INDEX

S. NO. PARTICULARS PAGE NO.

1. Introduction Pg.no. 1-2

2. Content Pg.no. 3-8

a) Payback Period Pg.no. 3

b) Formula of Payback Period Pg.no. 3

c) Examples of Payback Period Pg.no.4

d) Decision Rule Pg.no. 5

e) Advantages of Payback Pg.no. 5

Period

f) Disadvantages of Payback Pg.no. 5

Period

g) Average Rate of Return Pg.no. 6

h) Formula of ARR Pg.no. 6

i) Accept Reject Criteria Pg.no. 6

j) Examples of ARR Pg.no. 6

k) Merits of ARR Pg.no. 6-8

l) Demerits of ARR Pg.no. 8

3. Findings Pg.no. 9

4. Conclusion Pg.no. 10
 PAYBACK PERIOD AND AVERAGE RATE OF RETURN

INTRODUCTION

In this assignment we will understand about payback period, its defination, formula,examples,
decison rule, advantages and disadvantages and about (ARR) Average Rate of Return, its
definition, formula, examples, merits and demerits.

First question arises, What is Payback Period?

Payback period is the time required to recover the initial cost of an investment. It is the number
of years it would take to get back the initial investment made for a project. Therefore, as a
technique of capital budgeting, the payback period will be used to compare projects and derive
the number of years it takes to get back the initial investment. The project with the least number
of years usually is selected.

Secondly, What is the formula for Payback Period?

Pay back period =

Total outflows Initial investment

Or

Inflow every year Net annual cash inflows

Then, What are the features of Payback period method?

1. Payback period is a simple calculation of time for the initial investment to return.
2. It ignores the time value of money. All other techniques of capital budgeting consider the
concept of time value of money. Time value of money means that a rupee today is more
valuable than a rupee tomorrow. So other techniques discount the future inflows and
arrive at discounted flows.
 3. It is used in combination with other techniques of capital budgeting. Owing to its
simplicity the payback period cannot be the only technique used for deciding the project
to be selected.

Next, What are the shortcomings of this method?

This method does not take into account the time value of money and treats all flows at par. For
example, Rs.1,00,000 invested yearly to make an investment of Rs.10,00,000 over a period of 10
years may seem profitable today but the same 1,00,000 will not hold the same value ten years
later. Also, the method does not take into account the cash flows post the return of investment.
Some projects may generate higher cash flows in the later life of the project.

Next comes, What is Average Rate of Return?

The Average Rate of Return or ARR, measures the profitability of the investments on the basis
of the information taken from the financial statements rather than the cash flows. It is also called
as Accounting Rate of Return

Then, The formula for calculating the average rate of return is:

Average Rate of Return = Average Income

Average Investment over the life of the project

Where, Average Income = Average of post-tax operating profit

Average Investment =

(Book value of investment in the beginning + book value of investments at the end) / 2

Then, What are the Merits of Average Rate of Return:

1. It is very simple to calculate and easy to understand

2. The measures the profitability of the entire project since it considers the cash flows
throughout the life of the project.
3. It is based on the accounting information which is readily available and easily understood
by the businessmen.
Lastly, What are the Demerits of Average Rate of Return:

1. It is based on the accounting information and not on the actual cash flows since the cash
flow approach is considered superior to the accounting approach.
2. It does not take into consideration, the Time Value of Money.
3. It is inadequate to differentiate between the projects on the basis of amounts required for
the investment, in case the proposals have the same rate of return.

Thus, this is the only method that uses the firm’s financial data to assess the profitability of the
project undertaken and do not rely on the future cash flows.

Now let us discuss each aspects briefly,

PAYBACK PERIOD

Payback period is the time in which the initial outlay of an investment is expected to be
recovered through the cash inflows generated by the investment. It is one of the simplest
investment appraisal techniques.

Since cash flow estimates are quite accurate for periods in the near future and relatively
inaccurate for periods in distant future due to economic and operational uncertainties, payback
period is an indicator of risk inherent in a project because it takes initial inflows into account and
ignores the cash flows after the point at which the initial investment is recovered.

Projects having larger cash inflows in the earlier periods are generally ranked higher when
appraised with payback period, compared to similar projects having larger cash inflows in the
later periods.
FORMULA OF PAYBACK PERIOD

The formula to calculate the payback period of an investment depends on whether the periodic
cash inflows from the project are even or uneven.

