Investment Appraisal: Basic Methods: Payback, Accounting Rate Of Return (Copy)
10.3 Investment Appraisal
10.3.2 Basic Methods: Payback and Accounting Rate of Return (ARR)
1. Payback Method
Meaning:
- Payback period is the time it takes for an investment to recover its initial cost from the cash inflows it generates.
- Focuses on liquidity and speed of return, not overall profitability.
Calculation:
- Payback Period = Time until cumulative cash inflows = Initial investment
- If cash inflows are uneven:
- Find the year before full recovery
- Add fraction of next year:
Fraction = Remaining investment ÷ Cash inflow of next year
Interpretation:
- Shorter payback → Less risk, quicker recovery of funds.
- Longer payback → More risk, slower recovery.
Example:
- Initial investment = £50,000
- Cash inflows: Year 1 = £15,000, Year 2 = £20,000, Year 3 = £25,000
- Cumulative: Year 1 = £15,000, Year 2 = £35,000, Year 3 = £60,000
- Payback = 2 + ((50,000–35,000)/25,000) = 2 + 0.6 = 2.6 years
2. Accounting Rate of Return (ARR)
Meaning:
- ARR measures average annual profit as a percentage of the average investment.
- Focuses on profitability rather than cash flow.
Formula:
- ARR (%) = (Average annual profit ÷ Average investment) × 100
Steps:
- Calculate average annual profit = Total profit ÷ Number of years
- Calculate average investment = (Initial investment + Residual value) ÷ 2
- Apply formula
Interpretation:
- Higher ARR → More profitable investment.
- Compare ARR to required rate of return to decide whether to invest.
Example:
- Initial investment = £100,000, Residual value = £20,000, Total profit over 5 years = £50,000
- Average annual profit = 50,000 ÷ 5 = £10,000
- Average investment = (100,000 + 20,000) ÷ 2 = £60,000
- ARR = (10,000 ÷ 60,000) × 100 = 16.67%
Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change A2 Level Business Full Scale Course