The payback period is the time taken in years for a project to recover its initial investment. The shorter the payback period the more valuable to investment is.
Consider a project with the following cash flows:
There are two types of decisions which may have to be made with regard to new investments, these are:
(a) Accept/reject decisions
(b) Ranking decisions
Accept/reject decisions arise in the case of independent projects about which decisions can be made without reference to other investments.
Ranking decisions arise when one must choose which is the most preferable of several alternative decisions. Such projects are called mutually exclusive projects.
The payback period unfortunately does not give any clear indication of whether to accept or reject a new project. The payback period calculated has to be compared with some sort of managerial target; if it is shorter than this target the project should be accepted and vice versa. However, there is no accepted method of calculating the target, therefore choosing it will be subject to some arbitrariness. A ranking decision can be undertaken with the payback measure; the project with the shortest payback period being preferable.
Disadvantages and Advantages of the Payback Period
(i) Cash flows after the payback period are ignored. If in Example 1 the cash flow in year 4 was Sh.20,000 this would clearly make the project more desirable. The payback period, however, would not reflect this, still being only 3 years.
(ii) It ignores the timing of cash flows. The payback period is unaffected the timing of cash flows within the payback period. Clearly the earlier they arise the more valuable will be the project.
(iii) No clear decision is given in an accept/reject situation.
The above clearly mean that the payback period has a limited use in terms of measuring the acceptability of projects. It is, however, the most popular technique although it is often used in conjunction with other methods of investment appraisal.
(i) It is simple to calculate. It is of particular advantage to a small company which may not have people with the skills associated with the more complicated techniques.
(ii) It gives an indication of liquidity, showing the period for which a company finds itself out of pocket because of the project.
(iii) It gives a measure of risk. Cash flows which arise further in the future will be less certain, therefore projects with a shorter payback period will generally be less risky.
Accounting Rate of Return (ARR)
The accounting rate of return measure is based upon accounting profits, not cash flows, and is similar to the measure of the return on capital employed used in assessing a company‟s overall profitability.
The calculation is:
A project with an initial expenditure of £400,000 will produce the following profits, after deducting depreciation of:
The accounting rate of return method is similar to the payback period method because both techniques require that an arbitrary decision be made concerning the target rate of return or payback period. The accounting rate of return method will enable us to rank mutually exclusive projects. Those with a higher rate of return will be preferable.
Advantages and Disadvantages of the accounting Rate of Return
(i) The calculation is simple.
(ii) It is concerned with profits and it is profits, not cash flows, which shareholders see reported in annual accounts.
(iii) It gives a percentage measure which may be more understandable than other measures of return.
(i) It is a crude averaging method which does not take into account the timing of cash flows.
(ii) It is based upon profits, not cash flows. Shareholders‟ wealth is determined cash; non-cash items such as accruals, provisions and depreciation will not be relevant. The apparent contradiction between this and the second advantage listed above will be discussed when we consider the Stock Exchange and share prices.