If the cash inflows are even (such as for investments in annuities), the formula to calculate
payback period is:

Payback Period = Initial Investment

Net Cash Flow per Period

When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period
and then use the following formula:

Payback Period = A + B

Where,

A is the last period number with a negative cumulative cash flow;

B is the absolute value (i.e. value without negative sign) of cumulative net cash flow at the end
of the period A; and

C is the total cash inflow during the period following period A

Cumulative net cash flow is the sum of inflows to date, minus the initial outflow.

Both of the above situations are explained through examples given below.
EXAMPLES

Example 1: Even Cash Flows

Company C is planning to undertake a project requiring initial investment of $105 million. The
project is expected to generate $25 million per year in net cash flows for 7 years. Calculate the
payback period of the project.

Solution:

Payback Period

= Initial Investment ÷ Annual Cash Flow

= $105M ÷ $25M

= 4.2 years

Example 2: Uneven Cash Flows

Company C is planning to undertake another project requiring initial investment of $50 million
and is expected to generate $10 million net cash flow in Year 1, $13 million in Year 2, $16
million in year 3, $19 million in Year 4 and $22 million in Year 5. Calculate the payback value
of the project.

Solution:

YEAR (Cash flows in millions)

Annual Cash Flow Cumulative Cash Flow

0 (50) (50)

1 10 (40)

2 13 (27)

3 16 (11)

4 19 8

5 22 32
Payback Period =

3 + 11/19 = 3 + 0.58 ≈ 3.6 years

Decision Rule

The longer the payback period of a project, the higher the risk. Between mutually exclusive
projects having similar return, the decision should be to invest in the project having the shortest
payback period.

When deciding whether to invest in a project or when comparing projects having different
returns, a decision based on payback period is relatively complex. The decision whether to
accept or reject a project based on its payback period depends upon the risk appetite of the
management.

Management will set an acceptable payback period for individual investments based on whether
the management is risk averse or risk taking. This target may be different for different projects
because higher risk corresponds with higher return thus longer payback period being acceptable
for profitable projects. For lower return projects, management will only accept the project if the
risk is low which means payback period must be short.

Advantages and Disadvantages

 Advantages of payback period are:

1. Payback period is very simple to calculate.
2. It can be a measure of risk inherent in a project. Since cash flows that occur later in a
project's life are considered more uncertain, payback period provides an indication of
how certain the project cash inflows are.
3. For companies facing liquidity problems, it provides a good ranking of projects that
would return money early.
 Disadvantages of payback period are:
 1. Payback period does not take into account the time value of money which is a serious
drawback since it can lead to wrong decisions. A variation of payback method that
attempts to address this drawback is called discounted payback period method.
2. It does not take into account, the cash flows that occur after the payback period.

This means that a project having very good cash inflows but beyond its payback period may be
ignored.

Average Rate of Return

Definition:

The Average Rate of Return or ARR, measures the profitability of the investments on the basis
of the information taken from the financial statements rather than the cash flows. It is also called
as Accounting Rate of Return

Formula:

The formula for calculating the average rate of return is:

Average Rate of Return = Average Income

Average Investment over the life of the project

Where,

Average Income = Average of post-tax operating profit

Average Investment =

(Book value of investment in the beginning + book value of investments at the end)

Accept-Reject Criteria:
The projects having the rate of return higher than the minimum desired returns are accepted.

Example 1:

XYZ Company is looking to invest in some new machinery to replace its current malfunctioning
one. The new machine, which costs $420,000, would increase annual revenue by $200,000 and
annual expenses by $50,000. The machine is estimated to have a useful life of 12 years and zero
salvage value.

Solution:

Step 1: Calculate Average Annual Profit

Inflows, Years 1-12

(200,000*12) $2,400,000

Less: Annual Expenses

(50,000*12) -$600,000

Less: Depreciation -$420,000

Total Profit $1,380,000

Average Annual Profit

(1,380,000/12)$115,000

Step 2: Calculate Average Investment

Average Investment

($420,000 + $0)/2 = $210,000

Step 3: Use ARR Formula

ARR = $115,000/$210,000 = 54.76%,

This means that for every dollar invested, the investment will return a profit of about 54.76 cents.
Example 2:

XYZ Company is considering investing in a project that requires an initial investment of

$100,000 for some machinery. There will be net inflows of $20,000 for the first two years,
$10,000 in years three and four, and $30,000 in year five. Finally, the machine has a salvage
value of $25,000.

