Payback Period And Average Rate Of Return 6b58

INDEX SR NO 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19

PARTICULARS Payback period-Introduction Purpose Construction Short comings Shortcut method Limitations Breanking down of payback period Capital budgeting and payback period Discounting Advantages and disadvantages Different formulae to calculate payback period Average rate of return Drawbacks ing of ARR Advantages and disadvantages of ARR Cost benefit analysis –payback and ARR How to calculate payback period and ARR Conclusion Bibliography

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Payback Period And Average Rate Of Return

Payback period Introduction; Payback period in capital budgeting refers to the period of time required to recoup the funds expended in an investment, or to reach the break-even point. For example, a Rs1000 investment made at the start of year 1 which returned Rs500 at the end of year 1 and year 2 respectively would have a two-year payback period in capital budgeting refers to the period of time required to recoup the funds expended in an investment, or to reach the break-even point. For example, a Rs1000 investment made at the start of year 1 which returned Rs500 at the end of year 1 and year 2 respectively would have a two-year payback period. Payback period is usually expressed in years. Starting from investment year by calculating Net Cash Flow for each year: Net Cash Flow Year 1 = Cash Inflow Year 1 Cash Outflow Year 1. Then Cumulative Cash Flow = (Net Cash Flow Year 1 + Net Cash Flow Year 2 + Net Cash Flow Year 3, etc.) Accumulate by year until Cumulative Cash Flow is a positive number: that year is the payback year. The time value of money is not taken into . Payback period intuitively measures how long something takes to "pay for itself." All else being equal, shorter payback periods are preferable to longer payback periods. Payback period is popular due to its ease of use despite the recognized limitations described below. The term is also widely used in other types of investment areas, often with respect to energy efficiency technologies, maintenance, upgrades, or other changes. For example, a compact fluorescent light bulb may be described as having a payback period of a certain number of years or operating hours, assuming certain costs. Here, the return to the investment consists of reduced operating costs. Although primarily a financial term, the concept of a payback period is occasionally extended to other uses, such as energy payback period (the period of time over which the energy savings of a project equal the amount of energy expended since project inception); these other may not be standardized or widely used. Purpose :Payback period as a tool of analysis is often used because it is easy to apply and easy to understand for most individuals, regardless of academic training or field of endeavor. When used carefully or to compare similar investments, it can be quite useful. As a stand-alone tool to compare an investment to "doing nothing," payback period has no explicit criteria for decisionmaking (except, perhaps, that the payback period should be less than infinity). 2

The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not for the time value of money, risk, financing, or other important considerations, such as the opportunity cost. Whilst the time value of money can be rectified by applying a weighted average cost of capital discount, it is generally agreed that this tool for investment decisions should not be used in isolation. Alternative measures of "return" preferred by economists are net present value and internal rate of return. An implicit assumption in the use of payback period is that returns to the investment continue after the payback period. Payback period does not specify any required comparison to other investments or even to not making an investment. Construction: Payback period is usually expressed in years. Start by calculating Net Cash Flow for each year: Net Cash Flow Year 1 = Cash Inflow Year 1 - Cash Outflow Year 1. Then Cumulative Cash Flow = (Net Cash Flow Year 1 + Net Cash Flow Year 2 + Net Cash Flow Year 3, etc.) Accumulate by year until Cumulative Cash Flow is a positive number: that year is the payback year. To calculate a more exact payback period: Payback Period = Amount to be Invested/Estimated Annual Net Cash Flow.[2] It can also be calculated using the formula: Payback Period = (p - n)÷p + ny = 1 + ny - n÷p (unit:years)

Where ny= The number of years after the initial investment at which the last negative value of cumulative cash flow occurs n= The value of cumulative cash flow at which the last negative value of cumulative cash flow occurs. p= The value of cash flow at which the first positive value of cumulative cash flow occurs. This formula can only be used to calculate the soonest payback period; that is, the first period after which the investment has paid for itself. If the cumulative cash flow drops to a negative value some time after it has reached a positive value, thereby changing the payback period, this formula can't be applied. This formula ignores values that arise after the payback period has been reached.

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Additional complexity arises when the cash flow changes sign several times; i.e., it contains outflows in the midst or at the end of the project lifetime. The modified payback period algorithm may be applied then. First, the sum of all of the cash outflows is calculated. Then the cumulative positive cash flows are determined for each period. The modified payback is calculated as the moment in which the cumulative positive cash flow exceeds the total cash outflow. Short comings: Payback period doesn't take into consideration the time value of money and therefore may not present the true picture when it comes to evaluating cash flows of a project. This issue is addressed by using DPP, which uses discounted cash flows. Payback also ignores the cash flows beyond the payback period. Most major capital expenditures have a long life span and continue to provide cash flows even after the payback period. Since the payback period focuses on short term profitability, a valuable project may be overlooked if the payback period is the only consideration. The payback period method (PBP) of capital budgeting calculates the time it takes to recover the initial cost of an investment. There are two approaches--the short cut method and the unequal cash flow method---both of which base their calculations on annual net cash flows (cash outflows minus cash inflows). As is true with NPV and IRR, each year may have different cash flow amounts. Short Cut Method When the amounts of annual operating cash flows expected from a potential capital asset acquisition are equal each year, the following short cut calculation can be used to determine the payback period: Payback period

=

Initial investment Annual operating cash flow amount

The payback period indicates how long it will take to recover the cash investment used to acquire the asset. The answer is expressed in years. Unequal Cash Flows Method When the dollar amount of operating cash flows are not expected to be the same amount each year, you must take a longer approach. In essence, you begin with the acquisition cost---the amount to be recovered, and subtract the expected cash flows for each year until you get to the point in time at which you have recovered all of the cash. Begin with the amount of cash used to purchase the investment and subtract the cash inflows for the first year:

