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

• 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 investment with $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: $ARR = \frac{Average Annual Net Income}{Initial Investment} \times 100%$
• Computation steps:
  1. Calculate total net income over project life
  2. Determine average annual net income
  3. Divide average annual net income by initial investment
  4. 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 investment, $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