INDEX

SR NO PARTICULARS PAGE
NO
1 Payback period-Introduction 1
2 Purpose 2
3 Construction 3
4 Short comings 3
5 Shortcut method 3
6 Limitations 4
7 Breanking down of payback period 5
8 Capital budgeting and payback period 5
9 Discounting 6
10 Advantages and disadvantages 7
11 Different formulae to calculate payback 9
period
12 Average rate of return 12
13 Drawbacks 13
14 Accounting of ARR 13
15 Advantages and disadvantages of ARR 15
16 Cost benefit analysis payback and ARR 20
17 How to calculate payback period and
ARR
18 Conclusion 25
19 Bibliography 27

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Payback Period And Average Rate Of Return

Payback period

Introduction;

Payback period in capital budgeting refers to the period of time required to recoup the funds
expended in an investment, or to reach the break-even point. For example, a Rs1000 investment
made at the start of year 1 which returned Rs500 at the end of year 1 and year 2 respectively
would have a two-year payback period

in capital budgeting refers to the period of time required to recoup the funds expended in an
investment, or to reach the break-even point. For example, a Rs1000 investment made at the
start of year 1 which returned Rs500 at the end of year 1 and year 2 respectively would have a
two-year payback period. Payback period is usually expressed in years. Starting from investment
year by calculating Net Cash Flow for each year: Net Cash Flow Year 1 = Cash Inflow Year 1 -
Cash Outflow Year 1. Then Cumulative Cash Flow = (Net Cash Flow Year 1 + Net Cash Flow
Year 2 + Net Cash Flow Year 3, etc.) Accumulate by year until Cumulative Cash Flow is a
positive number: that year is the payback year.

The time value of money is not taken into account. Payback period intuitively measures how
long something takes to "pay for itself." All else being equal, shorter payback periods are
preferable to longer payback periods. Payback period is popular due to its ease of use despite the
recognized limitations described below.

The term is also widely used in other types of investment areas, often with respect to energy
efficiency technologies, maintenance, upgrades, or other changes. For example, a compact
fluorescent light bulb may be described as having a payback period of a certain number of years
or operating hours, assuming certain costs. Here, the return to the investment consists of reduced
operating costs. Although primarily a financial term, the concept of a payback period is
occasionally extended to other uses, such as energy payback period (the period of time over
which the energy savings of a project equal the amount of energy expended since project
inception); these other terms may not be standardized or widely used.

Purpose :Payback period as a tool of analysis is often used because it is easy to apply and easy
to understand for most individuals, regardless of academic training or field of endeavor. When
used carefully or to compare similar investments, it can be quite useful. As a stand-alone tool to
compare an investment to "doing nothing," payback period has no explicit criteria for decision-
making (except, perhaps, that the payback period should be less than infinity).

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The payback period is considered a method of analysis with serious limitations and qualifications
for its use, because it does not account for the time value of money, risk, financing, or other
important considerations, such as the opportunity cost. Whilst the time value of money can be
rectified by applying a weighted average cost of capital discount, it is generally agreed that this
tool for investment decisions should not be used in isolation. Alternative measures of "return"
preferred by economists are net present value and internal rate of return. An implicit assumption
in the use of payback period is that returns to the investment continue after the payback period.
Payback period does not specify any required comparison to other investments or even to not
making an investment.

Construction: Payback period is usually expressed in years. Start by calculating Net Cash Flow
for each year: Net Cash Flow Year 1 = Cash Inflow Year 1 - Cash Outflow Year 1. Then
Cumulative Cash Flow = (Net Cash Flow Year 1 + Net Cash Flow Year 2 + Net Cash Flow Year
3, etc.) Accumulate by year until Cumulative Cash Flow is a positive number: that year is the
payback year.

To calculate a more exact payback period: Payback Period = Amount to be Invested/Estimated

Annual Net Cash Flow.[2]

It can also be calculated using the formula:

Payback Period = (p - n)p + ny

= 1 + ny - np (unit:years)

Where
ny= The number of years after the initial investment at which the last negative value of
cumulative cash flow occurs

n= The value of cumulative cash flow at which the last negative value of cumulative cash flow
occurs.
p= The value of cash flow at which the first positive value of cumulative cash flow occurs.
This formula can only be used to calculate the soonest payback period; that is, the first period
after which the investment has paid for itself. If the cumulative cash flow drops to a negative
value some time after it has reached a positive value, thereby changing the payback period, this
formula can't be applied. This formula ignores values that arise after the payback period has been
reached.

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Additional complexity arises when the cash flow changes sign several times; i.e., it contains
outflows in the midst or at the end of the project lifetime. The modified payback period
algorithm may be applied then. First, the sum of all of the cash outflows is calculated. Then the
cumulative positive cash flows are determined for each period. The modified payback is
calculated as the moment in which the cumulative positive cash flow exceeds the total cash
outflow.

Short comings: Payback period doesn't take into consideration the time value of money and
therefore may not present the true picture when it comes to evaluating cash flows of a project.
This issue is addressed by using DPP, which uses discounted cash flows. Payback also ignores
the cash flows beyond the payback period. Most major capital expenditures have a long life span
and continue to provide cash flows even after the payback period. Since the payback period
focuses on short term profitability, a valuable project may be overlooked if the payback period is
the only consideration.

The payback period method (PBP) of capital budgeting calculates the time it takes to recover the
initial cost of an investment. There are two approaches--the short cut method and the unequal
cash flow method---both of which base their calculations on annual net cash flows (cash
outflows minus cash inflows). As is true with NPV and IRR, each year may have different cash
flow amounts.

Short Cut Method

When the amounts of annual operating cash flows expected from a potential capital asset
acquisition are equal each year, the following short cut calculation can be used to determine the
payback period:

Payback Initial investment

=
period Annual operating cash flow amount

The payback period indicates how long it will take to recover the cash investment used to acquire
the asset. The answer is expressed in years.

