technique looks at the time necessary for the project’s cash inflows to recoup the capital cost of the project considered. This method is also acclaimed for its simplicity in its calculation and understandably. Management also tend to like this model, since it emphasis projects that are able to generate quickly cash towards the company and thus enhance a sound liquidity in cash terms (RAI Foundation Colleges, p 1). The salient weakness of this technique, similar to the previous one is its omission of the time value of money principle.
Over time, money loses its value due to opportunity cost and inflation leading to the assertion that $1 today is much more valuable than $1 next year (Investopedia 2008). Therefore by failing to consider discount future cash inflows the payback method is not providing accurately the financial viability of the project. Its drastic attention on time taken to recoup the capital expenditure may also deter from highlighting the project that maximizes wealth (RAI Foundation Colleges, p 1-2). This is a critical disadvantage, because it may fail in the maximization of stakeholders’ wealth.