Chapter 4 • Investment appraisal methods
project when confronted by opposition to that project from other managers who do
not have a financial background. Perhaps it is used in conjunction with a discounting
method or is used only for relatively minor decisions. Another possibility is that PBP
is used as an initial ‘screening’ device through which all project proposals must pass
before the detailed analysis is conducted. This point is somewhat undermined, how-
ever, by the fact that both PBP and the discounting methods use the same basic inputs
(predicted cash flows). Having identified these inputs it is little additional effort to
apply discount factors to them.
Chen and Clark (1994) undertook a survey of US manufacturing businesses and
found that the use of PBP is strongly linked to the extent to which managers believe
that accounting profits are important to the way in which their performance is
assessed, particularly where their remuneration is linked to accounting profit. PBP
tends to favour projects that will generate fairly high operating cash flows and, there-
fore, profits, in the short term.
A further, and perhaps more likely, reason for PBP’s continued popularity may lie
in the fact that the discounting methods whose theoretical development mostly
occurred during the 1960s have only recently fully established themselves. This may
be particularly so with non-financial managers. The popularity of PBP may stem from
a lack of managerial sophistication.
Graham and Harvey (2001) found that businesses at the smaller end (in terms of
sales turnover) of those surveyed were likely to use PBP almost as frequently as they
used NPV or IRR. They also found that, among such businesses, PBP was most likely
to be of importance where the most senior management was older and less well
qualified. This seems to support the suggestion that PBP tends to be used by less
sophisticated managers.
One well-known, and very successful, business that seems to use PBP is the high
street and mail order retailer Next plc. It says in its 2006 annual report, with reference
to new store openings during 2005, ‘We estimate that payback of the net capital
invested in new space will be 17 months, which will be well within our investment
criteria of 24 months.’ It is interesting to note that Next states its financial objective as
‘long-term sustainable growth in earnings per share’, rather than maximisation of
shareholder wealth.Accounting rate of return
Despite its almost complete lack of theoretical justification ARR continues to be widely
used. As with PBP, this fact could call into question whether businesses do actually
seek a shareholder wealth maximisation objective. The widespread use of ARR may
indicate that businesses are in fact pursuing some accounting return objective, pos-
sibly in conjunction with some wealth-enhancing one (also discussed in Chapter 2).
However, as with PBP, use of ARR may imply a lack of managerial sophistication.
Most managements are fairly used to financial statements (income statements and the
like). It may be that they prefer to think in accounting terms rather than in discounted
cash flow terms, despite the fact that accounting measures are inappropriate for
assessing individual investment opportunities, certainly where shareholder wealth
maximisation is the goal. It may simply be that managers are concerned with the effect
on the financial statements of undertaking a particular project. The research discussed
in Chapter 2 (page 24) suggests that some businesses pursue a percentage rate of
return on investment objective. This is a measure based on the financial statements.