Unequal Cash Flows Method

When the dollar amount of operating cash flows are not expected to be the same amount each
year, you must take a longer approach. In essence, you begin with the acquisition cost---the
amount to be recovered, and subtract the expected cash flows for each year until you get to the
point in time at which you have recovered all of the cash.

Begin with the amount of cash used to purchase the investment and subtract the cash inflows for
the first year:

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 Amount to recover Year 1 cash flows = Remaining cash to recover

If the amount of remaining cash flows to recover is greater than or equal to the cash flows of
year 2, subtract the cash flows expected for year 2.

Continue subtracting projected operating cash flows for each subsequent year until the remaining
cash flows not yet recovered are less than the cash flows expected for the next year. Determine
the point during the next year that the remaining cash will be recovered. This is achieved by
calculating the percentage portion of the next year that will pass at the point the final cash
recovery is expected to occur. The portion of final recovery year is calculated as :
Cash remaining to be recovered
Portion of final year
Cash to be received during the final
=
year
The payback period is equal to the number of full years plus the portion of final recovery year.

Interpret the Payback Period

The payback period indicates how long it will take to recover the cash investment used to acquire
the asset. It is expressed in years with two decimals, such as 4.25 years. In general, shorter
payback periods are more attractive because the cash is recovered in a shorter period of time. If
the cash is expected to be recovered in a time period shorter than the useful life of the
investment, it is tentatively deemed acceptable. However, other capital budgeting methods
should always be used in conjunction with the payback period method, because even when the
PBP appears to be an acceptable investment, it may not be acceptable under a method that
considers the time value of money.

If the shortcut method is used to calculate the PBP, the results may indicate a payback period that
is greater than the useful life of the asset. It is not possible to have a useful life greater than the
payback period because the 'end' of the useful life indicates the asset will no longer be used in
the production of income. When it is no longer used, it no longer brings in economic resources.
As such, when the numerical result using the shortcut method appears to have a payback period
that exceeds the useful life, the interpretation is 'the investment will never be recovered.'

Limitations of the Payback Period Method

The payback period method has some faults that create limitations on its usage. First, it does not
consider the total stream of cash flows. It ignores those after the end of the recovery period. For
example, if a potential investment of Rs10,000 is expect to generate Rs6,000 in year 1, Rs4,000
in year 2, and Rs3,000 in year 3, the payback period method will consider years 1 and 2 since by
the end of year 2, all Rs10,000 of the investment will be recovered. The cash flow in year 3 is
ignored.

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The second drawback of the payback period method is that it does not consider the time value of
money in its calculations. Assume two potential investments, each with a cost of Rs10,000 and
an estimated 3 year period of benefit. Investment A has recoveries of Rs8,000, Rs2,000, and
Rs3,000, respectively for the three years, while investment B has recoveries of Rs2,000,
Rs8,000, and Rs4,000, respectively for its three years of benefits. Both investments have a 2 year
payback period since 100 percent of the cost will be recovered within two years. However,
because money has value over time, investment A clearly brings in more cash earlier in its life
(year 1)
Example : Uneven Cash Flows
Company C is planning to undertake another project requiring initial investment of Rs50 million
and is expected to generate Rs10 million in Year 1, Rs13 million in Year 2, Rs16 million in year
3, Rs19 million in Year 4 and Rs22 million in Year 5. Calculate the payback value of the project.
Solution
(cash flows in Cumul
millions) ative
Year Cash Cash
Flow Flow
0 (50) (50)
1 10 (40)
2 13 (27)
3 16 (11)
4 19 8
5 22 30
Payback Period
= 3 + (|-Rs11M| Rs19M)
= 3 + (Rs11M Rs19M)
3 + 0.58
3.58 years

BREAKING DOWN 'Payback Period'

Much of corporate finance is about capital budgeting. One of the most important concepts that
every corporate financial analyst must learn is how to value different investments or operational
projects. The analyst must figuring out a reliable way to determine the most profitable project or
investment to undertake. One way corporate financial analysts do this is with the payback period.

Capital Budgeting and The Payback Period

Most capital budgeting formulas take the time value of money into consideration. The time value
of money (TVM) is the idea that cash in hand today is worth more than it is in the future because
it can be invested and make money from that investment. Therefore, if you pay an investor

6
tomorrow, it must include an opportunity cost. The time value of money is a concept that assigns
a value to this opportunity cost.
The payback period does not concern itself with the time value of money. In fact, the time value
of money is completely disregarded in the payback method, which is calculated by counting the
number of years it takes to recover the cash invested. If it takes five years for the investment to
earn back the costs, the payback period is five years. Some analysts like the payback method for
its simplicity. Others like to use it as an additional point of reference in a capital budgeting
decision framework.

Discounting payback period

The discounted payback period is a capital budgeting procedure used to determine the
profitability of a project. A discounted payback period gives the number of years it takes to break
even from undertaking the initial expenditure, by discounting future cash flows and recognizing
the time value of money. The net present value aspect of the discounted payback period does not
exist in a payback period in which the gross inflow of future cash flows are not discounted.

BREAKING DOWN 'Discounted Payback Period'

The general rule for the calculation is to accept projects that result in a discounted payback
period that is less than the targeted period. A company is able to compare its required break-even
date to when the project will break even in terms of discounted cash flows, to approve or reject
the project.

Discounted Payback Period Calculation

To begin, the cash flow of a project must be estimated and broken down into periods. These cash
flows are then reduced by their present value factor to reflect the discounting. With the
assumption of a large cash outflow to begin the project, future discounted cash flows are net
against the initial outflow. The discounted payback period is calculated when the inflows equal
the outflows.

Peg Payback Period

A key ratio that is used to determine the time it would take for an investor to double their money
in a stock investment. The price-to-earnings growth payback period is the time it would take for
a company's earnings to equal the stock price paid by the investor. A company's PEG ratio is
used rather than their price-to-earnings ratio because it is assumed that a company's earnings will
grow over time.

