The emphasis with payback is very much placed on the speedy return of investments. This is often considered important, if above all liquidity is thought to be more important than profits.
Disadvantages
The main disadvantage is the matter that payback ignores the time value of money, neglecting the need to compare future cash flows with the initial investment after they have been discounted to their present values.
Payback, as mentioned earlier only offers an estimate as to what cash flows will be in later years, and in some cases this may cause problems as cash flow after the payback period has finished can take a sudden decline.
With using payback an arbitrary choice of time period cut off for accepting or rejecting a project has to be decided on. Often projects that are time consuming are discriminated against.
ARR
The ARR (Accounting rate of return, and also commonly known as ROCE: Return on capital employed, and, ROI: Return on investment) is the ratio of average annual profits to the capital invested, expressed as a percentage. One of the many formulas to work out ARR is as follows:
Average Annual Profit
Average Investment
An example of how to work out the ARR of a project is shown below.
Investment Year 0 -1000
Net Cash Inflow
Yr1 350
Yr2 350
Yr3 350
Yr4 350
Yr5 350
Total Cash Inflow 1750
Total Net Profit Over 5 Years 150
The ARR of the project shown above is therefore:
150
x 100 = 15%
1000
A project is thought to be worth the investment if the ARR is greater than, or equal to, a predetermined hurdle rate.
Advantages
The main advantage, and basically the only real reason that ARR is still used by many organisations for project evaluation, belongs to the fact that many organisations are often analysed in this way, as well as management being evaluated in this way. Due to this, managers have a natural tendency to use this ratio.
Other reasons for its continued use include the fact that it takes into account all of the cash flows, along with its simplicity to calculate and understand.
Disadvantages
Again, like payback, ARR ignores the time value of money. It odes not take into account the fact that money received in year 1 is of more value than an identical sum received in year 3. Also, it does not allow for the timing of outflows and inflows.
On top of these, there is no universally accepted method of calculating ARR. Variations maybe that:
Profits may be before or after tax
Capital may or may not include working capital
Capital invested may mean the initial capital investment or the average of the capital invested over the life of the project.
I shall now go onto to compare and contrast two other forms of investment analysis. These being NPV (Net present value) and IRR (Internal rate of return)
NPV
As the flaws in the payback and ARR methods were recognised, people began to search for ways in which to improve the effectiveness of investment analysing. One method they came up with was NPV (Net present value). NPV takes into account the timing of cash flows. It recognises that a given sum of money of money is worth more today than it is tomorrow. The reason for this being that, money invested today will yield a return. The formula for NPV is as follows:
i=n
Ci
NPV = ∑
(1+r)i
i=0
where C is the net cash flow in the period, i is the period number, and r is the discount rate.
If the NPV of a project is positive this can be interpreted as the potential increase in consumption made possible by the project in present day terms.
This is illustrated more clearly below:
Because the net present value is negative it is rejected, as the general rule of thumb is that a project is only acceptable if it has a positive NPV.
If two projects are being considered the one with the higher NPV should be accepted.
IRR
IRR (Internal rate of return) can be defined as the discount rate that gives zero NPV. This method of project analysis is commonly used in finance, and whilst it is a useful measure it should also be noted that IRR can sometimes be a misleading measure, and it is therefore important to calculate and analyse it properly. The formula used to calculate IRR for a project that is purchased over n years is shown below:
F0 + F1 + F2 + . . . + Fn = 0
1+r (1+r) ₂ (1+r)n
However, except by chance the IRR cannot be found directly. It can either be found by drawing a graph known as a present value profile or, more commonly, by calculations involving linear interpolation.