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Amount to recover − Year 1 cash flows = Remaining cash to recover If the amount of remaining cash flows to recover is greater than or equal to the cash flows of year 2, subtract the cash flows expected for year 2. Continue subtracting projected operating cash flows for each subsequent year until the remaining cash flows not yet recovered are less than the cash flows expected for the next year. Determine the point during the next year that the remaining cash will be recovered. This is achieved by calculating the percentage portion of the next year that will at the point the final cash recovery is expected to occur. The portion of final recovery year is calculated as : Cash remaining to be recovered Portion of final year Cash to be received during the final = year The payback period is equal to the number of full years plus the portion of final recovery year. Interpret the Payback Period The payback period indicates how long it will take to recover the cash investment used to acquire the asset. It is expressed in years with two decimals, such as 4.25 years. In general, shorter payback periods are more attractive because the cash is recovered in a shorter period of time. If the cash is expected to be recovered in a time period shorter than the useful life of the investment, it is tentatively deemed acceptable. However, other capital budgeting methods should always be used in conjunction with the payback period method, because even when the PBP appears to be an acceptable investment, it may not be acceptable under a method that considers the time value of money. If the shortcut method is used to calculate the PBP, the results may indicate a payback period that is greater than the useful life of the asset. It is not possible to have a useful life greater than the payback period because the 'end' of the useful life indicates the asset will no longer be used in the production of income. When it is no longer used, it no longer brings in economic resources. As such, when the numerical result using the shortcut method appears to have a payback period that exceeds the useful life, the interpretation is 'the investment will never be recovered.' Limitations of the Payback Period Method The payback period method has some faults that create limitations on its usage. First, it does not consider the total stream of cash flows. It ignores those after the end of the recovery period. For example, if a potential investment of Rs10,000 is expect to generate Rs6,000 in year 1, Rs4,000 in year 2, and Rs3,000 in year 3, the payback period method will consider years 1 and 2 since by the end of year 2, all Rs10,000 of the investment will be recovered. The cash flow in year 3 is ignored.

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The second drawback of the payback period method is that it does not consider the time value of money in its calculations. Assume two potential investments, each with a cost of Rs10,000 and an estimated 3 year period of benefit. Investment A has recoveries of Rs8,000, Rs2,000, and Rs3,000, respectively for the three years, while investment B has recoveries of Rs2,000, Rs8,000, and Rs4,000, respectively for its three years of benefits. Both investments have a 2 year payback period since 100 percent of the cost will be recovered within two years. However, because money has value over time, investment A clearly brings in more cash earlier in its life (year 1) Example : Uneven Cash Flows Company C is planning to undertake another project requiring initial investment of Rs50 million and is expected to generate Rs10 million in Year 1, Rs13 million in Year 2, Rs16 million in year 3, Rs19 million in Year 4 and Rs22 million in Year 5. Calculate the payback value of the project. Solution (cash flows in Cumul millions) ative Year Cash Cash Flow Flow 0 (50) (50) 1 10 (40) 2 13 (27) 3 16 (11) 4 19 8 5 22 30 Payback Period = 3 + (|-Rs11M| ÷ Rs19M) = 3 + (Rs11M ÷ Rs19M) ≈ 3 + 0.58 ≈ 3.58 years

BREAKING DOWN 'Payback Period' Much of corporate finance is about capital budgeting. One of the most important concepts that every corporate financial analyst must learn is how to value different investments or operational projects. The analyst must figuring out a reliable way to determine the most profitable project or investment to undertake. One way corporate financial analysts do this is with the payback period. Capital Budgeting and The Payback Period Most capital budgeting formulas take the time value of money into consideration. The time value of money (TVM) is the idea that cash in hand today is worth more than it is in the future because it can be invested and make money from that investment. Therefore, if you pay an investor

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tomorrow, it must include an opportunity cost. The time value of money is a concept that assigns a value to this opportunity cost. The payback period does not concern itself with the time value of money. In fact, the time value of money is completely disregarded in the payback method, which is calculated by counting the number of years it takes to recover the cash invested. If it takes five years for the investment to earn back the costs, the payback period is five years. Some analysts like the payback method for its simplicity. Others like to use it as an additional point of reference in a capital budgeting decision framework.

Discounting payback period The discounted payback period is a capital budgeting procedure used to determine the profitability of a project. A discounted payback period gives the number of years it takes to break even from undertaking the initial expenditure, by discounting future cash flows and recognizing the time value of money. The net present value aspect of the discounted payback period does not exist in a payback period in which the gross inflow of future cash flows are not discounted.

BREAKING DOWN 'Discounted Payback Period' The general rule for the calculation is to accept projects that result in a discounted payback period that is less than the targeted period. A company is able to compare its required break-even date to when the project will break even in of discounted cash flows, to approve or reject the project.

Discounted Payback Period Calculation To begin, the cash flow of a project must be estimated and broken down into periods. These cash flows are then reduced by their present value factor to reflect the discounting. With the assumption of a large cash outflow to begin the project, future discounted cash flows are net against the initial outflow. The discounted payback period is calculated when the inflows equal the outflows.

Peg Payback Period A key ratio that is used to determine the time it would take for an investor to double their money in a stock investment. The price-to-earnings growth payback period is the time it would take for a company's earnings to equal the stock price paid by the investor. A company's PEG ratio is used rather than their price-to-earnings ratio because it is assumed that a company's earnings will grow over time. 7

BREAKING DOWN 'PEG Payback Period' The best reason for calculating the PEG payback period is to determine the riskiness of an investment. Generally the longer the payback period the more risky an investment becomes. This is because the payback period relies on the assesment of a company's earnings potential. It is harder to predict such potential further into the future, and subsequently there is a greater risk that those returns will not occur.

