Accounts and Finance

Investment Appraisal: Payback Period

What is investment?TASK:

Write your own definition of

‘investment’ in your workbook.

Provide at least 3 examples of investment.

Definition Investment refers to the purchase of an

asset with the potential to yield financial benefits

What’s ‘yield’?Yield: the

rate of return

Investment Appraisal The term that refers to the techniques used

to calculate financial costs and benefits of an investment decision

Four main methods of investment appraisal:1. Payback Period2. Accounting Rate of Return3. Discounted Cash Flow4. Net Present Value

Payback Period The payback period refers to the

period of time to repay the cost of the initial investment

Calculation:initial investment ($)

contribution per month ($)

The amount you expect this

investment to make each month

(after maintenance/taxe

s/etc)

Let’s try it... Calculation:

initial investment ($)contribution per month ($)

Scenario: a firm thinks about buying a new truck. It will cost $10 000 to buy. After insurance, servicing, and running costs, it is anticipated that the truck will make the firm $6000 per year ($500 per month). We work the payment period out like this:

$10 000$500

PAYBACK PERIOD = 20mths

Is it worth it?

Firms will mostly only undertake investment projects if the payback period is relatively short.

That is, there is no point in investing in something if it will be obsolete before the payback period.

Advantages

Simple and quick Good for firms who have cash flow problems; allows

them to easily see when they will regain money Firms can see if they will break-even on a purchase

before it needs to be replaced Different projects and their costs can be easily

compared Allows a firm to see what investment will get a good

return for shareholders Less room for error ad the assessment is only for

short term

Disadvantages

May create a situation that encourages managers to only consider short term benefits when really they should be considering the long term benefits as well

Contribution per month is unlikely to remain constant, due to changes in demand pattern. This could result in the payback period being longer than first anticipated

Focuses on time rather than profit, and profit is the main aim of most businesses

MORE HOMEWORK:Complete Question

3.2.1 on page 351 of your textbook. Write your answers in your workbook using full

sentences.

HOMEWORK: Finish table of Payback Period

Adv/Disadv

2. Accounting rate of return This method calculates the average profit on an investment as a %

of the amount invested. The formula: APR = total profits during projects / number of years of

projects x100 initial amount invested ($)

Why is this useful? The APR allows you the manager, to compare the rates of

returns on other investment projects. Used to assess the risks and rewards involved in an

investment. For example: if an APR is 12% on a project vs. 4% in interest rate on

savings, the real rate of return is 8%. So it might be worth the risk to invest on the project vs. to saving your money.

Accounting rate of return

Advantages disadvantages

Enables easy comparisons of different investment projects. You are looking for

the investment which provides the most return for less money invested.

It ignores the timing of cash inflows.

Prone to forecasting errors.

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