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BREAKING DOWN 'PEG Payback Period'
The best reason for calculating the PEG payback period is to determine the riskiness of an
investment. Generally the longer the payback period the more risky an investment becomes. This
is because the payback period relies on the assesment of a company's earnings potential. It is
harder to predict such potential further into the future, and subsequently there is a greater risk
that those returns will not occur.

Payback Method Advantages and Disadvantages

The payback period is useful from a risk analysis perspective, since it gives a quick picture of the
amount of time that the initial investment will be at risk. If you were to analyze a prospective
investment using the payback method, you would tend to accept those investments having rapid
payback periods, and reject those having longer ones. It tends to be more useful in industries
where investments become obsolete very quickly, and where a full return of the initial
investment is therefore a serious concern. Though the payback method is widely used due to its
simplicity, it suffers from the following problems:

1. Asset life span. If an assets useful life expires immediately after it pays back the initial
investment, then there is no opportunity to generate additional cash flows. The payback
method does not incorporate any assumption regarding asset life span.

2. Additional cash flows. The concept does not consider the presence of any additional cash
flows that may arise from an investment in the periods after full payback has been
achieved.

3. Cash flow complexity. The formula is too simplistic to account for the multitude of cash
flows that actually arise with a capital investment. For example, cash investments may be
required at several stages, such as cash outlays for periodic upgrades. Also, cash outflows
may change significantly over time, varying with customer demand and the amount of
competition.

4. Profitability. The payback method focuses solely upon the time required to pay back the
initial investment; it does not track the ultimate profitability of a project at all. Thus, the
method may indicate that a project having a short payback but with no overall
profitability is a better investment than a project requiring a long-term payback but
having substantial long-term profitability.

5. Time value of money. The method does not take into account the time value of money,
where cash generated in later periods is work less than cash earned in the current period.

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 A variation on the payback period formula, known as the discounted payback formula,
eliminates this concern by incorporating the time value of money into the calculation.

6. Individual asset orientation. Many fixed asset purchases are designed to improve the
efficiency of a single operation, which is completely useless if there is a process
bottleneck located downstream from that operation that restricts the ability of the
business to generate more output. The payback period formula does not account for the
output of the entire system, only a specific operation. Thus, its use is more at the tactical
level than at the strategic level.

7. Incorrect averaging. The denominator of the calculation is based on the average cash
flows from the project over several years - but if the forecasted cash flows are mostly in
the part of the forecast furthest in the future, the calculation will incorrectly yield a
payback period that is too soon. The following example illustrates the problem.

Payback Method Example

ABC International has received a proposal from a manager, asking to spend Rs1,500,000 on
equipment that will result in cash inflows in accordance with the following table:

Year Cash Flow

1 +Rs150,000

2 +150,000

3 +200,000

4 +600,000

5 +900,000

The total cash flows over the five-year period are projected to be Rs2,000,000, which is an
average of Rs400,000 per year. When divided into the Rs1,500,000 original investment, this
results in a payback period of 3.75 years. However, the briefest perusal of the projected cash
flows reveals that the flows are heavily weighted toward the far end of the time period, so the
results of this calculation cannot be correct.

Instead, the company's financial analyst runs the calculation year by year, deducting the cash
flows in each successive year from the remaining investment. The results of this calculation are:

Year Cash Flow Net Invested Cash

0 -Rs1,500,000

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1 +Rs150,000 -1,350,000

2 +150,000 -1,200,000

3 +200,000 -1,000,000

4 +600,000 -400,000

5 +900,000 0

The table indicates that the real payback period is located somewhere between Year 4 and Year 5.
There is Rs400,000 of investment yet to be paid back at the end of Year 4, and there is
Rs900,000 of cash flow projected for Year 5. The analyst assumes the same monthly amount of
cash flow in Year 5, which means that he can estimate final payback as being just short of 4.5
years.

Summary

The payback method should not be used as the sole criterion for approval of a capital investment.
Instead, consider using the net present value or internal rate of return methods to incorporate the
time value of money and more complex cash flows, and use throughput analysis to see if the
investment will actually boost overall corporate profitability. There are also other considerations
in a capital investment decision, such as whether the same asset model should be purchased in
volume to reduce maintenance costs, and whether lower-cost and lower-capacity units would
make more sense than an expensive "monument" asset.

Different Formulas Of Pay Back Period

Unlike net present value method and internal rate of return method, payback method does not
consider the present value of cash flows. Under this method, an investment project is accepted or
rejected on the basis of payback period. Payback period means the period of time that a project
requires to recover the money invested in it. The payback period of a project is expressed in
years and is computed using the following formula:

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Formula of payback period:

According to this method, the project that promises a quick recovery of initial investment is
considered desirable. If the payback period of a project computed by the above formula is shorter
than or equal to the managements maximum desired payback period, the project is accepted
otherwise it is rejected. For example, if a company wants to recoup the cost of a machine within
5 years of purchase, the maximum desired payback period of the company would be 5 years. The
purchase of machine would be desirable if it promises a payback period of 5 years or less.

Consider the following example to understand the analysis of a project under this method:
Example
Due to increased demand, the management of Rani Beverage Company is considering to
purchase a new equipment to increase the production and revenues. The useful life of the
equipment is 10 years and the companys maximum desired payback period is 4 years. The
inflow and outflow of cash associated with the new equipment is given below:
The initial cost of equipment Rs37,500
Annual cash inflow:
Sales Rs75,000
Annual cash outflow:
Cost of ingredients Rs45,000
Salaries expenses Rs13,500
Maintenance expenses Rs1,500
Non cash expenses:
Depreciation Rs5,000

Solution:

Step 1: In order to compute the payback period of the equipment, we need to workout the net
annual cash inflow by deducting the total of cash outflow from the total of cash inflow associated
with the equipment.