Payback Method Advantages and Disadvantages The payback period is useful from a risk analysis perspective, since it gives a quick picture of the amount of time that the initial investment will be at risk. If you were to analyze a prospective investment using the payback method, you would tend to accept those investments having rapid payback periods, and reject those having longer ones. It tends to be more useful in industries where investments become obsolete very quickly, and where a full return of the initial investment is therefore a serious concern. Though the payback method is widely used due to its simplicity, it suffers from the following problems: 1. Asset life span. If an asset’s useful life expires immediately after it pays back the initial investment, then there is no opportunity to generate additional cash flows. The payback method does not incorporate any assumption regarding asset life span. 2. Additional cash flows. The concept does not consider the presence of any additional cash flows that may arise from an investment in the periods after full payback has been achieved. 3. Cash flow complexity. The formula is too simplistic to for the multitude of cash flows that actually arise with a capital investment. For example, cash investments may be required at several stages, such as cash outlays for periodic upgrades. Also, cash outflows may change significantly over time, varying with customer demand and the amount of competition. 4. Profitability. The payback method focuses solely upon the time required to pay back the initial investment; it does not track the ultimate profitability of a project at all. Thus, the method may indicate that a project having a short payback but with no overall profitability is a better investment than a project requiring a long-term payback but having substantial long-term profitability. 5. Time value of money. The method does not take into the time value of money, where cash generated in later periods is work less than cash earned in the current period.

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A variation on the payback period formula, known as the discounted payback formula, eliminates this concern by incorporating the time value of money into the calculation. 6. Individual asset orientation. Many fixed asset purchases are designed to improve the efficiency of a single operation, which is completely useless if there is a process bottleneck located downstream from that operation that restricts the ability of the business to generate more output. The payback period formula does not for the output of the entire system, only a specific operation. Thus, its use is more at the tactical level than at the strategic level. 7. Incorrect averaging. The denominator of the calculation is based on the average cash flows from the project over several years - but if the forecasted cash flows are mostly in the part of the forecast furthest in the future, the calculation will incorrectly yield a payback period that is too soon. The following example illustrates the problem. Payback Method Example ABC International has received a proposal from a manager, asking to spend Rs1,500,000 on equipment that will result in cash inflows in accordance with the following table: Year

Cash Flow

1

+Rs150,000

2

+150,000

3

+200,000

4

+600,000

5

+900,000

The total cash flows over the five-year period are projected to be Rs2,000,000, which is an average of Rs400,000 per year. When divided into the Rs1,500,000 original investment, this results in a payback period of 3.75 years. However, the briefest perusal of the projected cash flows reveals that the flows are heavily weighted toward the far end of the time period, so the results of this calculation cannot be correct. Instead, the company's financial analyst runs the calculation year by year, deducting the cash flows in each successive year from the remaining investment. The results of this calculation are: Year 0

Cash Flow

Net Invested Cash -Rs1,500,000 9

1

+Rs150,000

-1,350,000

2

+150,000

-1,200,000

3

+200,000

-1,000,000

4

+600,000

-400,000

5

+900,000

0

The table indicates that the real payback period is located somewhere between Year 4 and Year 5. There is Rs400,000 of investment yet to be paid back at the end of Year 4, and there is Rs900,000 of cash flow projected for Year 5. The analyst assumes the same monthly amount of cash flow in Year 5, which means that he can estimate final payback as being just short of 4.5 years. Summary The payback method should not be used as the sole criterion for approval of a capital investment. Instead, consider using the net present value or internal rate of return methods to incorporate the time value of money and more complex cash flows, and use throughput analysis to see if the investment will actually boost overall corporate profitability. There are also other considerations in a capital investment decision, such as whether the same asset model should be purchased in volume to reduce maintenance costs, and whether lower-cost and lower-capacity units would make more sense than an expensive "monument" asset.

Different Formulas Of Pay Back Period Unlike net present value method and internal rate of return method, payback method does not consider the present value of cash flows. Under this method, an investment project is accepted or rejected on the basis of payback period. Payback period means the period of time that a project requires to recover the money invested in it. The payback period of a project is expressed in years and is computed using the following formula: 10

Formula of payback period:

According to this method, the project that promises a quick recovery of initial investment is considered desirable. If the payback period of a project computed by the above formula is shorter than or equal to the management’s maximum desired payback period, the project is accepted otherwise it is rejected. For example, if a company wants to recoup the cost of a machine within 5 years of purchase, the maximum desired payback period of the company would be 5 years. The purchase of machine would be desirable if it promises a payback period of 5 years or less.

Consider the following example to understand the analysis of a project under this method: Example Due to increased demand, the management of Rani Beverage Company is considering to purchase a new equipment to increase the production and revenues. The useful life of the equipment is 10 years and the company’s maximum desired payback period is 4 years. The inflow and outflow of cash associated with the new equipment is given below: The initial cost of equipment Rs37,500 Annual cash inflow: Sales Rs75,000 Annual cash outflow: Cost of ingredients Rs45,000 Salaries expenses Rs13,500 Maintenance expenses Rs1,500 Non cash expenses: Depreciation Rs5,000 Solution: Step 1: In order to compute the payback period of the equipment, we need to workout the net annual cash inflow by deducting the total of cash outflow from the total of cash inflow associated with the equipment. Computation of net annual cash inflow: Rs75,000 – (Rs45,000 + Rs13,500 + Rs1,500) = Rs15,000 11

Step 2: Now, the amount of investment required to purchase the equipment would be divided by the amount of net annual cash inflow (computed in step 1) to find the payback period of the equipment.

