Traditional Techniques

AVERAGE RATE OF RETURN

Computation: - The average rate of return (ARR) method of evaluating proposed capital
expenditure is also known as the accounting rate of return method. It is based upon accounting
information rather than cash flows. There is no unanimity regarding the definition of the rate of
return. There are a number of alternative methods for calculating the ARR. The most common usage
of the average rate of return (ARR) expresses it as follows:

 The average profits after taxes are determined by adding up the after-tax profits expected
for each year of the project’s life and dividing the result by the number of years. In the case
of annuity, the average after-tax profits are equal to any year’s profits.
 The average investment is determined by dividing the net investment by two. This averaging
process assumes that the firm is using straight line depreciation, in which case the book
value of the asset declines at a constant rate from its purchase price to zero at the end of its
depreciable life. This means that, on the average, firms will have one-half of their initial
purchase price in the books.
 If the machine has salvage value, then only the depreciable cost (cost-salvage value) of the
machine should be divided by two in order to ascertain the average net investment, as the
salvage money will be recovered only at the end of the life of the project. Therefore, an
amount equivalent to the salvage value remains tied up in the project throughout its life
time. Hence, no adjustment is required to the sum of salvage value to determine the
average investment.
 Likewise, if any additional net working capital is required in the initial year which is likely to
be released only at the end of the project’s life, the full amount of working capital should be
taken in determining relevant investment for the purpose of calculating ARR. Thus,

For instance, given the information: initial investment (purchase of machine) - Rs 11,000, salvage
value - Rs 1,000, working capital - Rs 2,000, service life (years) - 5 and that the straight line method
of depreciation is adopted.
Average investment is: Rs 2,000 + Rs 1,000 + 1/2 (Rs 11,000 – Rs.1,000) = Rs 8,000
Example:
Accept-reject Rule:
With the help of the ARR, the financial decision maker can decide whether to accept or reject the
investment proposal.
 As an accept-reject criterion, the actual ARR would be compared with a predetermined or a
minimum required rate of return or cut-off rate.
 A project would qualify to be accepted if the actual ARR is higher than the minimum
desired ARR. Otherwise, it is liable to be rejected.
 Alternatively, the ranking method can be used to select or reject proposals. The alternative
proposals under consideration may be arranged in the descending order of magnitude,
starting with the proposal with the highest ARR and ending with the proposal having the
lowest ARR. Obviously, projects having higher ARR would be preferred to projects with
lower ARR.

Evaluation of ARR:
In evaluating the ARR, as a criterion to select/reject investment projects, its merits and drawbacks
need to be considered.
Merits:
 Simplicity The ARR method is simple to understand and use. It does not
involve complicated computations.
 Accounting data The ARR can be readily calculated from the accounting data;
unlike in the NPV and IRR methods, no adjustments are required to arrive at
cash flows of the project.
 Accounting profitability The ARR rule incorporates the entire stream of
income in calculating the project's profitability.
Demerits:
 Cash flows ignored The ARR method uses accounting profits, not cash flows, in
appraising the projects. Accounting profits are based arbitrary assumptions and
choices and also include non-cash items. It is, therefore, inappropriate to rely on them
for measuring the acceptability of the investment projects.
 Time value ignored The averaging of income ignores the time value of money. In fact,
 this procedure gives more weightage to the distant receipts.
 Arbitrary cut-off The firm employing the ARR rule uses an arbitrary cut-off yardstick.
Generally, the yardstick is the firm's current return on its assets (book-value). Because
of this, the growth companies earning very high rates on their existing assets may reject
profitable projects (i.e., with positive NPVs) and the less profitable companies may
accept bad projects (i.e., with negative NPVs).

PAYBACK (Period) Method

The payback (PB) is one of the most popular and widely recognized traditional

method of evaluating investment proposals.
 Payback is the number of years required to recover the original cash outlay
invested in a project.
 It is the most widely employed, quantitative method for appraising capital expenditure
decisions. This method answers the question: How many years will it take for the cash
benefits to pay the original cost of an investment, normally disregarding salvage value.
 Cash benefits here represent CFAT (Cash Flow After Tax) ignoring interest payment. Thus,
the pay back method (PB) measures the number of years required for the CFAT to pay
back the original outlay required in an investment proposal.
 There are two ways of calculating the PB period.
a. Payback for Constant Cash Flows
b. Payback for Uneven Cash Flows
a) Payback for Constant Cash Flows

This method can be applied when the cash flow stream is in the nature of annuity for each year of
the project’s life, that is, CFAT are uniform. In such a situation, the initial cost of the investment is
divided by the constant annual cash flow.

