3.2 Learning Objectives


  • Payback period and Average rate of return (ARR)
  • Calculate the payback period and ARR for an investment.
  • Analyse the results of the calculations.

Average Rate of Return (ARR)


Introduction
  • Also known as the accounting rate of return
  • Calculates the average profit on an investment project as a percentage (%)
  • Can be expressed as the mathematical statement below:

hungz.png

Why is ARR expressed as a percentage (%)
  • Allow managers to compare rates of return on other investment project
  • Compared with basic interest rate to assess rewards for the risk involved in the investment

Advantages
  • enables easy comparisons of forecast proceeds of different investment projects, helping business make decisions

Disadvantages
  • ignores timing of cash inflows, making it prone to forecasting errors when considering seasonal factors
  • project's useful life span needed before any calculations can be made
  • errors more likely the longer the time period that is under consideration

Payback Period


Introduction
  • the period of time an investment project needs to earn enough profits to repay the costs of initial investment
  • formula for calculating payback period:
    PBP_eq.png
  • most investment projects only considered if they have relatively short payback period
  • unlikely in reality that incone stream will be constant each year

Advantages
  • simple and quick method of investment appraisal
  • useful for firms with cash flow problems so can identify how long will it take for cash to be recouped
  • allows a business to see whether or not it will break-even on the purchase of assets before replacement (suitable for fast-paced technological environment)
  • can be used to compare different investment projects with different costs by calculating payback period for each option
  • help assess projects which will yield a quick return for shareholders
  • assess only short term so payback calculations less prone to forecasting errors

Disadvantages
  • short-termism approach, causing employees to only focus on short-term benefits and ignore potential gains in longer term
  • contribution per month unlikely to be constant as demand is prone to seasonal fluctuations
  • payback focuses on time as key criterion rather than on profits, the main aim of most private sector business

E.g. Calculate the Payback Period and Average Rate of Return for the five options.

Option
1
2
3
4
5
Initial Cost
550000
550000
290000
460000
800000
Annual Net Cash Flow





Year 1
20000
50000
15000
30000
130000
Year 2
75000
175000
80000
95000
250000
Year 3
200000
200000
120000
150000
390000
Year 4
250000
175000
100000
210000
290000
Year 5
200000
70000
60000
300000
200000

Option
1
2
3
4
5
Payback Period
4 yrs
3 yrs 9 mths
3 yrs 9 mths
3 yrs 11 mths
3 yrs 1 mth
Average Rate of Return
7.00%
4.36%
5.86%
14.10%
11.50%
Calculation of Payback Period:
Amount left after 3 years = $550 000 - ($5 000 + $17 500 + $200 000)
= $125 000

How much needed from 4th year = $125 000 / $175 000
= 0.714

How many months needed from 4th year = 0.714 x 12 months
= 8.57 months
= approximately 9 months