Investment Appraisal methods are crucial tools used by businesses to evaluate the viability and profitability of potential investment projects. Two commonly used methods in this process are the Payback Period and Accounting Rate of Return (ARR):
Payback Period:
Definition: The Payback Period is the time it takes for an investment to generate enough cash flows to recover the initial cost of the investment. It's a simple way to assess how quickly an investment can pay for itself.
Example:
Imagine you are running a small business and considering purchasing a new machine to increase production. The machine costs $1,200. You expect it to generate a net cash flow of $400 per year.
So, the payback period is:
Payback Period = Initial Investment / Annual Net Cash Flow
Payback Period = $1,200 / $400
Payback Period = 3 years
So, the Payback Period for the new machine is 3 years. This means it will take 3 years for the investment to generate enough cash to cover its initial cost. After this period, the machine will start generating profit for your business.
Do it yourself:
Imagine you are running a small bakery and considering purchasing a new oven to increase your baking capacity. The oven costs $2,000. You expect it to generate a net cash flow of $500 per year. Calculate payback period
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Worksheet 2: Click here to download
Advantages of the Payback Period Method:
- Simplicity: The payback period method is easy to understand and calculate, making it accessible for businesses of all sizes.
- Quick Assessment: It provides a fast way to evaluate how quickly an investment can recoup its initial cost, which is useful for assessing liquidity and short-term risk.
- Risk Reduction: By focusing on shorter payback periods, businesses can minimize exposure to long-term uncertainties and risks.
Disadvantages of the Payback Period Method:
- Ignores Time Value of Money: The method does not account for the time value of money, meaning it treats cash flows received in the future as having the same value as cash flows received today.
- No Consideration of Cash Flows After Payback: It ignores any benefits or cash inflows that occur after the payback period, potentially overlooking the full profitability of an investment.
- Lacks Profitability Measure: The payback period does not provide information on the overall profitability or return on investment, only on how quickly the initial investment can be recovered
Average Rate of Return (ARR): Definition and Example
Definition:
The AverageRate of Return (ARR) is a method used to measure the profitability of an investment. It calculates the percentage return expected on an investment based on the average annual accounting profit compared to the initial investment cost. ARR helps businesses compare the efficiency of different investments.
Example:
Imagine you are considering investing in a new piece of equipment for your business. The equipment costs $10,000, and you expect it to generate an annual net cash flow of $3,000 for five years.
Steps to Calculate ARR
Step 1: Total net cash flow ( $ 3000 X 5 = $ 15,000)
Step 2: The forecast profit ( $ 15,000 minus $ 10, 000 = $ 5 000)
Step 3: The average annual profit ( $ 5000 /5 years= $ 1000)
Step 4: Hence the ARR =$ 1000/ $10,000 X 100 = 10 %
So, the Average Rate of Return (ARR) for the new equipment is 10%. This means that, on average, the investment is expected to generate a 10% return each year based on the initial cost of the equipment.
Do it yourself:
Maxell Engineering Company is planning to invest in new machinery worth $40,000. The expected annual net cash flow is $12,000 for the next five years. Calculate ARR for the proposed investment
Advantages of the ARR Method:
- Simplicity: The ARR method is easy to understand and calculate, making it accessible for managers and decision-makers without a strong financial background.
- Focus on Profitability: ARR focuses on accounting profits, providing a clear measure of the potential profitability of an investment relative to its cost.
- Comparative Analysis: The ARR allows for easy comparison between different investment opportunities by expressing the return as a percentage, helping businesses choose the most profitable projects.
Disadvantages of the ARR Method:
- Ignores Time Value of Money: The ARR method does not consider the time value of money, meaning it treats all future profits as equally valuable, regardless of when they are received.
- Relies on Accounting Profits: ARR is based on accounting profits rather than cash flows, which can be influenced by non-cash items like depreciation and may not accurately reflect the actual cash benefits of an investment.
- No Consideration of Project Lifespan: The ARR method does not take into account the varying lifespans of different projects, potentially favoring investments with shorter durations over those with longer-term benefits.
Differences between the Payback period and ARR
| Payback period | ARR |
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Multiple Choice Questions
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What is the primary purpose of the Payback Period method in investment appraisal?
A) To calculate the overall profitability of an investment
B) To determine how quickly an investment can recover its initial cost
C) To account for the time value of money
D) To compare different investment projects based on their net present value
Explanation: The primary purpose of the Payback Period method in investment appraisal is to determine how quickly an investment can recover its initial cost.
In the Accounting Rate of Return (ARR) method, what is primarily measured?
A) The time required to recoup the initial investment
B) The average annual profit as a percentage of the initial investment
C) The present value of future cash flows
D) The total cash inflows from an investment
Explanation: In the Accounting Rate of Return (ARR) method, the primary measure is the average annual profit as a percentage of the initial investment.
Which of the following is a disadvantage of the Payback Period method?
A) It is difficult to understand and calculate
B) It ignores the time value of money
C) It requires detailed accounting data
D) It focuses on long-term profitability
Explanation: A disadvantage of the Payback Period method is that it ignores the time value of money.
Which of the following best describes a disadvantage of the ARR method?
A) It is complex and time-consuming to calculate
B) It ignores cash flows and focuses on accounting profits
C) It considers the time value of money
D) It prioritizes short-term gains over long-term profitability
Explanation: A disadvantage of the ARR method is that it ignores cash flows and focuses on accounting profits.
Imagine you are running a small bakery and considering purchasing a new oven that costs $1800. If the oven generates a net cash flow of $600 per year, what is the Payback Period?
A) 2 years
B) 2.5 years
C) 3 years
D) 3.5 years
Explanation: The Payback Period is calculated by dividing the cost of the oven by the annual net cash flow. $1800 / $600 = 3 years.
What is one of the key differences between the Payback Period and ARR methods?
A) Payback Period considers the time value of money, while ARR does not
B) ARR focuses on liquidity, while Payback Period focuses on profitability
C) Payback Period measures how quickly an investment recovers its cost, while ARR measures the average annual return
D) ARR is based on cash flows, while Payback Period is based on accounting profits
Explanation: One of the key differences between the Payback Period and ARR methods is that the Payback Period measures how quickly an investment recovers its cost, while ARR measures the average annual return.
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