Question

Consider the differences between payback period and the accounting rate of return.

Explain why one provides a more accurate analysis of an investment decision than the other.

Answer 1

Pay Back Period:

Pay Back Period method is commonly used Methodology to evaluate any Capital Expenditure proposals. In simple words, this methodology measures the time taken to recover the total project cost (Initial Cash Outflow) by taking into consideration, total Cash Inflow during the given period. Pay Back Period is usually expressed in terms of number of years.

Formula:

• In case of Constant Cash Inflow:

Pay Back Period = Initial Cash Outflow/Annual Cash Inflow

• In case of Irregular Cash Inflow:

Example:

Initial Cash Outflow         : $ 500,000

Yearly Cash Inflow           : 1^st Yr $35,000; 2^nd Yr $65,000; 3^rd Yr $85,000; 4^th Yr $65,000;

5^th Yr $45,000; 6^th Yr $85,000; 7^th Yr $55,000; 8^th Yr $75,000;

9^th Yr $45,000

Initial Cash Outflow: $ 500,000
Years	Cash Inflow	Cumulative Cash Inflow
1	$35,000	$35,000
2	$65,000	$100,000
3	$85,000	$185,000
4	$65,000	$250,000
5	$45,000	$295,000
6	$85,000	$380,000
7	$55,000	$435,000
8	$75,000	$510,000
9	$45,000	$555,000

               

Now $435,000 is recovered in 7^th Yr, leaving a balance of $35,000 to be recovered.

Pay Back Period = 7 + (35,000/75,000) - as the entire 8^th Yr not to be considered for $ 35,000 Recovery

                                = 7.47 Yrs

Advantages:

• Quick and Easy to Understand, Compute & Apply
• Best Methodology in case of Multiple Project proposals

Accounting Rate of Return (ARR):

This Methodology measures the profitability of the Capital Expenditure Proposals. The Accounting Rate of Return (ARR) is the ratio of the Average Annual profit after Tax to the Average Investment.

ARR = (Average Annual Profit after Tax /Average Investment) x 100

Example:

Cost of Plant & Machinery = $ 500,000

Yearly Profits                          =        1^st Yr $35,000; 2^nd Yr $65,000; 3^rd Yr $85,000; 4^th Yr $65,000;

5^th Yr $45,000

Average Profit                        =        $59,000 ($35,000+$65,000+$85,000+$65,000+$45,000)/5

ARR                                       =        59,000/500,000

                                               =        11.8%

Advantages:

• Easy to Compute & Apply
• Cash Inflow for the entire period is taken into consideration
• Best methodology in case of Single Project proposals

To summarize, ARR methodology provides more accurate analysis of the Investment decision than PBP methodology for the below reasons:

• ARR methodology considers the Cash Flows even after the Payback period (which is completely ignored in PBP methodology)
• ARR methodology measures the Profitability of a single project, hence the decision making tends to be more accurate
• ARR methodology is more useful for Investment decisions, as the period is usually long term in real life situations.