INVESTMENT APPRAISAL

TECHNIQUES
PAYBACK PERIOD AND
ACCOUNTING RATE OF
RETURN
 OBJECTIVES
Calculate the payback period and the
accounting rate of return for a given
project
Identify the advantages and the
disadvantages of the payback period
and the accounting rate of return
 payback
The time required for the cash
inflows from a capital investment
project to equal the initial cash
outflow(s).
The length of time required to
recover the cost of an investment
Often used as the first screening
method
A project should not be evaluated on
the basis of payback alone.
 Calculation
Profits before depreciation are
used to calculate payback
 Formulae
Depends on whether the cash flow
per period from the project is even
or uneven.
Where even:
Payback = Initial investment
Cash inflow per period
 Formula cont
Where uneven:
Payback = A + B
C
Where:
A is the last period with a negative cumulative cash
flow;
B is the absolute value of cumulative cash flow at the
end of period A;
C is the total cash flow during the period after A
Decision Rule: Accept the project only if its payback
period is less than the target payback period
 Example
Company C is planning to undertake
a project requiring initial investment
of k105 million. The project is
expected to generate k25 million per
year for 7 years. Calculate the
payback period of the project.
 Example
An asset costing k120,000 is to be
depreciated over ten years to a nil residual
value. Profits after depreciation for the first
five years are a follows:
Year
1 12,000
2 17,000
3 28,000
4 37,000
5 8,000
 Example cont
Requirement:
Calculate the payback period to the
nearest month.
 Disadvantages
Ignores the timing of cash flows
Ignores the cash flows after the end
of the payback period
Ignores the time value of money
Does not distinguish between
projects with the same payback
period
The choice of any cut-off payback
period by an organization is arbitrary
 Disadvantages cont
It may lead to excessive investment
in short-term projects
Does not take account of the
variability of cash flows
 Advantages
A long payback means capital is tied
up
Focus on early payback can enhance
liquidity
Investment risk is increased if
payback is longer
Shorter-term forecasts are likely to
be moe reliable
The calculation is quick and simple
Payback is easily understood concept
 Exercise
A project requires an initial
investment in equipment of k100,000
and will produce eight equal annual
cash flows of k40,000.00.The
investment has no scrap value and
straight line depreciation is used.
Required:
Calculate the payback period.
 Accounting Rate of Return
Expresses the average accounting
profit a percentage of the capital
outlay
Involves estimating the accounting
rate of return that a project should
yield. If it exceeds a target rate of
return then the project is acceptable.
 Calculation
ARR= Average annual accounting
profit x 100%
Initial Investment
ARR= Average annual accounting
profit x 100%
Average investment

The average investment is calculated

as:
 Example
A project involves the immediate
purchase of plant at a cost of
k110,000.It would generate annual
profits before depreciation of
k24,000 for five years. Scrap value
will be k10,000 at the end of the fifth
year.
Required:
Calculate the ARR using the initial and
average investment.
 Advantages
Quick and simple to calculate
Involves familiar concept of a
percentage return
Accounting profits can be easily
calculated from financial statements
Looks at the entire project life
 Disadvantages
Does not take account of the timing
of the profits from a project
Is a relative measure rather than an
absolute measure and hence takes
no account of the size of the
investment
Takes no account of the length of the
project
Ignores the time value of money
THANK YOU