Good morning everyone. Today we’re going to look at investment appraisal, which is a way businesses decide whether an investment project is worth doing or not. Think of it like this: if a company is planning to buy a new machine, open a new store, or launch a new product, it needs to know whether that investment will bring in enough money to make it worthwhile.
There are many methods used for investment appraisal, but today we’ll focus on two basic ones — the Payback Period and the Accounting Rate of Return, or ARR. These methods are simple and widely used, especially when businesses need quick and easy comparisons between projects.
Let’s start with the Payback Period. This method tells us how long it takes for an investment to recover its initial cost from the cash inflows it generates. In other words, it answers the question, “How quickly will we get our money back?”
For example, imagine a business spends fifty thousand dollars on a new machine. The machine is expected to bring in fifteen thousand dollars in the first year, twenty thousand in the second, and twenty-five thousand in the third. By the end of year two, the business has recovered thirty-five thousand dollars. That means there are fifteen thousand still to recover. In year three, the machine brings in twenty-five thousand, which is more than enough. So the payback period is two years and about six-tenths of a year, or roughly two years and seven months.
The shorter the payback period, the better, especially for businesses in fast-moving industries like technology, where products can become outdated quickly. The main advantages of this method are that it’s simple to use, easy to understand, and focuses on cash flow. But it also has some weaknesses. It ignores any cash inflows that happen after the payback period and it doesn’t consider the time value of money — meaning that it treats all money as equal, no matter when it’s received. It also doesn’t show how profitable the project actually is.
Now let’s move to the second method, the Accounting Rate of Return, or ARR. While the payback method focuses on cash flow, ARR focuses on profitability. It measures the average annual accounting profit from the investment as a percentage of the initial investment.
Let’s take an example. Suppose a business invests one hundred thousand dollars in equipment that will last four years. The expected profits are ten thousand in year one, fifteen thousand in year two, twenty thousand in year three, and twenty-five thousand in year four. Altogether that’s seventy thousand dollars of total profit over four years. The average annual profit is seventeen thousand five hundred.
Now, to calculate ARR, we take that average profit and divide it by the average investment. Since there’s no residual value in this example, the average investment is simply the initial one hundred thousand dollars. So ARR equals seventeen thousand five hundred divided by one hundred thousand, which is 17.5 percent.
This tells the business that the project is expected to generate an average return of 17.5 percent each year. The higher the ARR, the better the investment looks.
The good thing about ARR is that it focuses on profitability and uses familiar accounting figures that managers already understand. However, it also has some weaknesses. Like the payback method, it ignores the timing of profits and the time value of money. It also relies on accounting profits, which can be affected by things like depreciation or different accounting policies.
To sum up, both Payback and ARR are useful for basic investment decisions. The Payback Period helps you understand how quickly you’ll recover your investment, while ARR helps you see how profitable the project might be in percentage terms.
However, neither method gives a full picture because they both ignore the time value of money and long-term profitability. That’s why businesses often use these methods as a starting point and then move on to more advanced techniques like Net Present Value, or Internal Rate of Return, for deeper analysis.
