Non Discounted Techniques Lecture

Non Discounted Techniques
Payback Period= Net initial cost of investment/Annual net after-tax cash inflows
Advantages:
1. Payback is simple to compute and easy to understand.
2. Payback gives information about the liquidity of the project.
3. It is a good surrogate for risk. A quick or short payback period indicates a less
risky project.
Disadvantages:
1. Payback does not consider the time value of money. All cash received during
the payback period is assumed to be equal value of in analyzing the
project.
2. It gives more emphasis on liquidity rather than on profitability of the project. In
other words, more emphasis is given on return of investment rather than the
return on investment.
3. It does not consider the salvage value of the project.
4. it ignores cash flow that ,ay occur after the payback period (short-sighted)
Bail- Out Method a modified payback period method wherein cash recoveries include
the estimated value at the end of each year of the project life.
Accounting Rate of Return = Average annual net income/ Investment*

*may be based on original or average investment
Advantages:
1. The ARR closely parallels accounting concepts income measurement and
investment return.
2. It facilitates the re-evaluation of projects due to ready availability of data from
the accounting records.
3. This method considers income over the entire life of the project.
4. It indicates and emphasizes the project’s profitability.
Disadvantages:
1. Like traditional payback methods, the ARR method does not consider the time
value of money.
2. With the computation of income and book value based on the historical cost
accounting data, the effect of inflation is ignored.
Other terms used to denote the ARR

- Book value rate of return - Approximate rate of return method
- Unadjusted rate of return - Financial statement rate of return method
- Simple rate of return - Average return on investment
Payback Reciprocal = Net cash inflows/ Investment
= 1/Payback Period
Payback reciprocal is a reasonable estimate of the discounted cash flow rate of return
(a.k.a. IRR) provided that the following conditions are met.
1. The economic life of the project is at least twice the payback period.
2. The net cash inflows are constant (uniform) throughout the life of the project.
Discounted Techniques
The time value of money is an opportunity cost concept. A peso on hand today is
worth more than a peso to be achieved tomorrow because of interests a peso could earn
by pitting it in a savings account or placing it in an investment that earns income. The
time value of money is usually measured by using a discount rate that is implied to be the
interest forgone by receiving funds at a later time.
Net Present Value (NPV)= Present value of cash inflows – Present value of cash
outflows
- Cash inflows include cash infused by the capital investment project on a

regular basis (e.g. annual cash inflow) and cash realizable at the end of the
capital investment project (e.g. salvage value, return of working capital
requirements)
- The net investment cost required at the inception of the project usually
represents present value of the cash outflows.
Advantages:
1. Emphasizes cash flows.
2. Recognizes time value of money.
3. Assumes discount rate as reinvestment rate
Disadvantages:
1. It requires determination of the costs of capital or the discount rate to be used.
2. The net present value of different competing projects may not be comparable
because of differences in magnitudes or sizes of the projects.
Profitability Index = Present value of cash inflows / Present value of cash outflows
NPV index = NPV / Investment
The profitability index method is designed to provide a common basis of ranking

alternatives that require different amounts of investment.
Other names:
Desirability index, present value index, and benefit cost ratio.
Internal Rate of Return (IRR) = is the rate of return that equates the present value of
cash inflows to present value of cash outflows. It is also known as discounted cash flow
rate of return, time-adjusted rate of return or sophisticated rate of return.
Guidelines in determining IRR:

1. Determine the present value factor (PVF) for the internal rate of return (IRR) with the
use of the following formula:
PVF for IRR = Net investment cost / Net cash inflows
2. Using the present value annuity table, find on line ‘n’ (economic life) the PVF
obtained in No.1. The corresponding rate is the IRR. If the exact rate is not found on the
PVF table, ‘interpolation’ process may be necessary/
Advantages:
1. Emphasizes cash flows
2. Recognizes the time value of money
3. Computed true return of project
Disadvantages:
1. Assumes that IRR is the re-investment rate.
2. When project includes negative earnings during its life, different rates of return may
result.

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Non Discounted Techniques

Accounting Rate of Return = Average annual net income/ Investment*

Other terms used to denote the ARR

- Cash inflows include cash infused by the capital investment project on a

NPV index = NPV / Investment

The profitability index method is designed to provide a common basis of ranking

Guidelines in determining IRR:

PVF for IRR = Net investment cost / Net cash inflows

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