YearsCash flows(£)0(900,000)150,0002120,0003350,000480,0005800,000Payback period Formula=Year before full recovery of initial investment + unrecovered amount at the beginning of the next year ÷Total cash inflow during that year. Payback period=4 years+300,000÷800,000=4.375 yearsAdvantages of payback periodIt is simple to understand, compute and use. It is ideal under high risk investment as it identifies which projects can recover the initial capital outlay in the shortest time period possible. Payback period does not entail any cost on the part of the company therefore it is cheaper to use to gauge the venture viability. Payback period will be realistic for those companies which wish to invest intermediary returns as it will choose those ventures that generate big returns faster. PBP also shows how money will be tied up in a project.
For companies operating in high risky areas, it is a powerful tool as it will choose the venture that pays back earliest, which minimizes the risk associated with returns. Disadvantages of payback periodIt ignores all the returns generated after the payback period as this are not part of the payback. Thus this technique is more lenders oriented than investor oriented. The viability of a project is not measured rather than the time period a project takes to recoup the initial capital outlay. PBP ignores the time value of money.
Money loses value with time. A shilling now will have lesser value than a shilling received 5 years from now. It may pose problems of setting a yardstick as to which should be the standard payback period. This problem is more severe if finance is generated on the retained earnings which have no maturity periods. The PBP set by management of a business may be a relative decision. It is not in line with the share holder’s goal of wealth creation.
The value of shares does not rely on the payback period but on the total cash flows. (b) Accounting rate of returnIt is also known as returns on investments. This method does not use cash flows but the accounting profits found in the financial statements of a company. ARR = Average income-Average depreciation ÷ Average investment of project×100Depreciation = initial amount - residual value ÷ number of useful economic life of the asset. Depreciation=£900,000-0÷5=£180,000 Average income=cash flows for each year less the depreciation÷ number of periods. Year 1=£50,000-£180,000=£-130,000Year 2=£120,000-£180,000=£-60,000Year 3=£350,000-£180,000=£170,000Year 4=£80,000-£180,000=£-100,000Year 5=£800,000-£180,000=£620,000(620,000+170,000-290,000)÷5=£100,000Average income=£100,000Average investment=Initial investment+ salvage value÷2Average investment= (£900,000+0) ÷2=£450,000ARR=£100,000÷£450,000×100=22.2%ADVANTAGES OF ARRIt is simple to comprehend and utilize in the gauging of the viability of an investment.
The financial statements of the company contain information of accounting nature that is readily employed. The project’s profitability is determined by all cash flows generated in its entire lifetime. DISADVANTAGES OF ARRIt ignores the time value of money. It uses accounting profits instead of cash flows which could have been arbitrarily determined. It does not allow for the fact that profits can be reinvested. NET PRESENT VALUEYEARCASH FLOWSPVIF (10%)PV(Present values)1£50,0000.90945,4502£120,0000.82699,1203£350,0000.751262,8504£80,0000.68354,6405£800,0000.621496,800TOTALS958,860NPV= PV (INFLOWS) - PV (OUTFLOWS) (INITIAL CAPITAL OUTLAY)