… Despite the shortcomings of the particular techniques that a company may wish to adopt, the importance of evaluating projects before they are accepted cannot be overstated. If this had been the norm rather than the exception, the corporate collapse would not have been as rapid as the one we are seeing today.

Usually in a business environment there are many decisions that come into play before money is invested in a project. Sometimes the decisions made reflect all considerations, both qualitative and quantitative.

Qualitative decisions are those that do not necessarily conform to the measurement in terms of naira and kobo. Such decisions take a critical look at the economic climate, the availability of personnel, the effect of government policy, the market environment in the usual interaction of demand and supply, and others which do not. are not easily quantifiable. Quantitative decisions, on the other hand, are those based on the amount of money that will be needed to get started, the returns expected from such operations, and the returns from other available projects, measured in terms of opportunity costs.

The sum of quantitative and qualitative decisions ultimately results in embarking on one particular project, as opposed to the other. It is therefore the responsibility of decision-makers to ensure that they are satisfied with the course of action they ultimately take. This exercise is often considered a project evaluation.

Project evaluation involves subjecting project opportunities to criteria defined by an organization to select those that best meet those criteria. To this end, a ranking method is used whereby projects are ranked in descending order with the best project coming first and the others following in terms of quality. In the end, the best projects are selected subject, however, to the availability of funds, as in a situation of capital rationing.

In short, capital rationing occurs in a situation where appropriate investments exist but insufficient funds to make them. It may be a one-period capital rationing, not lasting more than one accounting period, or a multi-period capital rationing that extends beyond one accounting period, and which may even occur intermittently.

Of course, it is not easy to determine which project best meets the criteria until an analysis is carried out. As a result of the appreciation of this discomfort, certain techniques have evolved, which greatly helps in quantifying the financial effect of embarking on any project. These techniques will be briefly examined in turn. The techniques that will be discussed are accounting rate of return (ARR) or return on investment (ROI) or return on capital employed (ROCE), payback period and discounted cash flow techniques.

Accounting rate of return (TRA)

The accounting rate of return on investment or return on capital employed measures the accounting profit that a particular project generates over its entire lifespan. An average of this profit is found and compared to the initial amounts invested; the percentage thus calculated will be used to determine the profitability of such an investment (project) or not.

The accounting rate of return is generally calculated as follows:

(a) Average accounting yield / Average investment x 100


(b) Average accounting yield / Average investment x 100

While Average Return on Investments = Initial Investment + Residual Value / 2

The residual value is the amount that will be recoverable at the end of the project. This could be, for example, the amount that the machines used in the project will be sold as scrap at the end of the project.

The accounting rate of return is easy to calculate and understand, even by a layman. For example, the cost of capital of a business is known; this is compared to the ARR to determine profitability. In a situation where the cost of capital is higher than the ARR, this project is not profitable. For example, a project with an APR of 10 percent, versus a cost of capital of 12 percent, indicates unprofitability. The fact that should be noted here is that accounting profit does not include the cost of obtaining the funds.

Another advantage of using ARR is that the information is readily available as it comes from the accounting records kept by the company. Even when estimates are made, it is much easier to use the basic concept of price minus cost to arrive at a profit.


However, ARR has a few flaws despite its simplicity. Although it considers projects throughout their life, ARR does not consider the time value of money. Since the future occurrence can hardly be predicted with certainty, coupled with rapid inflation, the time value of money becomes very relevant.

The expected benefits to be realized in the future are only simple projections which, perhaps, could be realized. This is a limitation of the forecast. All the same, ARR provides an acid test in project evaluation.

Payback period

The payback period corresponds to the moment when a project will have to recover its initial investment or investment, in order to be considered profitable. The use of accounting profit and the returns or profits recorded each year is used to reduce the amount initially invested until that amount is fully recovered. For example, a project that costs 100,000 to complete with a profit in year (1) one of 30,000, second year 25,000, third year 25,000, fourth year 20,000, the fifth year of 17,500 and year six of 15,000 will have four years as a payback period.

But sometimes the return period maybe sometimes is during the year. In such a situation, to really determine the period will be as follows: 37,500 will be calculated as follows:

Initial investment ?? Balance: ₦
Profit for year 1 40,000 110,000
Profit for year 2 45,000 65,000
Profit for year 3 47,000 18,000
Profit for year 4 43,500 25,500

The payback period = three years + 18,000 / 43,500 X 12 = three years, five months.

The payback period is also easy to calculate and understand as it doesn’t require a lot of complications. It does not require severe technicality and, as such, can be easily used by anyone. When more than one project is considered, the project with the shorter payback period is the most profitable.

Another advantage of this technique is that it dampens the effect of uncertainty on future estimates, as projects with too long a payback period may not be considered.

It is, however, necessary to have a standard time frame that an organization will consider its average payback period. It is a difficult thing to decide.

It is also factual that cash flows are related to the type of operations involved and therefore the classification of projects of a different nature can be misleading. A poultry farmer will generate income sooner than a plantation farmer and comparing it to the initial stage can be unfair.

Like everything human with shortcomings, the payback period, even at this, provides valuable guidance in evaluating projects.

Discounted cash flow techniques

These are techniques that take into consideration the time value of money. Projects using this technique are valued by discounting the income generated at the rate of the company’s cost of capital. The main methods of the technique are net present value and internal rate of return.

Net present value (NPV) measures the value of a unit of naira today on a future date. The total sum of the income generated will then be deducted from the amount initially invested to give the Net Present Value.

A positive NPV means that the project is profitable and must therefore be accepted. In contrast, a negative NPV, on the other hand, indicates an unprofitable project that should be rejected. However, a zero NPV means that the project is at breakeven point and as such, acceptance or rejection will depend on the attitude of the decision maker.

The internal rate of return (IRR) is used to determine the rate at which a project will be at zero point, i.e. at a breakeven point, and all projects that have a higher return are considered profitable.

The most important advantage of discounted cash flow techniques is that they take time and the value of money into consideration. It also takes into account the cash flows throughout the life of the project.

Between NPV and IRR, there may be conflicts. However, the results provided by NPV are more reliable because IRR itself uses trial and error techniques.

In conclusion, despite the shortcomings of the particular techniques that a company may wish to adopt, the importance of evaluating projects before they are accepted cannot be overstated. If this had been the norm rather than the exception, the corporate collapse would not have been as rapid as the one we are seeing today.

Bolutife Oluwadele, Chartered Accountant and Specialist in Public Policy and Administration, writes from Canada. He is the author of Thoughts of a village boy and can be contacted via: [email protected]

Support PREMIUM TIMES integrity and credibility journalism

Good journalism is expensive. Yet only good journalism can guarantee the possibility of a good society, responsible democracy and transparent government.

For free and ongoing access to the best investigative journalism in the country, we ask that you consider modestly supporting this noble enterprise.

By contributing to PREMIUM TIMES, you are helping to maintain relevant journalism and ensure that it remains free and accessible to everyone.

Make a donation

TEXT OF THE ANNOUNCEMENT : To advertise here . Call Willie +2347088095401 …

PT Mag campaign ad

About The Author

Related Posts