Capital budgeting evaluation methods help businesses make smart investment decisions. Two key methods are payback period and accounting rate of return (ARR). These tools assess how quickly investments pay off and their overall profitability .
While payback period focuses on recovering initial costs, ARR looks at long-term returns. Both have pros and cons. Understanding these methods helps managers choose the best projects for their company's goals and risk tolerance.
Capital Budgeting Evaluation Methods
Payback period calculation and interpretation
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Payback period measures time required to recover initial investment in years or months
Calculation method varies for even cash flows (Initial investment / Annual cash inflow ) and uneven cash flows (Cumulative cash inflows until recovery)
Shorter payback periods preferred, compared against company's maximum acceptable period (3-5 years)
Decision rule accepts projects with shorter periods than maximum, rejects longer ones
Example: 100 , 000 i n v e s t m e n t w i t h 100,000 investment with 100 , 000 in v es t m e n tw i t h 25,000 annual cash inflow has 4-year payback period
Limitations of payback period method
Ignores time value of money , disregarding future cash flows ' present value
Disregards cash flows after payback period, potentially overlooking long-term profitability
Doesn't consider overall profitability or return on investment
Biased towards short-term projects, potentially rejecting valuable long-term investments
Fails to account for risk differences between projects (high-risk vs low-risk)
Difficulty setting appropriate maximum payback period across diverse industries
Not suitable for comparing projects with different lifespans (5-year vs 10-year projects)
Accounting rate of return computation
ARR measures profitability based on average annual income and initial investment
Calculation: A R R = [ A v e r a g e A n n u a l N e t I n c o m e ] ( h t t p s : / / w w w . f i v e a b l e K e y T e r m : a v e r a g e a n n u a l n e t i n c o m e ) I n i t i a l I n v e s t m e n t × 100 % ARR = \frac{[Average Annual Net Income](https://www.fiveableKeyTerm:average_annual_net_income)}{Initial Investment} \times 100\% A RR = I ni t ia l I n v es t m e n t [ A v er a g e A nn u a lN e t I n co m e ] ( h ttp s : // www . f i v e ab l eKey T er m : a v er a g e a nn u a l n e t i n co m e ) × 100%
Computation steps:
Calculate total net income over project life
Determine average annual net income
Divide average annual net income by initial investment
Express result as percentage
Higher ARR indicates better profitability, compared to company's required rate of return (15%)
Decision rule accepts projects with ARR higher than required rate, rejects lower ones
Example: 100 , 000 i n v e s t m e n t , 100,000 investment, 100 , 000 in v es t m e n t , 20,000 average annual income yields 20% ARR
Payback period vs ARR analysis
Time focus: Payback period short-term oriented, ARR considers entire project life
Profitability: Payback period ignores, ARR focuses on overall profitability
Cash flow vs accounting income : Payback period uses cash flows, ARR uses accounting income
Time value of money: Both methods ignore, potential drawback in long-term decisions
Calculation complexity: Payback period generally simpler, ARR requires more steps
Decision criteria: Payback period based on recovery time, ARR on percentage return
Risk consideration: Payback period indirectly considers through shorter periods, ARR doesn't explicitly account for risk
Example: Project A (2-year payback, 18% ARR) vs Project B (3-year payback, 22% ARR) highlights trade-offs