Computation of net annual cash inflow:

Rs75,000 (Rs45,000 + Rs13,500 + Rs1,500)

= Rs15,000

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Step 2: Now, the amount of investment required to purchase the equipment would be divided by
the amount of net annual cash inflow (computed in step 1) to find the payback period of the
equipment.

= Rs37,500/Rs15,000

=2.5 years

Depreciation is a non cash expense and therefore has been ignored.

According to payback method, the equipment should be purchased because the payback period
of the equipment is 2.5 years which is shorter than the maximum desired payback period of the
company.

Comparison of two or more alternatives choosing from several alternative

projects:

Where funds are limited and several alternative projects are being considered, the project with
the shortest payback period is preferred. It is explained with the help of the following example:

Example 2:

The management of Health Supplement Inc. wants to reduce its labor cost by installing a new
machine. Two types of machines are available in the market machine X and machine Y.
Machine X would cost Rs18,000 where as machine Y would cost Rs15,000. Both the machines
can reduce annual labor cost by Rs3,000.

Required: Which is the best machine to purchase according to payback method?

Solution:

Machine X Machine Y

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Cost of machine (a) Rs18,000 Rs15,000

Annual cost saving (b) Rs3,000 Rs3,000

Payback period (a)/(b) 6 years 5 years

According to payback method, machine Y is more desirable than machine X because it has a
shorter payback period than machine X.

Payback method and uneven cash flow:

In the above examples we have assumed that the projects generate even cash inflow (same cash
inflow during each period) but when projects generate uneven cash inflow (different cash inflow
in different periods), the payback period formula given above cannot be used to compute
payback period.

Example 3:

An investment of Rs200,000 is expected to generate the following cash flows in six years:

Year Net cash flow

1 Rs30,000

2 Rs40,000

3 Rs60,000

4 Rs70,000

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5 Rs55,000

6 Rs45,000

Required: Compute payback period of the investment. Should the investment be made if
management wants to recover the initial investment in 3 years or less?

Solution:

(1). Because the cash inflow is uneven, the payback period formula cannot be used to compute
the payback period. We can compute the payback period by computing the cumulative net cash
flow as follows:

Year Net cash flow Cumulative net cash inflow

1 Rs30,000 Rs30,000

2 Rs40,000 Rs70,000

3 Rs60,000 Rs130,000

4 Rs70,000 Rs200,000

5 Rs55,000 Rs255,000

6 Rs45,000 Rs300,000

Payback period is 4 years because the cumulative cash flow at the end of 4th year becomes equal
to initial amount of investment.

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(2). As the payback period is longer than the maximum desired payback period of the
management (3 years), the investment should not be made.

Average Rate Of Return

Accounting rate of return, also known as the Average rate of return, or ARR is a financial
ratio used in capital budgeting. The ratio does not take into account the concept of time value of
money. ARR calculates the return, generated from net income of the proposed capital
investment. The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is
expected to earn seven cents out of each dollar invested (yearly). If the ARR is equal to or
greater than the required rate of return, the project is acceptable. If it is less than the desired rate,
it should be rejected. When comparing investments, the higher the ARR, the more attractive the
investment. Over one-half of large firms calculate ARR when appraising projects.

The accounting rate of return (ARR) is the amount of profit, or return, an

individual can expect based on an investment made. Accounting rate of
return divides the average profit by the initial investment to get the ratio or
return that can be expected. ARR does not consider the time value of money,
which means that returns taken in during later years may be worth less than
those taken in now, and does not consider cash flows, which can be an
integral part of maintaining a business.

BREAKING DOWN 'Accounting Rate of Return - ARR'

Accounting rate of return is also called the simple rate of return and is a
metric useful in the quick calculation of a companys profitability. ARR is used
mainly as a general comparison between multiple projects as it is a very
basic look at how a project is doing.

Calculation of Accounting Rate of Return

The accounting rate of return is calculated by dividing the average annual accounting profit by
the initial investment of the project. The profit is calculated using the appropriate accounting

15
framework including generally accepted accounting principles (GAAP) or international financial
reporting standards (IFRS). The profit calculation includes depreciation and amortization of
project assets. The initial investment is the fixed asset investment plus any changes to working
capital due to the asset. If the project spans multiple years, an average of total revenue per year
or investment per year is used.

Accounting Rate of Return Example

The total profit from a project over the past five years is Rs50,000. During this span, a total
investment of Rs250,000 has been made. The average annual profit is Rs10,000 (Rs50,000/5
years) and the average annual investment is Rs50,000 (Rs250,000/5 years). Therefore, the
accounting rate of return is 20% (Rs10,000/Rs50,000).

Accounting Rate of Return Drawbacks

In addition to the lack of consideration given to the time value of money as well as cash flow
timing, accounting rate of return does not provide any insight as to constraints, bottleneck
ramifications or impacts on company throughput. Accounting rate of return isolates individual
projects and may not capture the systematic impact a project may have on the entire entity both
positively and negatively. Accounting rate of return is not ideal to use for comparative purposes
because financial measurements may not be consistent between projects and other non-financial
factors need consideration. Finally, accounting rate of return does not consider the increased risk
of long-term projects and the increased variability associated with long periods of time.

More About Of Accounting Average Rate Of Return

A second simplified approach to capital budgeting is the accounting rate of return method. It is
considered to be 'simplified' because it does not use time value of money in evaluating capital
investments. This capital budgeting method uses net income, not cash flows.

The accounting rate of return (ARR) method calculates the return generated from the average net
income expected for each of the years the proposed capital investment is expected to be used in
operations. It is much like the rate of return concept you learned in financial accounting,
however this return is based on a single proposed asset acquisition, while the rate of return in
financial accounting was based on the return generated by a company's total assets.

The calculation of accounting rate of return is calculated as:

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 Accounting rate of return Average net income
= Average investment

Average net income is calculated by dividing the number of years the investment is expected to
generate economic resources into the total net income for these same years.

