Investment Appraisal: Basic Methods: Payback, Accounting Rate Of Return (Copy)
10.3 Investment Appraisal
10.3.2 Basic Methods: Payback, Accounting Rate Of Return (ARR)
The Meaning Of Payback And ARR
- Payback Period
- Definition: The time it takes for a business to recover its initial investment from the net cash inflows of a project.
- Measures liquidity rather than overall profitability.
- Expressed in years and months (or just years).
- Useful for businesses that want to know how quickly they will get their money back.
- Accounting Rate of Return (ARR)
- Definition: ARR measures the average annual accounting profit (not cash flow) as a percentage of the initial investment or average investment.
- Formula:
ARR=Average annual accounting profitInitial (or average) capital cost×100text{ARR} = frac{text{Average annual accounting profit}}{text{Initial (or average) capital cost}} times 100
- Focuses on profitability rather than liquidity.
- Compares returns to the cost of investment, helping managers decide if the project is worthwhile.
Calculation Of Payback Period
- Step 1: List the net annual cash inflows from the project.
- Step 2: Add cumulative cash inflows year by year.
- Step 3: Identify the year when cumulative inflows equal or exceed the initial investment.
- Step 4: If recovery happens mid-year, calculate the fraction of the year using:
Payback Period=Last year before payback+Amount still to recoverCash inflow in the following yeartext{Payback Period} = text{Last year before payback} + frac{text{Amount still to recover}}{text{Cash inflow in the following year}}
- Example:
- Initial investment = $100,000
- Net cash inflows per year: Year 1 = $30,000; Year 2 = $40,000; Year 3 = $50,000; Year 4 = $30,000
- Cumulative inflows:
- End of Y1: $30,000
- End of Y2: $70,000
- End of Y3: $120,000 → payback achieved during year 3
- To calculate exact month: $100,000 − $70,000 = $30,000 still needed in Year 3.
- Fraction of year = 30,000 ÷ 50,000 = 0.6 of a year = 7.2 months.
- Payback period = 2 years + 7.2 months ≈ 2 years 7 months.
Calculation Of ARR (Accounting Rate Of Return)
- Step 1: Find the total profit over the project’s life.
- Step 2: Divide by the number of years to find the average annual profit.
- Step 3: Divide the average annual profit by the initial investment (or average investment).
- Step 4: Multiply by 100 to get the percentage.
- Example:
- Initial investment = $100,000
- Profits over 4 years = $20,000, $25,000, $30,000, $35,000
- Total profit = $110,000
- Average annual profit = 110,000 ÷ 4 = $27,500
- ARR = (27,500 ÷ 100,000) × 100 = 27.5%
- Interpretation: The project earns an average of 27.5% return on the investment per year. If this exceeds the firm’s required rate of return (cost of capital), the project is acceptable.
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
Interpretation Of Payback And ARR
- Payback
- The shorter the payback period, the lower the risk of the project.
- Attractive for businesses with cash flow concerns or operating in uncertain industries.
- Focuses on liquidity, not profitability.
- Favours quick-return projects over long-term but profitable investments.
- Example: A retail chain may prefer a project that recovers in 2 years over one that recovers in 5 years, even if the latter is more profitable overall.
- ARR
- Shows profitability relative to investment.
- Can be compared with the cost of capital and other investment opportunities.
- Higher ARR = better financial return.
- Example: A project with ARR of 27% is attractive if the company’s target return is 15%.
Methods Of Improving Gearing
- Reduce reliance on debt
- Repay existing long-term loans.
- Avoid over-borrowing for expansion.
- Increase equity finance
- Issue new shares to raise funds.
- Attract venture capital or private investors.
- Improve profitability and cash flow
- Increase sales revenue through new markets or products.
- Cut unnecessary costs to retain more earnings.
- Use retained profit instead of borrowing.
- Lease assets
- Leasing reduces need for large upfront borrowing for equipment or property.
- Debt restructuring
- Renegotiate loan terms (lower interest, longer repayment).
- Convert debt into equity.
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
Links Between Liquidity, Gearing And Operations Strategy
- Liquidity and gearing
- High gearing increases repayment commitments → worsens liquidity.
- Low liquidity makes it harder to service debt, increasing risk of insolvency.
- Link to inventory control
- Efficient inventory management (JIT, reduced wastage) improves liquidity by lowering tied-up cash.
- High gearing requires better working capital control.
- Link to quality management
- Highly geared firms may cut corners to save costs, risking quality.
- Alternatively, they may invest in quality to boost revenue and repay loans faster.
- Link to employees’ roles
- In highly geared firms, employees may face higher pressure to perform.
- Risk of low morale and industrial unrest if cost-cutting reduces pay or benefits.
- Link to capacity management
- High gearing may force businesses to increase utilisation of existing capacity rather than expand.
- Low gearing allows investment in new capacity with less risk.
- Link to efficiency
- Gearing decisions influence efficiency through investment in technology, automation, and economies of scale.
- Highly geared firms may focus on productivity to generate cash for loan repayments.
Diagram – Gearing Ratio
Capital Employed
-------------------------------
| Shareholders' Equity |
| + Retained Earnings |
| + Non-current Liabilities |
-------------------------------
|
Gearing Ratio = (Non-current Liabilities ÷ Capital Employed) × 100
Examples:
- Gearing 20% → Low risk, more equity-based.
- Gearing 50% → Balanced.
- Gearing 70% → Highly geared, risk of high interest burden.
Key Insights
- Payback period focuses on speed of recovering investment (liquidity).
- ARR measures profitability of an investment compared to the cost of capital.
- High gearing provides growth opportunities but increases financial risk.
- Low gearing offers stability but may limit expansion potential.
- Liquidity and gearing are interlinked — poor liquidity plus high gearing can quickly lead to cash flow crises.
- Strategic operations decisions (e.g., investment in automation or expansion) must balance cost efficiency, risk, and funding sources.
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