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:

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:

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

3.2 Learning ObjectivesAverage Rate of Return (ARR)Introductionaccounting rate of returnWhy is ARR expressed as a percentage (%)AdvantagesDisadvantagesPayback PeriodIntroductionAdvantagesDisadvantagesE.g. Calculate the Payback Period and Average Rate of Return for the five options.

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