Investment appraisal tools like Payback Period and Average Rate of Return (ARR) help businesses make informed decisions when choosing between competing investment opportunities.
Payback Period
What is the Payback Period?
The Payback Period is a quantitative investment appraisal technique used to determine how long it takes a business to recoup its original investment from the cash inflows generated by the investment. In other words, it calculates the length of time required for an investment to "pay for itself". This period is typically measured in years and months and is especially valuable for businesses that need to recover their capital quickly due to financial constraints or risk concerns.
The payback period is a widely used method in business decision-making because of its simplicity and focus on liquidity. It doesn’t assess profitability over the full lifespan of a project but instead concentrates on the time it takes to recover the initial outlay, making it appealing for firms operating in volatile markets or industries with rapid technological changes.
Formula for Payback Period
The method of calculating the payback period depends on whether the project produces equal cash inflows each year or uneven inflows.
When cash inflows are the same each year, the formula is:
Payback Period = Initial Investment ÷ Annual Cash Inflow
When cash inflows vary year by year, the cumulative cash inflows are added up until the total equals or surpasses the original investment. The point at which this occurs determines the payback period.
Example Calculation: Even Cash Inflows
Suppose a company is considering purchasing new machinery for £20,000, and this machine is expected to generate an annual cash inflow of £5,000. Using the payback formula:
Payback Period = 20,000 ÷ 5,000 = 4 years
This means the company would fully recover the cost of the machine after four years of operation. This kind of situation, where inflows are predictable and regular, is straightforward to analyse.
Example Calculation: Uneven Cash Inflows
Now consider a different investment project that requires an initial outlay of £30,000, but generates the following cash inflows:
Year 1: £8,000
Year 2: £10,000
Year 3: £12,000
Year 4: £6,000
To calculate the payback period:
After Year 1: £8,000
After Year 2: £8,000 + £10,000 = £18,000
After Year 3: £18,000 + £12,000 = £30,000
Thus, the investment is paid back at the end of Year 3. The payback period is 3 years.
Suppose the inflow in Year 3 had only been £9,000. The cumulative inflow after 3 years would then be £27,000, meaning the investment hasn’t yet been recovered. The remaining amount to be recovered would be:
£30,000 - £27,000 = £3,000
The inflow in Year 4 is £6,000, so the remaining amount would be recovered in:
£3,000 ÷ £6,000 = 0.5 years
Therefore, the total payback period would be:
3 years + 0.5 years = 3.5 years (or 3 years and 6 months)
Interpretation and Use of Payback Period
The shorter the payback period, the more attractive the investment is considered, especially to businesses that prioritise fast recovery of funds and risk reduction.
This method is particularly useful for:
Liquidity-focused businesses – firms that operate with limited cash reserves or rely on short-term financing may favour projects that recoup investment quickly.
Technologically sensitive industries – where investments can become obsolete quickly, a shorter payback reduces the likelihood of being left with outdated assets.
High-risk environments – where the future is uncertain, fast recovery lowers the chance of capital loss.
Simple projects – where detailed financial modelling is not feasible or necessary.
However, it is important to recognise that while the payback period is a useful tool for assessing liquidity and risk exposure, it is not a measure of profitability. A project with a fast payback may deliver lower long-term profits than one with a longer payback but higher overall returns.
Average Rate of Return (ARR)
What is the Average Rate of Return?
The Average Rate of Return (ARR) is another financial investment appraisal method that evaluates the profitability of a project by comparing the average annual accounting profit it generates to the initial investment cost. Unlike the payback period, ARR focuses on profitability over the entire lifespan of the investment, making it suitable for comparing the financial attractiveness of multiple projects.
The result is expressed as a percentage return, which allows decision-makers to benchmark the expected return against the company’s required rate of return or interest rates on borrowed capital.
ARR provides a long-term performance view, helping businesses align investments with their broader profit objectives and financial goals.
Formula for ARR
The formula for ARR is:
ARR = (Average Annual Accounting Profit ÷ Initial Investment) × 100
Where:
Average Annual Accounting Profit is the total net profit (after expenses and depreciation) divided by the number of years of the project.
The initial investment is the total capital outlay required to start the project.
Example Calculation of ARR
Suppose a business is evaluating a project that requires an initial investment of £50,000. It expects to earn the following net profits over a 5-year period:
Year 1: £10,000
Year 2: £12,000
Year 3: £14,000
Year 4: £11,000
Year 5: £13,000
First, calculate the total profit:
10,000 + 12,000 + 14,000 + 11,000 + 13,000 = £60,000
Then calculate the average annual profit:
60,000 ÷ 5 = £12,000
Now apply the ARR formula:
ARR = (12,000 ÷ 50,000) × 100 = 24%
This means that on average, the project returns 24 percent of the initial investment each year.
Interpretation and Use of ARR
ARR helps management determine whether an investment meets the business's required profitability standards. A higher ARR generally indicates a more attractive investment.
It is especially useful in the following situations:
Comparing multiple projects – ARR gives a percentage-based figure that makes comparison easy.
Profit-focused businesses – especially those aiming to maximise returns to shareholders.
Simple performance benchmarks – ARR can be compared to the company’s hurdle rate or the interest rate it pays on borrowed capital.
Long-term investment decisions – where total profitability is more important than the speed of return.
However, since ARR uses accounting profit rather than cash flows, it may not fully reflect the financial viability of a project. It can also be affected by non-cash expenses like depreciation and doesn’t factor in when profits occur.