= Rs37,500/Rs15,000 =2.5 years Depreciation is a non cash expense and therefore has been ignored. According to payback method, the equipment should be purchased because the payback period of the equipment is 2.5 years which is shorter than the maximum desired payback period of the company.

Comparison of two or more alternatives – choosing from several alternative projects: Where funds are limited and several alternative projects are being considered, the project with the shortest payback period is preferred. It is explained with the help of the following example:

Example 2: The management of Health Supplement Inc. wants to reduce its labor cost by installing a new machine. Two types of machines are available in the market – machine X and machine Y. Machine X would cost Rs18,000 where as machine Y would cost Rs15,000. Both the machines can reduce annual labor cost by Rs3,000. Required: Which is the best machine to purchase according to payback method? Solution:

Machine X

Machine Y

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Cost of machine (a)

Rs18,000

Rs15,000

Annual cost saving (b)

Rs3,000

Rs3,000

Payback period (a)/(b)

6 years

5 years

According to payback method, machine Y is more desirable than machine X because it has a shorter payback period than machine X. Payback method and uneven cash flow: In the above examples we have assumed that the projects generate even cash inflow (same cash inflow during each period) but when projects generate uneven cash inflow (different cash inflow in different periods), the payback period formula given above cannot be used to compute payback period.

Example 3: An investment of Rs200,000 is expected to generate the following cash flows in six years:

Year

Net cash flow

1

Rs30,000

2

Rs40,000

3

Rs60,000

4

Rs70,000

13

5

Rs55,000

6

Rs45,000

Required: Compute payback period of the investment. Should the investment be made if management wants to recover the initial investment in 3 years or less? Solution: (1). Because the cash inflow is uneven, the payback period formula cannot be used to compute the payback period. We can compute the payback period by computing the cumulative net cash flow as follows:

Year

Net cash flow

Cumulative net cash inflow

1

Rs30,000

Rs30,000

2

Rs40,000

Rs70,000

3

Rs60,000

Rs130,000

4

Rs70,000

Rs200,000

5

Rs55,000

Rs255,000

6

Rs45,000

Rs300,000

Payback period is 4 years because the cumulative cash flow at the end of 4th year becomes equal to initial amount of investment. 14

(2). As the payback period is longer than the maximum desired payback period of the management (3 years), the investment should not be made.

Average Rate Of Return

ing rate of return, also known as the Average rate of return, or ARR is a financial ratio used in capital budgeting. The ratio does not take into the concept of time value of money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents out of each dollar invested (yearly). If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. Over one-half of large firms calculate ARR when appraising projects.

The ing rate of return (ARR) is the amount of profit, or return, an individual can expect based on an investment made. ing rate of return divides the average profit by the initial investment to get the ratio or return that can be expected. ARR does not consider the time value of money, which means that returns taken in during later years may be worth less than those taken in now, and does not consider cash flows, which can be an integral part of maintaining a business. BREAKING DOWN 'ing Rate of Return - ARR' ing rate of return is also called the simple rate of return and is a metric useful in the quick calculation of a company’s profitability. ARR is used mainly as a general comparison between multiple projects as it is a very basic look at how a project is doing. Calculation of ing Rate of Return The ing rate of return is calculated by dividing the average annual ing profit by the initial investment of the project. The profit is calculated using the appropriate ing 15

framework including generally accepted ing principles (GAAP) or international financial reporting standards (IFRS). The profit calculation includes depreciation and amortization of project assets. The initial investment is the fixed asset investment plus any changes to working capital due to the asset. If the project spans multiple years, an average of total revenue per year or investment per year is used. ing Rate of Return Example The total profit from a project over the past five years is Rs50,000. During this span, a total investment of Rs250,000 has been made. The average annual profit is Rs10,000 (Rs50,000/5 years) and the average annual investment is Rs50,000 (Rs250,000/5 years). Therefore, the ing rate of return is 20% (Rs10,000/Rs50,000).

ing Rate of Return Drawbacks In addition to the lack of consideration given to the time value of money as well as cash flow timing, ing rate of return does not provide any insight as to constraints, bottleneck ramifications or impacts on company throughput. ing rate of return isolates individual projects and may not capture the systematic impact a project may have on the entire entity – both positively and negatively. ing rate of return is not ideal to use for comparative purposes because financial measurements may not be consistent between projects and other non-financial factors need consideration. Finally, ing rate of return does not consider the increased risk of long-term projects and the increased variability associated with long periods of time.

More About Of ing Average Rate Of Return

A second simplified approach to capital budgeting is the ing rate of return method. It is considered to be 'simplified' because it does not use time value of money in evaluating capital investments. This capital budgeting method uses net income, not cash flows. The ing rate of return (ARR) method calculates the return generated from the average net income expected for each of the years the proposed capital investment is expected to be used in operations. It is much like the rate of return concept you learned in financial ing, however this return is based on a single proposed asset acquisition, while the rate of return in financial ing was based on the return generated by a company's total assets. The calculation of ing rate of return is calculated as: 16

ing rate of return Average net income = Average investment

Average net income is calculated by dividing the number of years the investment is expected to generate economic resources into the total net income for these same years. The average investment is based on the book value of the potential capital budgeting acquisition. The beginning book value and the ending book value are averaged to obtain the average investment. Beginning book value is the book value at the beginning of year 1 and ending book value is the book value at the end of the useful life of the proposed investment. Average investment = [Book value beginning of year 1 + Book value end of useful life]/2 Recall that book value is the cost of a long-term asset minus the amount of accumulated depreciation. At the end of an asset's life, the asset's cost minus accumulated depreciation will equal the salvage value. When the asset is sold for the salvage value amount, there is no gain or loss on the sale. Interpret the ing Rate of Return The ARR is expressed as a percentage return with two decimals displayed, such as 6.93%. This amount tells you that the company is expected to earn almost 7 cents of profit out each dollar it will have tied up in the investment If the ARR is equal to or greater than the required rate of return, the project is acceptable. If the investment is expected to generate a return that is less than the desired rate of return, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. Limitations of the ing Rate of Return ARR ignores the time value of money in its computations. By doing this, it views amounts generated in the first year to be equal to the amounts generated in the last year on a dollar per dollar basis. In essence, it ignores the timing of the cash flows within the useful life.