The average investment is based on the book value of the potential capital budgeting
acquisition. The beginning book value and the ending book value are averaged to obtain the
average investment. Beginning book value is the book value at the beginning of year 1 and
ending book value is the book value at the end of the useful life of the proposed investment.

Average investment = [Book value beginning of year 1 + Book value end of useful life]/2

Recall that book value is the cost of a long-term asset minus the amount of accumulated
depreciation. At the end of an asset's life, the asset's cost minus accumulated depreciation will
equal the salvage value. When the asset is sold for the salvage value amount, there is no gain or
loss on the sale.

Interpret the Accounting Rate of Return

The ARR is expressed as a percentage return with two decimals displayed, such as 6.93%. This
amount tells you that the company is expected to earn almost 7 cents of profit out each dollar it
will have tied up in the investment If the ARR is equal to or greater than the required rate of
return, the project is acceptable. If the investment is expected to generate a return that is less than
the desired rate of return, it should be rejected. When comparing investments, the higher the
ARR, the more attractive the investment.

Limitations of the Accounting Rate of Return

ARR ignores the time value of money in its computations. By doing this, it views amounts
generated in the first year to be equal to the amounts generated in the last year on a dollar per
dollar basis. In essence, it ignores the timing of the cash flows within the useful life.

Formula
Accounting Rate of Return is calculated using the following formula:
Average Accounting Profit
ARR =
Average Investment

17
Average accounting profit is the arithmetic mean of accounting income expected to be earned
during each year of the project's life time. Average investment may be calculated as the sum of
the beginning and ending book value of the project divided by 2. Another variation of ARR
formula uses initial investment instead of average investment.

Example : An initial investment of Rs130,000 is expected to generate annual cash inflow of

Rs32,000 for 6 years. Depreciation is allowed on the straight line basis. It is estimated that the
project will generate scrap value of Rs10,500 at end of the 6th year. Calculate its accounting rate
of return assuming that there are no other expenses on the project.
Solution
Annual Depreciation = (Initial Investment Scrap Value) Useful Life in Years
Annual Depreciation = (Rs130,000 Rs10,500) 6 Rs19,917
Average Accounting Income = Rs32,000 Rs19,917 = Rs12,083
Accounting Rate of Return = Rs12,083 Rs130,000 9.3%

Advantages And Disadvantages Of Average Rate Of Return

Advantages of Accounting Rate of Return Method (ARR Method)

The following are the advantages of Accounting Rate of Return method.

1. It is very easy to calculate and simple to understand like pay back period. It considers the total
profits or savings over the entire period of economic life of the project.

2. This method recognizes the concept of net earnings i.e. earnings after tax and depreciation.
This is a vital factor in the appraisal of a investment proposal.

3. This method facilitates the comparison of new product project with that of cost reducing
project or other projects of competitive nature.

4. This method gives a clear picture of the profitability of a project.

5. This method alone considers the accounting concept of profit for calculating rate of return.
Moreover, the accounting profit can be readily calculated from the accounting records.

6. This method satisfies the interest of the owners since they are much interested in return on
investment.

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7. This method is useful to measure current performance of the firm.

Disadvantages or Weakness or Limitations of Accounting Rate of Return

Method

This method has some disadvantages or limitations also. They are briefly explained below.

1. The results are different if one calculates ROI and others calculate ARR. It creates problem in
making decisions.

2. This method ignores time factor. The primary weakness of the average return method of
selecting alternative uses of funds is that the time value of funds is ignored.

3. A fair rate of return can not be determined on the basis of ARR. It is the discretion of the
management.

4. This method does not consider the external factors which are also affecting the profitability of
the project.

5. It does not taken into the consideration of cash inflows which are more important than the
accounting profits.

6. It ignores the period in which the profits are earned as a 20% rate of return in 10 years may be
considered to be better than 18% rate of return for 6 years. This is not proper because longer the
term of the project, greater is the risk involved.

7. This method cannot be applied in a situation when investment in a project to be made in parts.

8. This method does not consider the life period of the various investments. But average earnings
is calculated by taking life period of the investment. As a result, average investment or initial
investment may remain the same whether investment has a life period of 4 years or 6 years.

9. It is not useful to evaluate the projects where investment is made in two or more installments
at different times.

Formula of accounting rate of return (ARR):

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 In the above formula, the incremental net operating income is equal to incremental revenues to
be generated by the asset less incremental operating expenses. The incremental operating
expenses also include depreciation of the asset.

The denominator in the formula is the amount of investment initially required to purchase the
asset. If an old asset is replaced with a new one, the amount of initial investment would be
reduced by any proceeds realized from the sale of old equipment.

Example 1:

The Fine Clothing Factory wants to replace an old machine with a new one. The old machine can
be sold to a small factory for Rs10,000. The new machine would increase annual revenue by
Rs150,000 and annual operating expenses by Rs60,000. The new machine would cost
Rs360,000. The estimated useful life of the machine is 12 years with zero salvage value.

Required:

1. Compute accounting rate of return (ARR) of the machine using above information.
2. Should Fine Clothing Factory purchase the machine if management wants an accounting
rate of return of 15% on all capital investments?
Solution:

(1): Computation of accounting rate of return:

= Rs60,000* / Rs350,000**

= 17.14%

*Incremental net operating income:

Incremental revenues Incremental expenses including depreciation
Rs150,000 (Rs60,000 cash operating expenses + Rs30,000 depreciation)
Rs150,000 Rs90,000
Rs60,000

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Cost reduction projects:

The accounting rate of return method is equally beneficial to evaluate cost reduction projects.
The accounting rate of return of the assets that are purchased with a view to reduce business
costs is computed using the following formula:

Example 2:

The P & G company is considering to purchase an equipment costing Rs45,000 to be used in

packing department. It would reduce annual labor cost by Rs12,000. The useful life of the
equipment would be 15 years with no salvage value. The operating expenses of the equipment
other than depreciation would be Rs3,000 per year.

Required: Compute accounting rate of return/simple rate of return of the equipment.

