Financial Management & Cost Accounting

Module 5. Investment decision

Lesson 28
PAY BACK PERIOD, ACCOUNTING RATE OF RETURN METHOD

28.1 Payback Period

Simple method of ranking a project is the length of time required to get back the investment on the project. The payback period of the project is estimated by using the straight forward formula:

P = I/E

.........(Eq. 28.1)

Where,

P = Payback period of the project in years,

I = Investment of the project in rupees, and

E = Annual net cash revenue in rupees.

The preference of a particular project is based on the lesser payback period. This is shown in Table 8.1

Table 28.1 Calculation of Payback Period

Initial investment = Rs.20,000

Year	Cash Flow (in Rs)
	Project ‘A’	Project ‘B’
0	-20,000	-20,000
1	5,000	4,000
2	5,000	4,000
3	5,000	4,000
4	5,000	4,000
5	5,000	4,000
6	5,000	4,000

Project 'A' = Rs. 20000/ Rs. 5000 = 4 years

Project 'B' = Rs. 20000/ Rs. 4000 = 5 years

It is inadequate to exercise the option among the alternatives, because it fails to consider very important points like, consistency of running, timing of the proceeds, returns after the payback period and whether the cash-flows would be positive or negative in future.

28.1.1 Proceeds per rupee of outlay

This is worked out by dividing the total proceeds with the total amount of investment, and a given project is ranked based on the highest magnitude of the parameter.

28.1.2 Average annual proceeds of rupee outlay

This is another simple choice criterion and in this procedure, total receipts are first divided by the project life span and the average proceeds obtained per year are divided by the initial investment on the project. Here too, ranking is given to the projects, based on the highest magnitude of the estimate.

The major drawback with undiscounted measures is that for the same data of the project, we get different rankings; hence, choice process becomes useless. Rankings by these methods are inconsistent and incompatible.

28.1.3 Discounted measures

Cash flows are yearly net benefits accrued from the project. It they are weighted by discount rate, they become discounted cash flows. These discounted cash flows are the best estimates to decide on the worth of the project. This approach will give the Net Present Worth of the project. The present worth of the costs is subtracted from the present worth of the benefits in order to arrive at the Net Present Worth of the project every year.

28.1.3.1 Measurement of the cash flows of the project

From the annual stream of gross benefits of the project, the capital invested and the other input costs like labour, machinery, fertilizers, pesticides, management, etc., are deducted. From the residual, the return of capital and return on capital or return to capital, i.e., recovering investment made in the project (depreciation) and compensation for the use of money (interest) are computed. This residual is called cash flow of the project. In financial analysis the cash flow is the net incremental benefit of the project. But, in accounting, the term implies the sum of cash flows of projects plus depreciation allowance. The concept of cash flow in the financial analysis includes, both return of capital and return to capital. We generally do not resort to deduction of depreciation, i.e., allowance of return of capital or interest in the economic analysis, because our analytical technique automatically takes care of return of capital in determining the worth of the project. In economic analysis, income taxes, sales taxes, custom duties are only transfer payments, but not payments used in the production process. Hence, from the gross returns these are not deducted. But, in financial analysis, taxes are a cost, which the individual must pay before arriving at the recovered capital, and compensating it for the use of capital.

By far, financial analysis aims at estimation of returns to all resources employed in the project. Hence, borrowed capital is considered as a benefit received, while, its interest is considered as a cost and it is deducted from the gross returns. In economic analysis, this consideration is ruled out because of the assumption, that all the resources employed in the project belong to someone or the other, within the society. In the economic analysis, it is important that the prices of some of the inputs must be shadow prices. In financial analysis all prices are market prices and they must include taxes and subsidies. For vivid distinction between cash flows in the economic analysis vis-à-vis financial analysis (Gittinger, 1976) may be referred.

ACCOUNTING RATE OF RETURN

The accounting rate of return, also called the average rate of return, is defined as

_____Profit after Tax_____

Book Value of the investment

The numerator of this ratio may be measured as the average annual post – tax profit over the life of the investment and the denominator is the average book value of fixed assets committed to the project. To illustrate the calculation, consider a project :

Year	Book value of fixed investment	Profit after tax
1	90,000	Rs. 20,000
2	80,000	22,000
3	70,000	24,000
4	60,000	26,000
5	50,000	28,000

The accounting rate of return is:

Obviously, the higher the accounting rate of return, the better the project. In general, projects which have an accounting rate of return equal to or greater than a pre-specified cut – off rate of return – which is usually between 20 percent and 30 percent – are accepted ; other are rejected.

Evaluation

Traditionally a popular investment appraisal criterion, the accounting rate of return has the following virtues.

• It is simple to calculate.
• It is based on accounting information which is readily available and familiar to businessman.
• While it considers benefits over the entire life of the project, it can be used even with limited data. As one executive put it: " The discounted cash flow methods calls for estimates of costs and revenues over the whole project life. this is difficult. Very often we can't estimate the life. We have been using machines longer than their life by good maintenance. Changes in costs and revenues cannot be predicted. Due to these difficulties we use the accounting rate of return. Here we take our best estimates for 2 – 3 years and calculate the average return. Once the project is established, the balance between cost and revenue can be maintained in normal circumstances."

Its shortcomings, however, seem to be considerable:

• It is based upon accounting profit, not cash flow.
• It does not take into account the time value of money. To illustrate this point, consider two investment proposals. A and B, each requiring an outlay of Rs. 100,000. Both the proposals have an expected life of 4 years after which their salvage value would be nil.

	A				B
Year	Book Value	Depre-ciation	Profit after tax	Cash Flow	Book Value	Depre-ciation	Profit after tax	Cash flow
0	100,000	0	0	(100,000)	100,000	0	0	(100,000)
1	75,000	25,000	40,000	75,000	75,000	25,000	10,000	35,000
2	50,000	25,000	30,000	50,000	50,000	25,000	20,000	45,000
3	25,000	25,000	20,000	25,000	25,000	25,000	30,000	55,000
4	0	25,000	10,000	0	0	25,000	40,000	65,000

Both the proposals, with an accounting rate of return equal to 40 percent, look alike from the accounting rate of return point of view, through project A, because it provides benefits earlier, is much more desirable. While the payback period criterion gives no weightage to more distant benefits, the accounting rate of return criterion seems to give them too much weight age.

• The accounting rate of return measure is internally inconsistent. While the numerator of this measure represents profit belonging to equity and preference stockholders its denominator represents fixed investment which is rarely, if ever, equal to the contribution of equity and preference stockholders.

• The accounting rate of return does not provide any guidance on what the target rate of return should be.