# Evaluation Methods: Payback Period & ARR

## Payback Period

Definition: The time required to recover the initial investment from project cash inflows.

### Advantages

Advantage	Explanation
Easy to compute	Simple arithmetic; no discounting required
Easy to understand	Gives a quick intuitive estimate of cash recovery time
Risk proxy	Longer payback = riskier project; particularly useful in fast-obsolescence industries (e.g., software) or cash-constrained firms

### Disadvantages

Disadvantage	Explanation
Ignores Time Value of Money	₹1 received in Year 1 treated identically to ₹1 in Year 5
Ignores post-payback cash flows	Profitable returns after the cutoff period are completely disregarded
Biased against long-term projects	Projects with high returns beyond the payback period are systematically penalised

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## Accounting Rate of Return (ARR)

Definition: Average annual accounting profit expressed as a percentage of average (or initial) investment.

### Advantages

Advantage	Explanation
Uses readily available data	No special procedures; uses accounting profit directly
Consistent metric	Same measure used for investment decisions and management performance evaluation
Considers full project life	Net income across the entire life is accounted for

### Disadvantages

Disadvantage	Explanation
Ignores Time Value of Money	Future profits are not discounted
Dependent on accounting procedures	Results vary with depreciation method, amortisation policy, etc.
Ignores cash flows	Uses accounting profit, not actual cash inflows
Ignores working capital	Only considers book value of fixed assets; overlooks working capital commitments

> Both Payback and ARR share one critical flaw: neither considers the time value of money.

Worked example

### Example 1

Project A: Initial investment ₹1,00,000. Cash inflows — Year 1: ₹40,000; Year 2: ₹40,000; Year 3: ₹20,000 (cumulative = ₹1,00,000 → payback = 3 years); Years 4–6: ₹30,000/year. Payback completely ignores the ₹90,000 earned post-payback, making this strong project look unattractive if a 2-year payback benchmark is used.

### Example 2

ARR Example: Machine cost ₹5,00,000; useful life 5 years; average annual profit after depreciation = ₹60,000. ARR = 60,000 ÷ 5,00,000 = 12%. Required rate = 10% → Accept. Limitation illustrated: whether the ₹60,000 arrives in Year 1 or Year 5 makes no difference to ARR, even though early receipt is clearly more valuable.

⚠️ Common exam mistakes

Using accounting profit instead of cash inflows to calculate payback period — payback is always computed using actual cash inflows, not profit.
Assuming a short payback period implies high profitability — payback only measures speed of cash recovery, not the total return generated.
Thinking ARR and Payback are both time-value methods — neither discounts cash flows; this is their single biggest shared weakness.
Confusing ARR with IRR — ARR uses accounting profit and book values; IRR uses cash flows and finds the actual rate of return.

Reference:

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Payback Period and Accounting Rate of Return (ARR) — Merits & Demerits

Worked example

⚠️ Common exam mistakes