Calculating Payback Period and Average Rate

of Return
Investment decisions involve comparison of benefits of a project with its cash outlay. The future
development of a firm depends on investment decisions. So these decisions are of considerable
significance.

Payback Period:
It is the simplest and most widely used method for appraising capital expenditure decisions.
Payback Period measures the rapidity with which the project cost will be recovered. It is usually
expressed in terms of years.
PBP = Initial cash outflow / Annual cash inflow [if cash inflows are constant]
There are two methods for computing the payback period. The above-mentioned method is used
when cash flow after tax is inform in each year of the project life but another method is applied
when the cash inflows after tax are not uniform over each year of the project life. These two
methods of computing payback period is explained with the help of examples.
Example 9.1:
A project requires an initial investment of Rs 40,000 and it is estimated to generate a cash inflow
of Rs 5,000 per year for 10 years. Calculate the payback period.
Solution:
Payback Period = Initial investment / Annual cash inflow
Rs 40,000 /Rs 5,000 = 8 years
Examine 9.2:
A project requires an initial investment of Rs 5, 00,000 and is estimated to generate future cash
inflow of Rs 62,000, Rs 70,000, Rs 45,000, Rs 72,000, Rs 75,000, Rs 85,000, Rs 90,000, Rs
56,000, Rs 50,000 and Rs 55,000. Compute the Payback period.

i. Advantages:
The Payback Period method of evaluating an investment proposal is very popular because it is
very easy to understand and calculate.
It has following advantages:
(i) This method is easy to understand, compute and apply.
(ii) It is a quick method of approximate screening of a project.
(iii) This method provides an indication to the prospective investors when their funds are likely to
be recovered.
(iv) It does not require the assumption of a discounting rate.
(v) It is helpful for selecting a project in case of capital rationing because projects having shorter
payback periods may be considered for investment.
ii. Disadvantages:
The method also suffers from certain disadvantages some of which are:
(i) In case of a single project, if fails to indicate whether an investment proposal should be
accepted or rejected.
(ii) It does not consider the time value of money.
(iii) It does not consider the cash flows beyond the payback period; it can be said to be the
measure of liquidity rather than profitability.
(iv) It ignores the capital wastage and economic life of the investment proposal.

iii. Evaluation Criteria of Payback Period:

In case of a single project, an investment proposal is selected if its payback period is less than
the period set by the management. Suppose the management of a firm fixed the payback period
for a project as N years, then the accept-reject criterion under the Payback Period (PBP) method
is stated below:
PBP < N: Accept the project
PBP > N: Reject the project
In case of mutually exclusive projects, a firm selects that project which has the shortest payback
period.

Average/Accounting Rate of Return:

It is another non-discounted evaluation technique of a capital expenditure decision. It is an
accounting technique to measure the profitability of the investment proposals. The Accounting
Rate of Return (ARR) is calculated by dividing the Average annual profit after tax by the Average
investment. Symbolically,
ARR = Average annual profit after tax /Average investment x 100
Example 9.3:
The cost of a machine is Rs 1, 55,000 and its expected life is 5 years. The scrap value of the
machine at the end of 5 years will be Rs 5,000.
The expected profits from the machine are given below:

i. Advantages:
The advantages of ARR are:
(i) Like PBP method, it is also easy to understand and calculate.
(ii) Unlike the PBP method, it takes into consideration the profits of the entire life of the project.
(iii) It helps measure the profitability of a proposed project.
ii. Disadvantages:

The disadvantages of ARR are:

(i) Like PBP method, it also does not take into account the time value of money.
(ii) It does not recognize the cash inflows and outflows of the project, since it is based on accounting income.
(iii) In case of a single project, it fails to indicate whether an investment should be accepted or
rejected unless compared with managements target rate.
iii. Evaluation Criteria of ARR:
In case of a single project, an investment proposal is selected if the ARR is more than or equal to
the rate fixed by the management. However, in case of mutually exclusive projects the project
having highest ARR should be selected.

Example 2: Compare the following two mutually exclusive projects on the basis of ARR. Cash
flows and salvage values are in thousands of dollars. Use the straight line
depreciation method.
Project A:

Year
Cash Outflow

91

130

105

-220

Cash Inflow
Salvage Value

10

Project B:

Year
Cash Outflow
Cash Inflow
Salvage Value
Solution

87

110

84

-198

18

Project A:

Step 1: Annual Depreciation = ( 220 10 ) / 3 = 70

Step 2: Year
Cash Inflow

91

130

105

Salvage Value
Depreciation*
Accounting Income

10
-70

-70

-70

21

60

45

Step 3: Average Accounting Income = ( 21 + 60 + 45 ) / 3

= 42
Step 4: Accounting Rate of Return = 42 / 220 = 19.1%
Project B:

Step 1: Annual Depreciation = ( 198 18 ) / 3 = 60

Step 2: Year
Cash Inflow

87

110

84

Salvage Value
Depreciation*
Accounting Income

18
-60

-60

-60

27

50

42

Step 3: Average Accounting Income = ( 27 + 50 + 42 ) / 3

= 39.666
Step 4: Accounting Rate of Return = 39.666 / 198 20.0%
Since the ARR of the project B is higher, it is more favorable than the project A.