For example, an investment of Rs 40,000 in a machine is expected to produce CFAT of Rs 8,000 for
10 years, PB = Rs 40,000/Rs 8,000 = 5 years

b) Payback for Uneven Cash Flows

The second method is used when a project’s cash flows are not uniform (mixed stream) but vary
from year to year. In such a situation, PB is calculated by the process of cumulating cash flows till
the time when cumulative cash flows become equal to the original investment outlay. Below
table presents the calculations of pay back period for same example given in ARR.

The initial investment of Rs 56,125 on machine A will be recovered between years 3 and 4. The pay
back period would be a fraction more than 3 years. The sum of Rs 48,000 is recovered by the end of
the third year. The balance Rs 8,125 is needed to be recovered in the fourth year. In the fourth year
CFAT is Rs 20,000. The pay back fraction is, therefore, 0.406 (Rs 8,125/Rs 20,000). The pay back
period for machine A is 3.406 years.

Similarly, for machine B the pay back period would be 2 years and a fraction of a year. As Rs 42,000
is recovered by the end of the second year, the balance of Rs 14,125 needs to be recovered in the
third year. In the third year CFAT is Rs 18,000. The pay back fraction is 0.785 (Rs 14,125/Rs 18,000).
Thus, the PB period for machine B is 2.785 years.

Acceptance Rule:
 Many firms use the payback period as an investment evaluation criterion and a
method of ranking projects. They compare the project's payback with a
predetermined, standard payback.
 The project would be accepted if its payback period is less than the maximum or
standard payback period set by management.
 As a ranking method, it gives highest ranking to the project, which has the shortest
payback period and lowest ranking to the project with highest payback period.
 If the firm has to choose between two mutually exclusive projects, the project with
shorter payback period will be selected

Evaluation of Payback

Payback is a popular investment criterion in practice. Still it is considered to have certain

merits and demerits.
Merits:
 Simplicity: The most significant merit of payback is that it is simple to understand and
easy to calculate. The business executives consider the simplicity of method as a
virtue. This is evident from their heavy reliance on it for appraising investment
proposals in practice.
 Cost effective: Payback method costs less than most of the sophisticated techniques
that require a lot of the analysts' time and the use of computers.
 Short-term effects: A company can have more favorable short-run effects on earnings
per share by setting up a shorter standard payback period. It should, however, be
remembered that this may not be a wise long-term policy as the company may have to
sacrifice its future growth for current earnings.
 Risk shield: The risk of the project can be tackled by having a shorter standard
payback period as it may ensure guarantee against loss. A company has to invest in
many projects where the cash inflows and life expectancies are highly uncertain. Under
such circumstances, payback may become important, not so much as a measure of
profitability but as a means of establishing an upper bound on the acceptable degree
of risk.9
 Liquidity: The emphasis in payback is on the early recovery of the investment. Thus,
it gives an insight into the liquidity of the project. The funds so released can be put
to other uses.
Demerits:
 Cash flows after payback: Payback fails to take account of the cash inflows earned
after the payback period
 As per the payback rule, both the projects are equally desirable since both return
the investment outlay in two years. If we assume an opportunity cost of 10 per cent,
Project X yields a positive net present value of ₹806 and Project Y yields a negative
net present value of ₹530. As per the NPV rule, Project X should be accepted and
Project Y rejected. The payback rule gave wrong results because it failed to consider
₹2,000 cash flow in the third year for Project X.

 Cash flows ignored: Payback is not an appropriate method of measuring the

profitability of an investment project as it does not consider all cash inflows
yielded by the project. Considering Project X again, payback rule did not take into
account its entire series of cash flows.
 Cash flow patterns: Payback fails to consider the pattern of cash inflows, i.e.,
magnitude and timing of cash inflows. In other words, it gives equal weights to
returns of equal amounts even though they occur in different time periods. For
example, compare the following projects C and D where they involve equal cash
outlay and yield equal total cash inflows over equal time periods:

Using payback period, both projects are equally desirable. But Project C should be
preferable as larger cash inflows will come earlier in its life. This is indicated by the
NPV rule; Project C has higher NPV (₹881) than Project D (₹798) at 10 per cent
opportunity cost. It should be thus clear that payback is not a measure of
profitability. As such, it is dangerous to use it as a decision criterion.
 Administrative difficulties: A firm may face difficulties in determining the
maximum acceptable payback period. There is no rational basis for setting a maximum
payback period. It is generally a subjective decision.
 Inconsistent with shareholder value: Payback is not consistent with the
objective of maximizing the market value of the firm's shares. Share values do
not depend on payback periods of investment projects.
Conclusion:
The ARR method continues to be used as a performance evaluation and control
measure in practice. But its use as an investment criterion is certainly undesirable. It
may lead to unprofitable allocation of capital.
Also, It is important to note that the payback is not a valid method for evaluating the
acceptability of the investment projects. It can, however, be used along with the NPV
rule as a first step in screening the projects roughly. In practice, the use of DCF
techniques has been increasing but payback continues to remain a popular and primary
method of investment evaluation.