Comparison of Payback Period and ARR
Payback Period and ARR are both non-discounted investment appraisal techniques, meaning they do not take into account the time value of money. Despite this, each method provides different insights and serves different business purposes.
Advantages of Payback Period
Easy to Calculate and Understand: One of the simplest investment appraisal tools.
Risk-Reduction Focused: Prioritises fast returns, reducing the period of risk exposure.
Cash Flow Awareness: Helps businesses with cash flow concerns evaluate how quickly capital will be recovered.
Suitable for Uncertain Environments: In dynamic industries, early recovery of funds is preferred.
Disadvantages of Payback Period
Ignores Total Profitability: Doesn’t consider returns beyond the payback period.
No Time Value of Money Considered: Doesn’t recognise that money received sooner is more valuable than money received later.
Arbitrary Decision Rule: Selecting a maximum acceptable payback period is often subjective and varies across firms.
Discourages Long-Term Investment: May lead to rejection of highly profitable projects with longer payback periods.
Advantages of ARR
Focus on Profitability: Takes total profits into account, aligning with financial goals.
Comparable: As a percentage, ARR makes it easy to compare projects or benchmark against target returns.
Simple and Intuitive: Understandable even without advanced financial knowledge.
Includes All Revenues: Unlike payback, considers the full stream of profits over the project’s life.
Disadvantages of ARR
Ignores Time Value of Money: Like the payback method, ARR assumes all profits are of equal value regardless of when they occur.
Uses Accounting Profits, Not Cash Flows: This means profits could be distorted by non-cash items such as depreciation or inventory adjustments.
No Indication of Investment Risk: Doesn’t reflect the variability or uncertainty of profits.
Can Be Misleading: A project might have a high ARR but take many years to recover the initial investment, exposing the firm to prolonged risk.
When Should Each Method Be Used?
The choice of investment appraisal technique often depends on the strategic context, financial position, and risk tolerance of the business.
Use Payback Period When:
Liquidity and cash flow are critical to the business’s survival or operations.
The project involves short-term assets or operates in a sector with fast-changing technology.
Management is concerned with minimising risk and wants to recover capital quickly.
The investment decision must be made quickly and with limited financial data.
Use ARR When:
The goal is to assess overall profitability across the entire life of the investment.
The business has access to comprehensive accounting information.
There is less urgency to recover cash quickly, and focus is on financial return targets.
The firm needs a simple performance measure to present to stakeholders or compare to other investment options.
Many businesses choose to use both techniques in combination. While the payback period informs on liquidity and risk, ARR offers insights into profitability. Together, they provide a broader view, supporting more balanced and informed investment decisions.
FAQ
Businesses often use the payback period method because it provides a quick and easy way to assess how soon they will recover their initial investment, which is vital for cash-strapped firms. In industries with high levels of uncertainty or where assets become obsolete quickly—like electronics or software—fast capital recovery reduces financial risk. It also aids in short-term decision-making without requiring complex financial analysis, which is useful for small firms lacking financial expertise or analytical tools.
While the payback period can compare projects, it is less effective when the projects differ significantly in size or lifespan. For example, a project with a shorter payback but lower total return may appear more attractive than a longer project with much higher overall profit. Since it doesn’t consider total profitability or returns after the payback point, it may favour short-term gains over better long-term investments. Thus, comparisons should be made cautiously and with other appraisal tools.
ARR uses accounting profit rather than cash flow, which means it includes depreciation and other non-cash items. This can distort the real financial return of a project. For example, two projects with identical cash flows might show different ARR values if they use different depreciation methods. As a result, ARR may not accurately reflect the investment's actual financial benefit. Businesses must understand these limitations and ensure consistency in accounting treatments when using ARR for decision-making.
Yes, it is possible. A project might return the initial investment quickly through high early cash inflows, giving it a short payback period. However, if subsequent cash inflows are minimal or the project doesn’t generate significant profit over its lifespan, the average profit will be low, resulting in a poor ARR. This highlights the importance of not relying solely on payback period for investment decisions, as it can overlook poor long-term profitability and mislead managers.
Businesses typically set internal benchmarks for ARR and payback period based on strategic goals, industry standards, and financial position. For ARR, a firm might require that any investment must exceed the company’s cost of capital or a target rate, such as 15%. For payback, they might decide only to accept projects that pay back within three years. These thresholds vary by company and are influenced by risk tolerance, cash flow needs, and sector-specific investment norms.
Practice Questions
Analyse the usefulness of the payback period method for a technology start-up considering investment in new software development. (6 marks)
The payback period is useful for a technology start-up because it focuses on recovering the initial investment quickly, which is crucial for firms with limited liquidity. In rapidly evolving sectors, where technology can become obsolete quickly, the speed of return helps minimise risk. The simplicity of the method also supports quick decision-making. However, it ignores profitability beyond the payback point and does not account for the time value of money, potentially leading to poor long-term decisions. Therefore, while useful for managing risk in uncertain environments, it should be used alongside other appraisal methods for more balanced decision-making.
Calculate the average rate of return (ARR) for an investment with a total profit of £60,000 over 4 years and an initial investment of £150,000. Assess one advantage and one disadvantage of using ARR. (9 marks)
ARR = (60,000 ÷ 4) ÷ 150,000 × 100 = 10%. One advantage of using ARR is that it considers the total profitability of the investment, making it useful for comparing long-term returns across different projects. The percentage format also makes it easy for managers to assess against required return targets. However, a key disadvantage is that it does not consider the time value of money, treating early and later profits as equal. This may mislead decision-makers if cash inflows are delayed. While informative, ARR should be complemented with other methods to give a complete investment picture.