Formula ing Rate of Return is calculated using the following formula: Average ing Profit ARR = Average Investment

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Average ing profit is the arithmetic mean of ing income expected to be earned during each year of the project's life time. Average investment may be calculated as the sum of the beginning and ending book value of the project divided by 2. Another variation of ARR formula uses initial investment instead of average investment.

Example : An initial investment of Rs130,000 is expected to generate annual cash inflow of Rs32,000 for 6 years. Depreciation is allowed on the straight line basis. It is estimated that the project will generate scrap value of Rs10,500 at end of the 6th year. Calculate its ing rate of return assuming that there are no other expenses on the project. Solution Annual Depreciation = (Initial Investment − Scrap Value) ÷ Useful Life in Years Annual Depreciation = (Rs130,000 − Rs10,500) ÷ 6 ≈ Rs19,917 Average ing Income = Rs32,000 − Rs19,917 = Rs12,083 ing Rate of Return = Rs12,083 ÷ Rs130,000 ≈ 9.3%

Advantages And Disadvantages Of Average Rate Of Return Advantages of ing Rate of Return Method (ARR Method) The following are the advantages of ing Rate of Return method. 1. It is very easy to calculate and simple to understand like pay back period. It considers the total profits or savings over the entire period of economic life of the project. 2. This method recognizes the concept of net earnings i.e. earnings after tax and depreciation. This is a vital factor in the appraisal of a investment proposal. 3. This method facilitates the comparison of new product project with that of cost reducing project or other projects of competitive nature. 4. This method gives a clear picture of the profitability of a project. 5. This method alone considers the ing concept of profit for calculating rate of return. Moreover, the ing profit can be readily calculated from the ing records. 6. This method satisfies the interest of the owners since they are much interested in return on investment.

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7. This method is useful to measure current performance of the firm. Disadvantages or Weakness or Limitations of ing Rate of Return Method This method has some disadvantages or limitations also. They are briefly explained below.

1. The results are different if one calculates ROI and others calculate ARR. It creates problem in making decisions. 2. This method ignores time factor. The primary weakness of the average return method of selecting alternative uses of funds is that the time value of funds is ignored. 3. A fair rate of return can not be determined on the basis of ARR. It is the discretion of the management. 4. This method does not consider the external factors which are also affecting the profitability of the project. 5. It does not taken into the consideration of cash inflows which are more important than the ing profits. 6. It ignores the period in which the profits are earned as a 20% rate of return in 10 years may be considered to be better than 18% rate of return for 6 years. This is not proper because longer the term of the project, greater is the risk involved. 7. This method cannot be applied in a situation when investment in a project to be made in parts. 8. This method does not consider the life period of the various investments. But average earnings is calculated by taking life period of the investment. As a result, average investment or initial investment may remain the same whether investment has a life period of 4 years or 6 years. 9. It is not useful to evaluate the projects where investment is made in two or more installments at different times.

Formula of ing rate of return (ARR):

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In the above formula, the incremental net operating income is equal to incremental revenues to be generated by the asset less incremental operating expenses. The incremental operating expenses also include depreciation of the asset. The denominator in the formula is the amount of investment initially required to purchase the asset. If an old asset is replaced with a new one, the amount of initial investment would be reduced by any proceeds realized from the sale of old equipment.

Example 1: The Fine Clothing Factory wants to replace an old machine with a new one. The old machine can be sold to a small factory for Rs10,000. The new machine would increase annual revenue by Rs150,000 and annual operating expenses by Rs60,000. The new machine would cost Rs360,000. The estimated useful life of the machine is 12 years with zero salvage value. Required: 1. 2.

Compute ing rate of return (ARR) of the machine using above information. Should Fine Clothing Factory purchase the machine if management wants an ing rate of return of 15% on all capital investments? Solution: (1): Computation of ing rate of return:

= Rs60,000* / Rs350,000** = 17.14% *Incremental net operating income: Incremental revenues – Incremental expenses including depreciation Rs150,000 – (Rs60,000 cash operating expenses + Rs30,000 depreciation) Rs150,000 – Rs90,000 Rs60,000

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Cost reduction projects: The ing rate of return method is equally beneficial to evaluate cost reduction projects. The ing rate of return of the assets that are purchased with a view to reduce business costs is computed using the following formula:

Example 2: The P & G company is considering to purchase an equipment costing Rs45,000 to be used in packing department. It would reduce annual labor cost by Rs12,000. The useful life of the equipment would be 15 years with no salvage value. The operating expenses of the equipment other than depreciation would be Rs3,000 per year. Required: Compute ing rate of return/simple rate of return of the equipment. Solution:

= Rs6,000* / Rs45,000 = 13.33% *Net cost savings: Rs12,000 – (Rs3,000 cash operating expenses + Rs3,000 depreciation expenses) Rs12,000 – Rs6,000 Rs6,000 Comparison of different alternatives: If several investments are proposed and the management have to choose the best due to limited funds, the proposal with the highest ing rate of return is preferred. Consider the following example:

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Example 3: The Good Year manufacturing company has the following different alternative investment proposals: Proposal A

Proposal B

Proposal C

Expected incremental income per year (a)

Rs50,000

Rs75,000

90,000

Initial investment (b)

Rs250,000

Rs300,000

Rs500,000

20%

25%

18%

Expected ing rate of return (a)/(b)

Required: Using ing rate of return method, select the best investment proposal for the company. Solution: If only ing rate of return is considered, the proposal B is the best proposal for Good Year manufacturing company because its expected ing rate of return is the highest among three proposals.

