This lesson examines two traditional, non-discounting methods of investment appraisal. It covers the calculation, decision rules, advantages, and significant limitations of the payback period and accounting rate of return methods.

• The Payback Period Method: The payback period is the time required for a firm to recover its original investment from the project’s cash inflows. It is one of the simplest and most widely used capital budgeting techniques.

• Calculation and Decision Rule: The payback period is calculated by dividing the initial investment by the annual cash inflow (assuming even cash flows). The decision rule is to accept a project if its payback period is less than a predetermined maximum period set by management.

• Advantages of Payback Period: Despite its simplicity, the payback period method continues to be widely used because it provides useful information about a project’s liquidity and risk. It is particularly useful for evaluating projects where liquidity is a primary concern.

• Limitations of Payback Period: The payback method has significant drawbacks:

  • It ignores the time value of money

  • It ignores cash flows that occur after the payback period

  • It does not provide a measure of profitability

• The Accounting Rate of Return (ARR): The accounting rate of return measures the return on a project in terms of accounting income rather than cash flow. It is calculated as average annual net income divided by the average investment.

• Limitations of ARR: The primary disadvantage of the accounting rate of return is that it does not consider the time value of money. It also relies on accounting income, which may be subject to different accounting treatments and does not represent actual cash flow.