Investment appraisal: payback and average rate of return

Net cash flows

Each method starts from the initial cost (an outflow in year 0) and the forecast net cash flow for each year: cash inflows (revenue from the project) minus cash outflows (running costs). The cumulative cash flow is the running total, starting from minus the initial cost.

Payback period

The payback period is the time taken for net cash inflows to repay the initial cost.

If payback falls part-way through a year: payback = years before + (amount still to recover / net cash flow of the next year) x 12 months.

Example: cost $200,000; net cash flows years 1 to 5: $50,000, $60,000, $70,000, $60,000, $40,000. Cumulative inflows: $50,000, $110,000, $180,000, $240,000, $280,000. After 3 years $180,000 has been recovered; $20,000 remains, out of year 4's $60,000. Months = 20,000 / 60,000 x 12 = 4. Payback = 3 years 4 months.

Strengths: simple; focuses on how quickly cash returns, which matters to firms with weak liquidity and in fast-changing markets where later forecasts are unreliable.

Weaknesses: ignores cash flows after payback, so it ignores overall profitability; ignores the time value of money.

Average rate of return (ARR)

ARR = (average annual profit / initial investment) x 100, where:

• total profit = total net cash inflows - initial cost;
• average annual profit = total profit / number of years.

Example: total inflows $280,000 - cost $200,000 = profit $80,000. Average = 80,000 / 5 = $16,000 a year. ARR = 16,000 / 200,000 x 100 = 8%.

Compare the ARR with the firm's target return or with the interest rate on borrowing (the opportunity cost of the money).

Strengths: uses all the cash flows; gives a percentage that is easy to compare.

Weaknesses: ignores timing, so $1 in year 5 counts the same as $1 in year 1; ignores the time value of money.

Limitations of investment appraisal

• All the figures are forecasts; the further ahead, the less reliable, and managers may be over-optimistic.
• Ignores qualitative factors: fit with objectives and strategy, effect on staff and brand, ethical and environmental impact, risk.
• Results depend on assumptions about costs, prices and the economy.

In the exam, always interpret: compare projects, compare with targets, and add qualitative points.

Worked example

A project costs $120,000. Net cash flows for years 1 to 5 are $30,000, $40,000, $40,000, $40,000, $30,000. Calculate the payback period and the ARR.

1. Cumulative: $30,000, $70,000, $110,000, $150,000, $180,000.
2. After 3 years $110,000 recovered; $10,000 left of year 4's $40,000: 10,000 / 40,000 x 12 = 3 months. Payback = 3 years 3 months.
3. Profit = 180,000 - 120,000 = $60,000; average = $12,000 a year.
4. ARR = 12,000 / 120,000 x 100 = 10%.

Answer: Payback 3 years 3 months; ARR 10%.

Check yourself

1. A project costs $200,000. Net cash flows for years 1 to 5 are $50,000, $60,000, $70,000, $60,000, $40,000. Calculate the payback period in years, as a decimal to 2 decimal places.
   Show answer

   3.33 years. After 3 years $180,000 is recovered; 20,000 / 60,000 = 0.33 of year 4. Payback = 3.33 years (3 years 4 months).

2. For the same project (cost $200,000, net cash flows $50,000, $60,000, $70,000, $60,000, $40,000), calculate the ARR.
   Show answer

   8.00 %. Profit 280,000 - 200,000 = 80,000; average 16,000; ARR = 16,000 / 200,000 x 100 = 8%.

3. A machine costs $90,000 and gives net cash flows of $40,000, $30,000, $25,000, $20,000 in years 1 to 4. Calculate the payback period in months.
   Show answer

   33.6 months. After 2 years $70,000 is recovered; $20,000 remains of year 3's $25,000: 20,000 / 25,000 x 12 = 9.6 months. Total = 24 + 9.6 = 33.6 months.

4. For the same machine (cost $90,000, net cash flows $40,000, $30,000, $25,000, $20,000), calculate the ARR to 2 decimal places.
   Show answer

   6.94 %. Profit = 115,000 - 90,000 = 25,000; average over 4 years = 6,250.00; ARR = 6.94%.

5. Which is a weakness of the payback method?
   • It is difficult to calculate
   • It uses every cash flow over the project's life
   • It ignores cash flows that arrive after the payback period
   • It gives the answer as a percentage
   Show answer

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

6. A project has an ARR of 9%. The firm can borrow at 11%. What does this suggest?
   • The project does not cover the cost of borrowing, so it may be rejected on financial grounds
   • The project should definitely go ahead
   • The payback period must be short
   • The project has a positive net present value
   Show answer

   The project does not cover the cost of borrowing, so it may be rejected on financial grounds. The return is below the opportunity cost of the money.

7. Which is a qualitative factor in an investment decision?
   • The payback period
   • The ARR
   • The effect of the new machinery on staff morale
   • The initial cost
   Show answer

   The effect of the new machinery on staff morale. Qualitative factors cannot easily be measured in money.

8. Explain why a business with cash flow problems might prefer payback to ARR when choosing between projects.
   Show answer

   Payback shows how quickly the initial cost is recovered, so a firm short of cash can choose the project that returns its money fastest, improving liquidity and reducing risk.. Payback measures speed of return; link to liquidity or risk.

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Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Business specification (XBS11/YBS11, 2018), Unit 3 Business decisions and strategy and Appendices 6, 7 and 9

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