Solution:

= Rs6,000* / Rs45,000

= 13.33%

*Net cost savings:

Rs12,000 (Rs3,000 cash operating expenses + Rs3,000 depreciation expenses)
Rs12,000 Rs6,000
Rs6,000

Comparison of different alternatives:

If several investments are proposed and the management have to choose the best due to limited
funds, the proposal with the highest accounting rate of return is preferred. Consider the
following example:

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Example 3:

The Good Year manufacturing company has the following different alternative investment
proposals:

Proposal A Proposal B Proposal C

Expected incremental income per year (a) Rs50,000 Rs75,000 90,000

Initial investment (b) Rs250,000 Rs300,000 Rs500,000

Expected accounting rate of return (a)/(b) 20% 25% 18%

Required: Using accounting rate of return method, select the best investment proposal for the
company.

Solution:

If only accounting rate of return is considered, the proposal B is the best proposal for Good Year
manufacturing company because its expected accounting rate of return is the highest among
three proposals.

Usefulness
Having calculated the percentage answer, how can this be used for project appraisal?
The accounting rate of return percentage needs to be compared to a target set by the organisation.
If the accounting rate of return is greater than the target, then accept the project, if it is less then
reject the project.
This leads to a couple of problems:
How is the target set? Should it be 25%, or 30%? The target set could be arbitrary
Which calculation method should be used? If in the above example, the target was 25%,
the project would be rejected under one calculation method but accepted under the other, so
changing the calculation method can change the decision as to whether the project should be
accepted or rejected.

Other problems with the accounting rate of return:

The timing of the cash flows is not considered. In our example, the biggest cash flow
arises in year five, but by then, the organisation may have ceased trading due to liquidity
issues in years three and four when only Rs5,000 cash is being received in each year.

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 It is a relative measure rather than an absolute measure it takes no account of the size of
the investment.
The time value of money is ignored.

There are, however, some positive aspects to the accounting rate of return:
It is simple to calculate from readily available accounting data no complicated discount
factors to calculate!
The concept of profit is easily understood by managers, and the answer is easily
interpreted does the project give the necessary accounting return or not?
The method looks at the whole life of the project, unlike, for example, the payback
method which may not.

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 Cost-Benefit Analysis: Payback & Accounting Rate of Return

Payback period and the accounting rate of return are two methods that can be used when
estimating or projecting the return on an investment. Because they offer different perspectives on
an investment return, they can both be useful when discussing the validity of an investment. The
payback period expresses how long it takes the benefit of the investment to cover the cost of the
investment, while the accounting rate of return is expressed by the annual rate of return
generated by the investment.

Before we get to the specifics of calculating payback period and the accounting rate of return,
let's set up an example we can use throughout the lesson. Karen has designed a very popular case
for smartphones. When she started her business, Karen rented a 3D printer from the local
university to manufacture her cases. Now that business is booming, she's considering buying her
own 3D printer so she can eliminate the constraints on time and resources, as well as the
overhead cost she would be paying the university. The 3D printer she's considering costs
Rs120,000.

To calculate the payback period, you need two pieces of information. First, you need the cost of
the investment, which we have. That's the Rs120,000 that Karen will have to spend to buy the
new 3D printer. The second piece of information you need is how much revenue the investment
will generate each time period. The time period could be months or years - just remember,
whatever time period you use at this point will determine the time period of your answer.

So, Karen looks at her books and sees that last year, just by selling her single case, she brought in
Rs78,000 in revenue. Being conservative and not wanting to oversell the idea of buying her
printer, Karen decides to forecast the same amount of sales for the next few years.

Now we have both pieces of information we need. To get the payback period for the 3D printer,
all we need to do is divide the cost of the investment by the revenue produced: Rs120,000 /
Rs78,000. That equals just over 1.5, and since the Rs78,000 was an annual number, our answer is
1.5 years. It will take just over 1.5 years for Karen to generate the amount of revenue that equals
the cost of the investment. There's an important note to make here. That payback period doesn't
actually mean the cost of the investment will be paid off in that amount of time. Karen could
have received a loan for her printer that she's paying off over five years

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The payback period (PBP) is the amount of time that is expected before an investment will be
returned in the form of income. When comparing two or more investments, business managers
and investors will typically compare the projects to see which one has the shorter PBP. Projects
with longer PBP are usually associated with higher risk.

For the purposes of this lesson, you will be a senior business manager for a large corporation and
one of your responsibilities is to select from among the many potential projects that are proposed
by employees and lower-level managers. Although the size of your company is big, there is not
enough money to fund all of the projects and the board of directors wants you to ensure that the
organization does not invest in risky ventures.

Before beginning to analyze the two proposed projects brought to your office, you notice that
one project has even cash flows and the other has uneven cash flows. There are two different
methods that you will need to use to see which one is the best choice for your company.
Even cash flows mean that the investment is expected to bring in income that is constant each
year. The first investment is for a new machine that will produce one of your company's products
more efficiently and will bring in the same income each month based on the organization's steady
production of that item. The cost of the machine is Rs28,120, and it is expected to bring the
company a net cash flow of Rs7,600 per year for the next fifteen years of the machine's useful
life.
The formula you will use to compute a PBP with even cash flows is:

By substituting the numbers into the formula, you divide the cost of the investment (Rs28,120)
by the annual net cash flow (Rs7,600) to determine the expected payback period of 3.7 years.

Uneven cash flows occur when the annual cash flows are not the same amount each year. Under
these circumstances, the formula that we used before will not work but being the wise business
manager that you are, you still know how to figure out the PBP for this project.
The second investment is for a totally new product that can be made with most of the same
machinery, but it will need some unique equipment and materials. Additionally, until the public is
aware of the product's existence, there will not be a lot of demand for it. The first two columns of
the table were provided by the business manager of that section based on her experience with
new products of this type. You were able to add the right hand column that shows the cumulative
net cash flows.