Usefulness Having calculated the percentage answer, how can this be used for project appraisal? The ing rate of return percentage needs to be compared to a target set by the organisation. If the ing rate of return is greater than the target, then accept the project, if it is less then reject the project. This leads to a couple of problems:  

How is the target set? Should it be 25%, or 30%? The target set could be arbitrary Which calculation method should be used? If in the above example, the target was 25%, the project would be rejected under one calculation method but accepted under the other, so changing the calculation method can change the decision as to whether the project should be accepted or rejected.

Other problems with the ing rate of return: 

The timing of the cash flows is not considered. In our example, the biggest cash flow arises in year five, but by then, the organisation may have ceased trading due to liquidity issues in years three and four when only Rs5,000 cash is being received in each year.

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 

It is a relative measure rather than an absolute measure – it takes no of the size of the investment. The time value of money is ignored.

There are, however, some positive aspects to the ing rate of return: 

It is simple to calculate from readily available ing data – no complicated discount factors to calculate!



The concept of profit is easily understood by managers, and the answer is easily interpreted – does the project give the necessary ing return or not?



The method looks at the whole life of the project, unlike, for example, the payback method which may not.

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Cost-Benefit Analysis: Payback & ing Rate of Return Payback period and the ing rate of return are two methods that can be used when estimating or projecting the return on an investment. Because they offer different perspectives on an investment return, they can both be useful when discussing the validity of an investment. The payback period expresses how long it takes the benefit of the investment to cover the cost of the investment, while the ing rate of return is expressed by the annual rate of return generated by the investment. Before we get to the specifics of calculating payback period and the ing rate of return, let's set up an example we can use throughout the lesson. Karen has designed a very popular case for smartphones. When she started her business, Karen rented a 3D printer from the local university to manufacture her cases. Now that business is booming, she's considering buying her own 3D printer so she can eliminate the constraints on time and resources, as well as the overhead cost she would be paying the university. The 3D printer she's considering costs Rs120,000.

To calculate the payback period, you need two pieces of information. First, you need the cost of the investment, which we have. That's the Rs120,000 that Karen will have to spend to buy the new 3D printer. The second piece of information you need is how much revenue the investment will generate each time period. The time period could be months or years - just , whatever time period you use at this point will determine the time period of your answer. So, Karen looks at her books and sees that last year, just by selling her single case, she brought in Rs78,000 in revenue. Being conservative and not wanting to oversell the idea of buying her printer, Karen decides to forecast the same amount of sales for the next few years. Now we have both pieces of information we need. To get the payback period for the 3D printer, all we need to do is divide the cost of the investment by the revenue produced: Rs120,000 / Rs78,000. That equals just over 1.5, and since the Rs78,000 was an annual number, our answer is 1.5 years. It will take just over 1.5 years for Karen to generate the amount of revenue that equals the cost of the investment. There's an important note to make here. That payback period doesn't actually mean the cost of the investment will be paid off in that amount of time. Karen could have received a loan for her printer that she's paying off over five years 24

The payback period (PBP) is the amount of time that is expected before an investment will be returned in the form of income. When comparing two or more investments, business managers and investors will typically compare the projects to see which one has the shorter PBP. Projects with longer PBP are usually associated with higher risk. For the purposes of this lesson, you will be a senior business manager for a large corporation and one of your responsibilities is to select from among the many potential projects that are proposed by employees and lower-level managers. Although the size of your company is big, there is not enough money to fund all of the projects and the board of directors wants you to ensure that the organization does not invest in risky ventures. Before beginning to analyze the two proposed projects brought to your office, you notice that one project has even cash flows and the other has uneven cash flows. There are two different methods that you will need to use to see which one is the best choice for your company. Even cash flows mean that the investment is expected to bring in income that is constant each year. The first investment is for a new machine that will produce one of your company's products more efficiently and will bring in the same income each month based on the organization's steady production of that item. The cost of the machine is Rs28,120, and it is expected to bring the company a net cash flow of Rs7,600 per year for the next fifteen years of the machine's useful life. The formula you will use to compute a PBP with even cash flows is:

By substituting the numbers into the formula, you divide the cost of the investment (Rs28,120) by the annual net cash flow (Rs7,600) to determine the expected payback period of 3.7 years.

