Pay Back Method:
Under this method the pay back period of each project/ investment proposal is calculated. The investment proposal, which has the least pay back period is considered profitable. Actual pay back period is compared with the standard one. If actual pay back period is less than the standard, the project will be accepted and in case, actual payback period is more than the standard pay back period, the project will be rejected. Thus, the project with the least payback period is considered profitable.
“Pay Back Period is the number of year required for the original investment to be recouped.
For eg, if the investment required for a project is Rs 20,000 and it is likely to generate cash flow of Rs 10,000 for 5 years, its payback period will be 2 years.
It means that investment will be recovered in first 2 year of the project.
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There are two methods of calculating payback period. First method is used when cash flows remains the same during the life time of the project. In such a case payback (PB) is calculated as under:-
INVESTMENT CO
PB = _______________________ =___
CONSTANT ANNUAL CASH FLOW C
For eg, if the investment for a machinery is Rs 50,000 and it will generate Rs 10,000 such year for 10 years, then its Pay Back period will be:-
Rs 50000
PB = _________ = 5 Years
Rs 10000
For the pay back period of 5 years, it can be observed that the investment of Rs 50,000 will be recovered by the business in 5 years.
ACCEPTANCE RULE
Accept if PB standard pay back.
MERITS
Easy to understand and compute.This method follows short terms view point, as a result, the obsolescence are minimum.Emphasis liquidility, therefore useful for the companies which faces the problem of liquidity. Such companies will invest their funds in such projects in which investment can be recovered in minimum time.Used to find out internal Rate of Return.Suitable for those organisations which emphasise on short-term investments rather than long terms development.Uses cash flow information.Easy and crude way to cope with risk.
Demerits
Ignores the value of money.Ignores the cash flows occurring after the pay back period. Thus does not take into account the whole profitability of the project. For eg: investment in a project is Rs 50,000. Its life 10 years and cash flows every year are Rs 10,000. Then its Pay back period will be 5 years. But the cash inflows of Rs 50,000 during the last 5 years have been taken into account.No objective way to determine the standard payback.This method also does not take into account the time value of money. The time value of money is the interest on investment. The payback period of two projects may be the same but a project may get more CFAT in the initial years and less in the later years. In such a case the cash flows in the initial years can fetch additional income of interest. Such a project may become more profitable than the others. But this method ignores this fact.This method does not take into account the total life time of the project.No relation with the wealth maximisation principle.not a measure of profitability.
II. Average Rate of Return Method: This method is also called Accounting Rate of Return Method. This method is based on accounting information rather than cash flows. There are various ways of calculating Average Rate of Return. It can be calculated as:-
Average annual Profit after Tax
ARR = ___________________________X100
Average Investment
Average Annual Profit = Total of after tax profit of all the year
___________________________
No. Of years
Average Investment = Original Investment + Salvage Value
________________________________
2
or Original Investment – Salvage Value
________________________________ + Salvage Value
2
If working Capital is also required in the initial year of the project, the average investment will be= Net working Capital + Salvage value + ½ (initial cost of Machine- Salvage Value).
In another method instead of average investment original cost is used.
In this method, to evaluate the project all those projects are accepted on which average rate of return is more than the predetermined rate. Thus, the project is given more significant on which the average rate of return is the highest.