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Cumulative cash flows are the running total added to the initial investment. Remember that the
initial investment is a cash outflow and is shown as a negative number. Year zero is the first year
that shows the amount of the initial investment, and each year afterwards has income that is
added to find the cumulative net cash flow for that year. We see that in the chart, it takes over
four years to pay back the initial investment.

One of the main reasons new investors lose money is because they chase after unrealistic rates of
return on their investments, whether they are buying stocks, bonds, mutual funds, real estate, or
some other asset class. This happens due to a lack of experience. Most folks just dont
understand how compounding works. Every increase in percentage profit each year means huge
increases in your ultimate wealth.
To provide a start illustration, Rs10,000 invested at 10% for 100 years turns into Rs137.8
million. The same Rs10,000 invested at twice the rate of return, 20%, does not merely double the
outcome, it turns it into Rs828.2 billion. It seems counter-intuitive that the difference between a
10% return and a 20% return is 6,010x as much money, but it's the nature of geometric growth.

So What's a Good Growth Rate?

When it comes to answering what a "good" rate of return on your investments is, I find myself
frequently reiterating the truism that past performance is no guarantee of future results, and that
even the best-structured portfolio or investment plan can result in permanent capital losses. I
think about risk a lot. It's in my nature. In fact, I believe people don't think about risk enough.
Things like the total decimation of the Austrian stock market upon the annexation of Austria by
Nazi Germany have happened, can happen, and will happen again at some point in the future.

There are no guarantees of any kind in life.

With that said, I think the only reasonable, academic position a person can take if they assume
that civilization will remain relatively stable is to answer that determining a "good" rate of return
on your investments is probably easiest if we examine the nearly 200 years of data from Ibbotson
& Associates, a data research firm that tracks financial market history.

It's not perfect for the reasons we just discussed, as well as several others, but it's the best we
have.

To accomplish this, the first thing we need to do is strip out inflation. The reality is, investors are
interested in increasing their purchasing power. That is, they dont care about dollars or yen
per se, they care about how many cheeseburgers, cars, pianos, computers, or pairs of shoes they
can purchase.

How do you calculate the payback period?

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The payback period is calculated by counting the number of years it will take to recover
the cash invested in a project.

Let's assume that a company invests Rs400,000 in more efficient equipment. The cash savings
from the new equipment is expected to be Rs100,000 per year for 10 years. The payback period
is 4 years (Rs400,000 divided by Rs100,000 per year).

A second project requires an investment of Rs200,000 and it generates cash as follows: Rs20,000
in Year 1; Rs60,000 in Year 2; Rs80,000 in Year 3; Rs100,000 in Year 4; Rs70,000 in Year 5. The
payback period is 3.4 years (Rs20,000 + Rs60,000 + Rs80,000 = Rs160,000 in the first three
years + Rs40,000 of the Rs100,000 occurring in Year 4).

Note that the payback calculation uses cash flows, not net income. Also, the payback calculation
does not address a project's total profitability. Rather, the payback period simply computes how
fast a company will recover its cash investment.

How do you calculate the average rate of return?

Average Rate of Return

The rate of
return on an investment that is calculated by taking the total cash inflow over the life of the inves
tmentand dividing it by the number of years in the life of the investment. The average rate of retu
rn does not guarantee thatthe cash inflows are the same in a given year; it simply guarantees that
the return averages out to the average rate ofreturn.

average rate of return

One way of measuring an investment's profitability.To calculate,one takes the total net earnings,d
ivides by the total numberof years the investment was held,and then divides that answer by the in
vestment's initial acquisition cost.
Example: Rainer spent Rs800,000 to buy an apartment building. After deducting all operat- ing e
xpenses, real estate taxes,and insurance, she receives Rs65,000 in the first year, Rs71,000 in the s
econd year, Rs69,000 in the third year, and Rs70,000 inthe fourth year. The total net earnings are
Rs275,000. Divide that number by the 4 years being analyzed, to reach Rs68,750 asan average a
nnual return. Divide Rs68,750 by the initial Rs800,000 investment to calculate the average rate o
f return of 8.59percent.
Payback Period In Capital Budgeting
In capital budgeting for a business firm, historically, the payback period is the selection criteria
that most business firm use to select capital projects. Even today, small businesses find the
payback period selection criteria most useful. Small business owners like to look at the time it
takes them to earn back their initial investment in a capital project.

27
What is a Capital Project?
A capital project is usually defined as buying or investing in a fixed asset which, by definition,
will last more than one year.

Current projects last less than one year.

Payback Period Capital Budgeting Decision Method

The definition of payback period for capital budgeting purposes is simple. The payback period is
the number of years it takes to payback the initial investment of a capital project from the cash
flows that the project produces.

The capital project could be buying a new plant or building or buying a new or replacement
piece of equipment. In this example, it is buying real estate. Most firms set a cut-off payback
period, maybe 3 years depending on their business. In other words, in this example, if the
payback is 2.5 years, the firm would purchase the asset or invest in the project. If the payback
were 4 years, it would not.

Calculating Payback Period

Most small businesses prefer a simple calculation, or approximation, for payback period:

Payback Period = Investment Required/Net Annual Cash Inflow*

*The net annual cash inflow is what the investment generates in cash each year. However, if this
investment was a replacement investment; for example, a machine replaced an obsolete
machine, then the net annual cash inflow becomes the incremental net annual cash flow from the
investment.

Payback occurs the year (plus a number of months) before the cash flow turns positive.

Larger firms may prefer a more complex calculation for payback so that they may gather more
information. Here is an alternative payback period calculation:

Payback Period = Number of years prior to full recovery of investment + Unrecovered cost
at start of year/Cash flow during full recovery year

This slightly more extensive equation may give you a little more information. For purposes of
examples in this article, we will stick with the simpler payback period equation.

Is Payback Period a Good Capital Evaluation Decision Method

Payback period has many deficiencies. If you add information to the analysis, you will see some
of its deficiencies. For example, if you add the economic lives of the two machines, you could

28
get a very different answer. So, one deficiency of payback is that is cannot determine the useful
lives of the equipment or plant it is evaluating.