Uneven cash flows occur when the annual cash flows are not the same amount each year. Under these circumstances, the formula that we used before will not work but being the wise business manager that you are, you still know how to figure out the PBP for this project. The second investment is for a totally new product that can be made with most of the same machinery, but it will need some unique equipment and materials. Additionally, until the public is aware of the product's existence, there will not be a lot of demand for it. The first two columns of the table were provided by the business manager of that section based on her experience with new products of this type. You were able to add the right hand column that shows the cumulative net cash flows. 25

Cumulative cash flows are the running total added to the initial investment. that the initial investment is a cash outflow and is shown as a negative number. Year zero is the first year that shows the amount of the initial investment, and each year afterwards has income that is added to find the cumulative net cash flow for that year. We see that in the chart, it takes over four years to pay back the initial investment. One of the main reasons new investors lose money is because they chase after unrealistic rates of return on their investments, whether they are buying stocks, bonds, mutual funds, real estate, or some other asset class. This happens due to a lack of experience. Most folks just don’t understand how compounding works. Every increase in percentage profit each year means huge increases in your ultimate wealth. To provide a start illustration, Rs10,000 invested at 10% for 100 years turns into Rs137.8 million. The same Rs10,000 invested at twice the rate of return, 20%, does not merely double the outcome, it turns it into Rs828.2 billion. It seems counter-intuitive that the difference between a 10% return and a 20% return is 6,010x as much money, but it's the nature of geometric growth. So What's a Good Growth Rate? When it comes to answering what a "good" rate of return on your investments is, I find myself frequently reiterating the truism that past performance is no guarantee of future results, and that even the best-structured portfolio or investment plan can result in permanent capital losses. I think about risk a lot. It's in my nature. In fact, I believe people don't think about risk enough. Things like the total decimation of the Austrian stock market upon the annexation of Austria by Nazi have happened, can happen, and will happen again at some point in the future. There are no guarantees of any kind in life. With that said, I think the only reasonable, academic position a person can take if they assume that civilization will remain relatively stable is to answer that determining a "good" rate of return on your investments is probably easiest if we examine the nearly 200 years of data from Ibbotson & Associates, a data research firm that tracks financial market history. It's not perfect for the reasons we just discussed, as well as several others, but it's the best we have. To accomplish this, the first thing we need to do is strip out inflation. The reality is, investors are interested in increasing their purchasing power. That is, they don’t care about “dollars” or “yen” per se, they care about how many cheeseburgers, cars, pianos, computers, or pairs of shoes they can purchase.

How do you calculate the payback period? 26

The payback period is calculated by counting the number of years it will take to recover the cash invested in a project. Let's assume that a company invests Rs400,000 in more efficient equipment. The cash savings from the new equipment is expected to be Rs100,000 per year for 10 years. The payback period is 4 years (Rs400,000 divided by Rs100,000 per year). A second project requires an investment of Rs200,000 and it generates cash as follows: Rs20,000 in Year 1; Rs60,000 in Year 2; Rs80,000 in Year 3; Rs100,000 in Year 4; Rs70,000 in Year 5. The payback period is 3.4 years (Rs20,000 + Rs60,000 + Rs80,000 = Rs160,000 in the first three years + Rs40,000 of the Rs100,000 occurring in Year 4). Note that the payback calculation uses cash flows, not net income. Also, the payback calculation does not address a project's total profitability. Rather, the payback period simply computes how fast a company will recover its cash investment.

How do you calculate the average rate of return? Average Rate of Return The rate of return on an investment that is calculated by taking the total cash inflow over the life of the inves tmentand dividing it by the number of years in the life of the investment. The average rate of retu rn does not guarantee thatthe cash inflows are the same in a given year; it simply guarantees that the return averages out to the average rate ofreturn. average rate of return One way of measuring an investment's profitability.To calculate,one takes the total net earnings,d ivides by the total numberof years the investment was held,and then divides that answer by the in vestment's initial acquisition cost. Example: Rainer spent Rs800,000 to buy an apartment building. After deducting all operat- ing e xpenses, real estate taxes,and insurance, she receives Rs65,000 in the first year, Rs71,000 in the s econd year, Rs69,000 in the third year, and Rs70,000 inthe fourth year. The total net earnings are Rs275,000. Divide that number by the 4 years being analyzed, to reach Rs68,750 asan average a nnual return. Divide Rs68,750 by the initial Rs800,000 investment to calculate the average rate o f return of 8.59percent.

Payback Period In Capital Budgeting In capital budgeting for a business firm, historically, the payback period is the selection criteria that most business firm use to select capital projects. Even today, small businesses find the payback period selection criteria most useful. Small business owners like to look at the time it takes them to earn back their initial investment in a capital project. 27

What is a Capital Project? A capital project is usually defined as buying or investing in a fixed asset which, by definition, will last more than one year. Current projects last less than one year. Payback Period Capital Budgeting Decision Method The definition of payback period for capital budgeting purposes is simple. The payback period is the number of years it takes to payback the initial investment of a capital project from the cash flows that the project produces. The capital project could be buying a new plant or building or buying a new or replacement piece of equipment. In this example, it is buying real estate. Most firms set a cut-off payback period, maybe 3 years depending on their business. In other words, in this example, if the payback is 2.5 years, the firm would purchase the asset or invest in the project. If the payback were 4 years, it would not. Calculating Payback Period Most small businesses prefer a simple calculation, or approximation, for payback period: Payback Period = Investment Required/Net Annual Cash Inflow* *The net annual cash inflow is what the investment generates in cash each year. However, if this investment was a replacement investment; for example, a machine replaced an obsolete machine, then the net annual cash inflow becomes the incremental net annual cash flow from the investment. Payback occurs the year (plus a number of months) before the cash flow turns positive. Larger firms may prefer a more complex calculation for payback so that they may gather more information. Here is an alternative payback period calculation: Payback Period = Number of years prior to full recovery of investment + Unrecovered cost at start of year/Cash flow during full recovery year This slightly more extensive equation may give you a little more information. For purposes of examples in this article, we will stick with the simpler payback period equation. Is Payback Period a Good Capital Evaluation Decision Method Payback period has many deficiencies. If you add information to the analysis, you will see some of its deficiencies. For example, if you add the economic lives of the two machines, you could

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get a very different answer. So, one deficiency of payback is that is cannot determine the useful lives of the equipment or plant it is evaluating. Perhaps an even more important criticism of payback period is that it does not consider time value of money. Cash inflows from the project that are scheduled to be received 2-10 years, or longer, in the future are weighted exactly the same as the cash flow expected to be received in year one. Due to risk, that is not good financial practice. Last, but not least, payback period does not handle a project with uneven cash flows well. If a project has uneven cash flows, then payback period is a fairly useless capital budgeting method. The one advantage of payback period is that it is a "quick and dirty" method of capital budgeting that can give management some sort of rough estimate concerning when the project will pay back their initial investment. Even considering the more advanced methods available, it seems that management still wants to rely on this tried and true method.