Solution:

Step 1: Calculate Average Annual Profit

Inflows, Years 1 & 2

(20,000*2) $40,000

Inflows, Years 3 & 4

(10,000*2) $20,000

Inflow, Year 5 $30,000

Less: Depreciation

(100,000-25,000) -$75,000

Total Profit $15,000

Average Annual Profit

(15,000/5) $3,000

Step 2: Calculate Average Investment

Average Investment

($100,000 + $25,000) / 2 = $62,500

Step 3: Use ARR Formula

ARR = $3,000/$62,500 = 4.8%

Merits of Average Rate of Return

1. It is very simple to calculate and easy to understand.

2. The measures the profitability of the entire project since it considers the cash flows
throughout the life of the project.
3. It is based on the accounting information which is readily available and easily understood
by the businessmen.

Demerits of Average Rate of Return

1. It is based on the accounting information and not on the actual cash flows since the cash
flow approach is considered superior to the accounting approach.
2. It does not take into consideration, the Time Value of Money.
3. It is inadequate to differentiate between the projects on the basis of amounts required for
the investment, in case the proposals have the same rate of return.
4. Thus, this is the only method that uses the firm’s financial data to assess the profitability
of the project undertaken and do not rely on the future cash flows.

FINDINGS
By this assignment we got to know about Payback Period and Average Rate of Return by the
help of various examples.

Payback period is very important because of;

1. Simplicity:
The concept is extremely simple to understand and calculate. When engaged in a rough
analysis of a proposed project, the payback period can probably be calculated without
even using a calculator or electronic spreadsheet.
2. Risk focus:
The analysis is focused on how quickly money can be returned from an investment,
which is essentially a measure of risk. Thus, the payback period can be used to compare
the relative risk of projects with varying payback periods.

Consequently, despite its lack of rigorous analysis, there are still situations in which the payback
period can be used to evaluate prospective investments. We suggest that it be used in conjunction
with other analysis methods to arrive at a more comprehensive picture of the impact of an
investment.

Likewise Average Rate of Return is very important aspect for us as;

1. It is very easy to calculate and simple to understand like pay back period. It considers the
total profits or savings over the entire period of economic life of the project.
2. This method recognizes the concept of net earnings i.e. earnings after tax and
depreciation. This is a vital factor in the appraisal of a investment proposal.
3. This method facilitates the comparison of new product project with that of cost reducing
project or other projects of competitive nature.
4. This method gives a clear picture of the profitability of a project.
5. This method alone considers the accounting concept of profit for calculating rate of
return.

CONCLUSION
By this assignment we can conclude that,

 Payback Period:

It is the simplest and most widely used method for appraising capital expenditure decisions.
Payback Period measures the rapidity with which the project cost will be recovered. It is usually
expressed in terms of years.

PBP = Initial cash outflow / Annual cash inflow [if cash inflows are constant]

There are two methods for computing the payback period. The above-mentioned method is used
when cash flow after tax is inform in each year of the project life but another method is applied
when the cash inflows after tax are not uniform over each year of the project life.

The payback method (PM) computes the length of time it takes a company to recover their initial
investment. In other words, it calculates how long it will take until either the amount earned or
the costs saved are equal to or greater than the costs of the project. This can be useful when a
company is focused solely on retrieving their funds from a project investment as quickly as
possible.

 Average / Accounting Rate of Return:

It is another non-discounted evaluation technique of a capital expenditure decision. It is an

accounting technique to measure the profitability of the investment proposals.

ARR = Average annual profit after tax /Average investment x 100

The accounting rate of return (ARR) computes the return on investment considering changes to
net income. It shows how much extra income the company could expect if it undertakes the
proposed project. Unlike the payback method, ARR compares income to the initial investment
rather than cash flows.

This method is useful because it reviews revenues, cost savings, and expenses associated with
the investment and, in some cases, can provide a more complete picture of the impact, rather
than focusing solely on the cash flows produced. However, ARR is limited in that it does not
consider the value of money over time, similar to the payback method.