Perhaps an even more important criticism of payback period is that it does not consider time
value of money. Cash inflows from the project that are scheduled to be received 2-10 years, or
longer, in the future are weighted exactly the same as the cash flow expected to be received in
year one.

Due to risk, that is not good financial practice.

Last, but not least, payback period does not handle a project with uneven cash flows well. If a
project has uneven cash flows, then payback period is a fairly useless capital budgeting method.

The one advantage of payback period is that it is a "quick and dirty" method of capital budgeting
that can give management some sort of rough estimate concerning when the project will pay
back their initial investment. Even considering the more advanced methods available, it seems
that management still wants to rely on this tried and true method.

Conclusion
An empirical study of the practices of the Capital Budgeting for evaluation of investment
proposals in the corporate sector in India has been made in the preceding chapters. Comparison,
wherever possible, has been made with the practices and procedures in the foreign countries. It
has to be noted that conclusions based upon a study of this type have to be taken as indicative of
broad trends only. However, the results of this study do indicate that majority of large scale
companies in India are aware of the need for a well formulated capital budgeting decisions. It is
proposed to review the important findings of this study and venture to outline some suggestions
and recommendations for the benefit of academicians, industry as well as for post doctoral
research. An in-depth analysis has been carried out to observe the trend and insight into factors
that influence capital budgeting decisions. The results of the survey and its analysis have been
provided in chapter 5. The companies in India do have specific amount of average size of annual
capital budget and all project size requires formal quantitative analysis. However, such analysis
and use of capital budgeting method differ on the basis of nature and size of a particular project

29
under consideration. Surprisingly, the companies under study in India seem to be planning one
year in advance only but here also the period of planning is different for different projects. This
may be due to volatile business environment. The authority to take final capital budgeting
decision rests with the chief finance officer and top management officials of all the organizations
under study. Another objective of this study is to analyze the problems faced to estimate the cash
flows associated with each capital investment accurately. The cash flow estimation is considered
as the most difficult task in capital budgeting decisions. This can be understood from the
responses of the respondents of the present study. Many respondents have replied that items like
expenses incurred on R&D, market survey, test marketing, interest on borrowings, depreciation,
income taxes etc. have been included in the cash flows which requires to be excluded actually. In
fact, many of them might have been intending to convey that they include it in the project cost.
Even the firms are using different inflation adjustment methods for their investment appraisal.
One of the objectives of this research is to analyze how Risk and Uncertainty in the future
estimates in investment projects is being taken care of. Sensitivity analysis is considered as the
most important technique while scenario analysis is considered as the second important
technique for assessing risk. The other more sophisticated techniques like Decision tree, Monte
Carlo simulation, Certainty equivalent, Probability analysis, Beta analysis has got very low
ratings that means these techniques are rarely used in practice by firms in India. The researcher
wanted to assess suitability of Discounted Cash Flow (DCF) Techniques in India and the
preferences between Net Present Value (NPV) and Internal Rate of Return (IRR) methods. All
the companies responded to my study are using DCF techniques either IRR or NPV or both
which indicates that now these techniques are very well accepted and used by finance officials of
the organizations. With reference to this Porwal (1976) in his study has mentioned, As long
term planning under the present conditions is not quite possible in India, the use of DCF methods
do not seem to be efficacious. However, it needs to be mentioned that as conditions improve, it
would be desirable for Indian companies to apply theoretically correct techniques in a larger
measure. Prasanna Chandra (1975) in his study conducted on 20 companies made the following
observations. The most commonly used method for evaluating the investments of small size is
payback period method.For investments of large size, the average rate of return is commonly
used as the principle criterion and the payback period is used as a supplementary criterion. DCF
techniques, though not commonly used, are gaining importance, particularly in the evaluation of
large investments. It appears that now though the government restrictions are minimized on
business but firms are always working under highly volatile environment. Still no respondents in
my study is using only pay back period method at the same time no organizations are using
single technique for evaluating capital budgeting proposals. Though Pay back period is still a
popular technique, it is always used with some other DCF techniques which are in most of the
cases IRR or NPV. The suitability of DCF techniques even depends on how professional the
organization is. But all the respondents in my study appreciate and use the suitability of these
techniques. In capital budgeting literature, two widely discussed methods for appraisal of capital
investments are the NPV and IRR methods. There is good amount of controversy exist regarding
the superiority of one method over the other. Many authors argue that the NPV method leads to
30
correct decision (Bierman and Smidt S, 1980). On the other hand Merret A J and Sykes A (1966)
prefer the yield method. In some situations the NPV and yield methods give contradictory
results. Babu C P (1984) explains the reasons for this phenomenon-in capital investment
appraisal using the yield like yield to maturity in bonds, or as a growth rate of an investment is
misleading, and is responsible for the contradictions that exist between the NPV and yield
methods. He further says that as the NPV criterion is compatible with the objective of the firm,
the yields can be used in such a manner so as to give the same results as that of NPV. The
respondents of my study prefer both the techniques but IRR (40.7%) seems to be given more
importance by them in comparison to NPV (33.3%) as it gives some rate for comparison. When
they were asked to mention frequency of the use of different capital budgeting techniques the
NPV (59.3%) got more preference than IRR (55.5%). Thus, it can be concluded that both the
techniques goes side by side when it comes to selecting one over the other. The respondents of
my study prefer both the techniques but IRR seems to be more favoured by them as it gives some
rate for comparison, however, there is a negligible difference between the preference for both the
techniques i.e. NPV and IRR.

Bibliography

www.unf.edu
www.investopedia.com
www.authorstream.com
www.study.com
accountingexplained.com
thefreedictionary.com
www.businessdictionary.com
businessjargons.com
www.wikipedia.com
www.swlearning.com
www.markedbyteachers.com
www.cpanet.com

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