Basic Methods: Payback, ARR

Basic Methods: Payback, Accounting Rate of Return (ARR)

Understanding Payback Period

Payback Period is a simple investment appraisal technique used to identify the time it will take for the investment to pay for itself through generated profits.
The payback period is calculated by dividing the initial outlay by the annual cash inflows.
The shorter the payback period, the more attractive the investment is to the business.
Payback period is often preferred due its ease of understanding and its emphasis on liquidity over profitability.
However, it ignores any cash inflows that occur after the payback period and does not take into account the time value of money.

Understanding Accounting Rate of Return (ARR)

Accounting Rate of Return (ARR) calculates the average annual profit of an investment as a percentage of the initial investment.
This method is based on average profits and therefore includes all cash inflows unlike the payback period.
A higher ARR indicates a more attractive investment, and it is often used to compare different investment options.
ARR is relatively easy to calculate and uses readily available accounting information.
However, similar to the Payback method, ARR does not consider the time value of money. It assumes profits earned throughout the project have the same value when, in reality, future profits hold less value due to factors like inflation and risk.
Another shortfall is the use of accounting profit instead of cash flows in calculations. This could lead to misleading results as accounting profit may not reflect the actual cash movements.

By understanding the limitations of both the Payback and ARR methods, businesses can use these techniques more effectively in their investment appraisals. They can also supplement these methods with other techniques to provide a more comprehensive view.