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In your own words briefly describe these techniques (payback period, ARR, IRR and NPV), using a simple example to assist your explanation. Detail the advantages and disadvantages of each method, and explain why the techniques which take into account the “time value of money” are considered superior to methods such as the accounting rate of return (ARR) and the payback period.

The payback period (PP)

Generally, the payback period can be defined as the time it takes the cash inflows from a capital investment project to equal the cash outflows, usually expressed in years. When deciding between two or more competing projects, the usual decision is to accept the one with the shortest payback. Payback is often used as a “first screening method”. This means that when a capital investment project is being considered, the first question to ask is: ‘How long will it take to pay back its cost?’ The company might have a target payback, and so it would reject a capital project unless its payback period was less than a certain number of years. For example:

Disadvantages of the payback method:

• It ignores the timing of cash flows within the payback period, the cash flows after the end of payback period and therefore the total project return.
• It ignores the time value of money. This means that it does not take into account the fact that $1 today is worth more than $1 in one year’s time. An investor who has $1 today can consume it immediately or alternatively can invest it at the prevailing interest rate, say 30%, to get a return of $1.30 in a year’s time.
• It is unable to distinguish between projects with the same payback period.
• It may lead to excessive investment in short-term projects.

Advantages of the payback method:

• Payback can be important: long payback means capital tied up and high investment risk. The method also has the advantage that it involves a quick, simple calculation and an easily understood concept.

The accounting rate of return - (ARR)

The ARR method (also called the return on capital employed (ROCE) or the return on investment (ROI) method) of appraising a capital project is to estimate the accounting rate of return that the project should yield. If it exceeds a target rate of return, the project will be undertaken.

Disadvantages of ARR method:

• It does not take account of the timing of the profits from an investment.
• It implicitly assumes stable cash receipts over time.
• It is based on accounting profits and not cash flows. Accounting profits are subject to a number of different accounting treatments.
• It is a relative measure rather than an absolute measure and hence takes no account of the size of the investment.
• It takes no account of the length of the project.
• It ignores the time value of money.

The internal rate of return (IRR)

The IRR is the discount rate at which the NPV for a project equals zero. This rate means that the present value of the cash inflows for the project would equal the present value of its outflows. The IRR is the break-even discount rate. The IRR is found by trial and error.

Economic rationale for IRR: If IRR exceeds cost of capital, project is worthwhile, i.e. it is profitable to undertake.

Disadvantage of IRR:

• It expresses the return in a percentage form rather than in terms of absolute dollar returns, e.g. the IRR will prefer 500% of $1 to 20% return on $100. However, most companies set their goals in absolute terms and not in % terms, e.g. target sales figure of $2.5 million.

Net present value (NPV)

The NPV method is used for evaluating the desirability of investments or projects.

Example of NPV calculation.

PV = $400(0.9091) + $400(0.8264) + $400(0.7513)

= $363.64 + $330.56 + $300.52

= $994.72

NPV = $994.72 - $800.00

= $194.72

Alternatively,

PV of an annuity = $400 (PVFAt.i) (3,0,10)

= $400 (0.9091 + 0.8264 + 0.7513)

= $400 x 2.4868

= $994.72

NPV = $994.72 - $800.00

= $194.72

Advantage of NPV:

• It ensures that the firm reaches an optimal scale of investment.

There are reasons that the techniques that consider time value of money are better. In fact, time value of money is the cornerstone concept of finance which cannot be taken for granted. The concept recognizes the amount of money worth less in the future, due to inflation and opportunity costs. As such, technique that employ the concept of time value of money will yield more accurate outcome in decision making as these techniques also recognize the impact of inflation and cost of capital. To illustrate: Inflation is particularly important in developing countries as the rate of inflation tends to be rather high. As inflation rate increases, so will the minimum return required by an investor. For example, one might be happy with a return of 10% with zero inflation, but if inflation was 20%, one would expect a much greater return.

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