Payback and average (accounting) rate of return

Payback period

Payback is the time taken for cumulative net cash inflows to equal the initial cost.

1. Draw up a table of net cash flows and a running balance (cumulative cash flow), starting with the cost as a negative in year 0.

2. Find the year in which the balance turns positive.

3. For the part year: months = amount still needed / net cash flow of that year x 12 (assuming cash flows evenly).

The June 2022 mark scheme shows, for example, 4 years + 120,000 / 720,000 x 12 = 4 years 2 months.

Strengths: simple, focuses on liquidity and risk (quick recovery is safer). Weaknesses: ignores cash flows after payback and the time value of money (unless discounted payback is used); not a measure of profitability.

Average rate of return (ARR)

ARR = average annual profit / average investment x 100

• Profit, not cash: annual profit = net cash flow - depreciation. (Total profit over the life = total net cash inflows - (cost - residual value).)
• Average investment = (initial cost + residual value) / 2

This is the version used in the June 2022 mark scheme. Examiners report that the formula is often omitted or wrong, so always state it.

Strengths: uses profit, which managers and shareholders understand; percentage easily compared with targets. Weaknesses: ignores the timing of returns and the time value of money; different versions of the formula give different answers.

Worked payback

A machine costs £200,000 and has a residual value of £20,000 after 4 years.

Year 4 includes the residual value

Using all the methods

A good evaluation of a project uses the figures you calculated (payback, ARR, NPV, IRR, PI), compares them with the company's targets and cost of capital, and adds non-financial points: reliability of the estimates, length of the project, effect on staff and customers, environmental issues, the source of finance, and alternatives. Then give a clear recommendation.

Worked example

Calculate the payback period and the ARR for the machine above.

1. After 2 years: (70,000) still to recover, i.e. £70,000
2. Part year: 70,000 / 84,000 x 12 = 10 months, so payback = 2 years 10 months
3. Total profit = 284,000 - 20,000 residual - depreciation 180,000 = £84,000; average = 84,000 / 4 = £21,000
4. Average investment = (200,000 + 20,000) / 2 = £110,000
5. ARR = 21,000 / 110,000 x 100 = 19.09%

Answer: Payback 2 years 10 months; ARR 19.09%

Check yourself

1. A project costs £150,000 and returns net cash flows of £40,000, £50,000, £72,000 and £30,000 in years 1 to 4. Calculate the number of months after year 2 needed to reach payback.
   Show answer

   10 months. After 2 years £90,000 is recovered; £60,000 more is needed: 60,000 / 72,000 x 12 = 10 months.

2. A project costs £96,000 and returns £24,000 a year evenly. Calculate the payback period in years.
   Show answer

   4 years. 96,000 / 24,000 = 4 years.

3. A machine costs £340,000 and has a residual value of £60,000. Calculate the average investment.
   Show answer

   £200000. (340,000 + 60,000) / 2 = £200,000.

4. Average annual profit from a project is £27,000 and the average investment is £180,000. Calculate the ARR.
   Show answer

   15.0 %. 27,000 / 180,000 x 100 = 15%.

5. A machine costs £120,000, has no residual value and lasts 4 years. Net cash inflows total £168,000 over its life. Calculate the ARR (average investment basis) to 2 decimal places.
   Show answer

   20.00 %. Total profit = 168,000 - 120,000 = 48,000; average 12,000; average investment 60,000; ARR = 20.00%.

6. Which is a weakness of the payback method?
   • It is difficult to calculate
   • It uses profit instead of cash
   • It requires a cost of capital
   • It ignores cash flows after the payback period
   Show answer

   It ignores cash flows after the payback period. A project with large later returns may be rejected.

7. Why must depreciation be deducted when calculating ARR, but not NPV?
   • ARR is based on cash; NPV on profit
   • ARR is based on accounting profit; NPV is based on cash flows
   • Depreciation is a cash flow in ARR
   • NPV already discounts depreciation
   Show answer

   ARR is based on accounting profit; NPV is based on cash flows. ARR uses profit; NPV uses cash.

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Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Accounting specification (XAC11/YAC11), Issue 2
• Pearson Edexcel IAL Accounting WAC12 Unit 2 mark scheme, June 2022
• Pearson Edexcel IAL Accounting WAC12 examiners' report, June 2025

Last updated 8 November 2026. Spotted a mistake? Tell us.