11.2 Evaluate the Payback and Accounting Rate of Return in Capital Investment Decisions

Capital investment decisions are crucial for businesses to grow and thrive. These choices involve evaluating potential projects to determine their profitability and feasibility. Two key methods used in this process are the payback period and accounting rate of return.

Non-time value methods like these offer quick insights but have limitations. While they're easy to calculate and understand, they don't account for the time value of money. This can lead to incomplete assessments, especially for long-term projects with complex cash flows.

Capital Investment Decisions

Payback period calculation methods

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• Payback period calculates the time required for cumulative cash inflows from an investment to equal the initial cash outlay
  • Assesses how quickly the investment will recover its initial cost
  • Investments with shorter payback periods are typically favored (2 years vs. 5 years)
• Even cash flows occur when the annual cash inflows remain consistent each year
  • Payback period formula for even cash flows: \text{Payback period} = \frac{\text{[Initial investment](https://www.fiveableKeyTerm:initial_investment)}}{\text{Annual [cash inflow](https://www.fiveableKeyTerm:cash_inflow)}}
  • Example: Initial investment of $100,000 with annual cash inflow of$25,000 results in a payback period of 4 years ($100,000 ÷$25,000)
• Uneven cash flows arise when the annual cash inflows fluctuate from year to year
  • Determine the cumulative cash inflow for each year until it equals or surpasses the initial investment
  • The payback period is the year in which the cumulative cash inflow reaches or exceeds the initial investment
  • If the cumulative cash inflow exceeds the initial investment within a given year, apply interpolation to calculate the fraction of the year needed to attain the initial investment
  • Example: Initial investment of $150,000 with cash inflows of$50,000, $60,000, and$70,000 in years 1, 2, and 3, respectively. The cumulative cash inflow exceeds the initial investment in year 3, so the payback period is between 2 and 3 years
• Cash flow analysis is crucial for accurate payback period calculations, especially for projects with uneven cash flows

Accounting rate of return application

• Accounting rate of return (ARR) evaluates the profitability of an investment using accounting income
  • ARR formula: \text{ARR} = \frac{\text{[Average annual income](https://www.fiveableKeyTerm:Average_Annual_Income)}}{\text{[Average investment](https://www.fiveableKeyTerm:Average_Investment)}}
  • Average annual income calculation: $\frac{\text{Total income over the investment's life}}{\text{Number of years}}$
  • Average investment calculation: \frac{\text{Initial investment} + \text{[Salvage value](https://www.fiveableKeyTerm:Salvage_Value)}}{2}
• Investments with higher ARR values are considered more profitable
• ARR advantages:
  • Simple to calculate and interpret
  • Utilizes readily accessible accounting data
• ARR limitations:
  • Fails to consider the time value of money
  • Disregards the timing of cash flows
• Example: An investment with an initial cost of $200,000, a salvage value of$50,000, and a total income of $375,000 over 5 years has an ARR of 30$75,000 ÷ $125,000)
• ARR is often used as a measure of return on investment (ROI) in capital budgeting decisions

Non-time value methods comparison

• Non-time value methods, such as payback period and accounting rate of return, do not account for the time value of money in capital budgeting decisions
• Advantages of non-time value methods:
  • Straightforward calculations and easy to understand
  • Offer a quick evaluation of an investment's profitability
  • Suitable for smaller investments or when the timing of cash flows is less significant (short-term projects)
• Limitations of non-time value methods:
  • Neglect the time value of money, potentially leading to suboptimal decisions
  • Fail to consider the size and timing of cash flows
  • May not fully capture the economic life of an investment (long-term projects)
• Despite their limitations, non-time value methods can serve as complementary tools in capital budgeting decisions, particularly when used alongside time value methods like net present value (NPV) and internal rate of return (IRR)
  • Example: Using payback period to identify investments with quick recovery of initial costs, then applying NPV to select the most profitable option among those with acceptable payback periods

Additional Considerations in Capital Investment Decisions

• Risk assessment: Evaluate potential uncertainties and their impact on project outcomes
• Opportunity cost: Consider the potential returns from alternative investments when making decisions
• Capital rationing: Allocate limited financial resources among competing investment opportunities to maximize overall returns