Conclusion An empirical study of the practices of the Capital Budgeting for evaluation of investment proposals in the corporate sector in India has been made in the preceding chapters. Comparison, wherever possible, has been made with the practices and procedures in the foreign countries. It has to be noted that conclusions based upon a study of this type have to be taken as indicative of broad trends only. However, the results of this study do indicate that majority of large scale companies in India are aware of the need for a well formulated capital budgeting decisions. It is proposed to review the important findings of this study and venture to outline some suggestions and recommendations for the benefit of academicians, industry as well as for post doctoral research. An in-depth analysis has been carried out to observe the trend and insight into factors that influence capital budgeting decisions. The results of the survey and its analysis have been provided in chapter 5. The companies in India do have specific amount of average size of annual capital budget and all project size requires formal quantitative analysis. However, such analysis and use of capital budgeting method differ on the basis of nature and size of a particular project 29

under consideration. Surprisingly, the companies under study in India seem to be planning one year in advance only but here also the period of planning is different for different projects. This may be due to volatile business environment. The authority to take final capital budgeting decision rests with the chief finance officer and top management officials of all the organizations under study. Another objective of this study is to analyze the problems faced to estimate the cash flows associated with each capital investment accurately. The cash flow estimation is considered as the most difficult task in capital budgeting decisions. This can be understood from the responses of the respondents of the present study. Many respondents have replied that items like expenses incurred on R&D, market survey, test marketing, interest on borrowings, depreciation, income taxes etc. have been included in the cash flows which requires to be excluded actually. In fact, many of them might have been intending to convey that they include it in the project cost. Even the firms are using different inflation adjustment methods for their investment appraisal. One of the objectives of this research is to analyze how ‘Risk’ and ‘Uncertainty’ in the future estimates in investment projects is being taken care of. Sensitivity analysis is considered as the most important technique while scenario analysis is considered as the second important technique for assessing risk. The other more sophisticated techniques like Decision tree, Monte Carlo simulation, Certainty equivalent, Probability analysis, Beta analysis has got very low ratings that means these techniques are rarely used in practice by firms in India. The researcher wanted to assess suitability of Discounted Cash Flow (DCF) Techniques in India and the preferences between Net Present Value (NPV) and Internal Rate of Return (IRR) methods. All the companies responded to my study are using DCF techniques either IRR or NPV or both which indicates that now these techniques are very well accepted and used by finance officials of the organizations. With reference to this Porwal (1976) in his study has mentioned, “As long term planning under the present conditions is not quite possible in India, the use of DCF methods do not seem to be efficacious. However, it needs to be mentioned that as conditions improve, it would be desirable for Indian companies to apply ‘theoretically correct’ techniques in a larger measure.” Prasanna Chandra (1975) in his study conducted on 20 companies made the following observations. “The most commonly used method for evaluating the investments of small size is payback period method….For investments of large size, the average rate of return is commonly used as the principle criterion and the payback period is used as a supplementary criterion. DCF techniques, though not commonly used, are gaining importance, particularly in the evaluation of large investments.” It appears that now though the government restrictions are minimized on business but firms are always working under highly volatile environment. Still no respondents in my study is using only pay back period method at the same time no organizations are using single technique for evaluating capital budgeting proposals. Though Pay back period is still a popular technique, it is always used with some other DCF techniques which are in most of the cases IRR or NPV. The suitability of DCF techniques even depends on how professional the organization is. But all the respondents in my study appreciate and use the suitability of these techniques. In capital budgeting literature, two widely discussed methods for appraisal of capital investments are the NPV and IRR methods. There is good amount of controversy exist regarding the superiority of one method over the other. Many authors argue that the NPV method leads to 30

correct decision (Bierman and Smidt S, 1980). On the other hand Merret A J and Sykes A (1966) prefer the yield method. In some situations the NPV and yield methods give contradictory results. Babu C P (1984) explains the reasons for this phenomenon-“…in capital investment appraisal using the yield like yield to maturity in bonds, or as a growth rate of an investment is misleading, and is responsible for the contradictions that exist between the NPV and yield methods.” He further says that as the NPV criterion is compatible with the objective of the firm, the yields can be used in such a manner so as to give the same results as that of NPV. The respondents of my study prefer both the techniques but IRR (40.7%) seems to be given more importance by them in comparison to NPV (33.3%) as it gives some rate for comparison. When they were asked to mention frequency of the use of different capital budgeting techniques the NPV (59.3%) got more preference than IRR (55.5%). Thus, it can be concluded that both the techniques goes side by side when it comes to selecting one over the other. The respondents of my study prefer both the techniques but IRR seems to be more favoured by them as it gives some rate for comparison, however, there is a negligible difference between the preference for both the techniques i.e. NPV and IRR.

Bibliography            

www.unf.edu www.investopedia.com www.authorstream.com www.study.com ingexplained.com thefreedictionary.com www.businessdictionary.com businessjargons.com www.wikipedia.com www.swlearning.com www.markedbyteachers.com www.anet.com

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