Key Idea: Before spending a large sum, a business asks how quickly it gets the money back and how much it earns on it. This topic is the methods that answer those questions, and what the numbers leave out.
Payback period
- How long the net cash flows take to repay the cost.
- Station Road: $120,000 back after 3 years and 8 months.
- Simple and stresses speed; ignores what comes after payback.
Average rate of return
- ARR = (total returns − cost) ÷ years of use ÷ cost × 100.
- Station Road: ($170,000 − $120,000) ÷ 5 ÷ $120,000 × 100 = 8.33%.
- Compares with a target rate; ignores when the money arrives.
Making the choice
- Use the methods together: they can point different ways.
- Forecast cash flows are only estimates.
- Weigh what the figures leave out: staff, risk, fit with the objectives.
Net present value (HL)
- Discount each year's net cash flow with the factor given, add them, subtract the cost.
- Station Road at 8%: NPV $14,523, so worth more than it costs.
- Allows for the time value of money; depends on the discount rate chosen.
The words to know
| Word | Means | Do not confuse with |
|---|---|---|
| Investment appraisal | judging whether an investment is worth making, using its forecast returns | a budget, which plans spending |
| Net cash flow | cash coming in from the project minus cash going out, each year | profit, which includes non-cash items |
| Payback period | the time it takes for net cash flows to repay the cost | the life of the project |
| Average rate of return (ARR) | the average yearly profit from a project as a percentage of its cost | the interest rate on a loan |
| Target (criterion) rate | the lowest ARR the owners will accept | the ARR of the project |
| Discount factor | the number that turns a future cash flow into its value today | the discount rate itself |
| Net present value (NPV) | total present value of the net cash flows minus the cost | total present value |
Calculate: a cumulative (running) total for payback, the ARR formula line by line, the answer with its unit (years and months, or %). For a Discuss or Recommend: the figures for each option, one factor they leave out, then a decision that says what it depends on.
Exam-style question
Lena's Bakery Ltd's Station Road shop would cost $120,000. Its forecast net cash flows are $30,000, $32,000, $34,000, $36,000 and $38,000 in years 1 to 5. Calculate the payback period (show all your working).
Model answer plan
See the mark-by-mark plan — for / against / judgement, with marking guidance — in study mode.
Important: In ARR, divide the average yearly return by the cost, not by the total returns. In payback, use the missing amount over the next year's cash flow, not over the cost. Write the formula before the numbers, every time.
Tap each card to check yourself.
The deck oven costs $45,000 and brings $18,000 a year. Payback? $45,000 ÷ $18,000 = 2.5 years = 2 years and 6 months.
Station Road's ARR is 8.33% and the target is 10%. Go ahead? On ARR alone, no. But the shop may still be worth it for reasons the figure leaves out.
One strength of payback? It is simple and shows how quickly the money comes back, which matters when cash is short.
One weakness of ARR? It ignores when the returns arrive: $50,000 in year 1 counts the same as $50,000 in year 5.
Name a factor the figures leave out. Any one: staff to run it, the risk the forecasts are wrong, rivals, fit with the objectives, the effect on the brand.
Why can payback and ARR disagree? Payback looks only at the early years; ARR counts every year, including those after payback.
The NPV is negative. What does it mean? (HL) At that discount rate the future cash flows are worth less today than the investment costs.
Exam tips
- Payback in years and months: running total, missing amount ÷ next year's cash flow × 12.
- ARR: (total returns − cost) ÷ years ÷ cost × 100, with the % sign.
- Compare ARR with the target rate the case gives.
- A Recommend needs the figures and at least one factor they leave out.
- Forecasts are estimates: say so when you judge an investment.