7.5 Non-discounted cash flow methods – payback period and accounting rate of return

Non-discounted cash flow methods are capital investment appraisal techniques that do not explicitly consider the time value of money. Two commonly used non-discounted cash flow methods are the Payback Period and the Accounting Rate of Return (ARR).

1. Payback Period: The Payback Period is a simple method that calculates the time required for an investment project to recover its initial investment. It determines the length of time it takes for the cumulative cash inflows from the project to equal or exceed the initial cash outlay. The Payback Period is typically expressed in years.

The formula to calculate the Payback Period is as follows: Payback Period = Initial Investment / Annual Cash Inflow

The Payback Period provides insight into the project’s liquidity and the timeframe within which the investment can be recouped. It is commonly used as a screening tool to assess the investment’s risk and to prioritize projects based on their payback period. Shorter payback periods are generally preferred as they indicate a faster return on investment.

However, the Payback Period has some limitations. It does not consider cash flows beyond the payback period, which may lead to overlooking the project’s long-term profitability. It also does not account for the time value of money, meaning it treats cash inflows received in different time periods equally.

2. Accounting Rate of Return (ARR): The Accounting Rate of Return calculates the average annual accounting profit generated by an investment project as a percentage of the initial investment cost. It focuses on the project’s profitability from an accounting perspective rather than cash flows.

The formula to calculate the Accounting Rate of Return is as follows: ARR = Average Annual Accounting Profit / Initial Investment

The average annual accounting profit is typically derived by dividing the project’s expected total accounting profit over its useful life by the number of years.

The ARR helps assess the project’s profitability based on accounting measures. It provides an indication of the average return generated by the project in relation to the initial investment. A higher ARR suggests a higher return on investment, indicating the project’s attractiveness.

However, the ARR has limitations as well. It relies heavily on accounting figures, which can be influenced by accounting policies and subjective estimates. It does not consider the time value of money, and it does not account for cash flows beyond the accounting profit. Therefore, it may not provide a comprehensive evaluation of the project’s financial performance.

Both the Payback Period and the Accounting Rate of Return are simple and straightforward capital investment appraisal methods. They can be useful in providing initial insights and in screening investment projects. However, it is important to consider their limitations and use them in conjunction with other appraisal techniques that account for the time value of money and provide a more comprehensive analysis of the project’s financial viability and profitability.