Two ideas, one budget: Lena and Marco have two plans on the table and money for one of them. Which one should the bakery choose?
Marco's plan
- The fourth shop on Station Road
Aisha's plan
- Aisha manages the High Street shop
- She wants to turn its back room into a small café corner with twelve seats
Both plans cost money now and bring money in later.
You already have two tools. Payback period (3.8.1) answers one question: how long until the money spent comes back? Average rate of return, or ARR (3.8.2), answers a different one: on average, how much does the plan earn each year, as a percentage of what it cost?
Choosing between two plans means working out both figures for both plans, then putting them side by side.
| Station Road shop | Café corner | |
|---|---|---|
| Cost now (year 0) | $120,000 | $50,000 |
| Net cash flow, years 1 to 5 | $30,000, $32,000, $34,000, $36,000, $38,000 | $20,000, $20,000, $12,000, $8,000, $5,000 |
| Cumulative cash flow | -$90,000, -$58,000, -$24,000, $12,000, $50,000 | -$30,000, -$10,000, $2,000, $10,000, $15,000 |
| Payback period | 3 years + ($24,000 ÷ $36,000 × 12) = 3 years 8 months | 2 years + ($10,000 ÷ $12,000 × 12) = 2 years 10 months |
| Total returns less cost | $170,000 - $120,000 = $50,000 | $65,000 - $50,000 = $15,000 |
| Average yearly return | $50,000 ÷ 5 = $10,000 | $15,000 ÷ 5 = $3,000 |
| ARR | $10,000 ÷ $120,000 × 100 = 8.33% | $3,000 ÷ $50,000 × 100 = 6.00% |
The two formulas, as 3.8.1 and 3.8.2 set them out: Payback period = the full years before the cumulative cash flow turns positive + (the amount still owed ÷ the next year's net cash flow × 12) months.
ARR = (total returns − capital cost) ÷ years of use ÷ capital cost × 100. The ARR formula is printed on the formula sheet; the payback method is not.
Now read across the table. The café gets its money back ten months sooner. Station Road earns the higher return, 8.33% a year against 6.00%.
The two tools point in different directions. That is normal, and it is exactly why a business uses both: each one sees something the other misses.
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A figure on its own says little. Is 8.33% a good return? Is 3 years 8 months a quick payback? You can only tell by comparing it with something (a benchmark).
Four benchmarks to hold a result against
The cost of borrowing
The bank would lend the bakery $120,000 at 8% a year (3.2.3). Station Road's ARR is 8.33%, so the shop earns only just more than the loan would cost. The café's 6.00% earns less.
The life of the asset or contract
The forecast runs five years and the fittings should last about ten. Station Road pays back after 3 years 8 months, well inside that, so there is a safety margin if sales start slowly.
The other option
Payback: the café is ten months quicker. ARR: Station Road earns 2.33 percentage points more a year. Each figure means most next to its rival.
What the owners want
Some businesses set a target, such as 'every project must pay back within three years' or 'earn at least 10%'. A result that misses the target fails, however good it looks.
Commenting on a result: To comment on a payback period or an ARR, say what the figure means, then hold it against a benchmark from the case.
Only describes
- 'Station Road pays back in 3 years 8 months'
Explains why the figure matters
- 'It pays back in 3 years 8 months, well inside the ten-year life of the fittings, so a slow first year would not put the money at risk'
Money that sits in the bank earns interest too. If a savings account paid 4%, a plan earning 3% would leave the bakery worse off than doing nothing. Every return is judged against what the money could earn somewhere else (the opportunity cost).
Size hides inside a percentage: ARR is a percentage of the cost. Station Road earns $10,000 a year on average and the café $3,000, partly because Station Road costs $70,000 more.
When two plans cost very different amounts, give the dollar figures as well as the percentages. They show how much profit each plan actually adds.
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When payback and ARR disagree, the figures cannot decide for you. The question becomes: which matters more to this business, getting its money back fast or earning the most from it?
Payback matters more when
- Cash is tight, so money tied up for long is a danger
- The market changes fast, so later cash flows are harder to trust
- The plan is borrowed against and the bank wants its money back soon
- A new rival could arrive and cut the later years' sales
ARR matters more when
- The business has cash to spare or cheap finance
- The owners want the most profit over the whole life of the plan
- The returns are expected to be steady for many years
- Its ARR clearly beats the cost of borrowing
At Lena's Bakery
- Cash is tight: $25,000 in the bank and $15,000 of the $30,000 overdraft used
- Growth is the goal: the owners want eight shops, and Station Road is the next one
- Station Road's cash flows rise each year; the café's fall once the coffee chain opens
- 8.33% barely beats the 8% loan; 6.00% does not
Look at the shape of the cash flows, not just the two results. The café's money comes early and then shrinks: $20,000 in year one, $5,000 in year five, because a coffee chain has taken the empty unit next door. Station Road starts slower and grows every year.
Payback stops counting the moment the money is back (3.8.1), so it cannot see that Station Road's best years come last. ARR takes an average (3.8.2), so it cannot see that the café's money comes early. Read each result knowing what it ignores.
The judgement in one line: The café is the safer, quicker bet. Station Road is the bigger, slower, better-paying one.
Which to choose depends on how much risk the bakery can carry now, and on what its owners are trying to achieve.
What the table cannot show: Priti, the head baker, reads the plans and says one thing: 'Who is going to bake for a fourth shop? My six bakers are already working flat out.'
Qualitative factors: No payback period shows that. Factors that cannot be measured in dollars are called qualitative factors, and they can outweigh the figures.
Five qualitative factors, at Lena's Bakery
People
Station Road needs more bread from Mill Lane, and Priti has no spare bakers; two more must be trained by March first. The café needs Aisha's time and a barista.
Objectives
The owners want eight shops, and opening Station Road by September is already a target. The café does not move the bakery towards more shops.
Risk in the forecast
Station Road's figures are a forecast for a shop that does not exist yet. The café's depend on how many customers the coffee chain next door takes.
Finance
$120,000 means a loan at 8% or new shares that dilute Lena's control (3.2.3). $50,000 is far easier to find, perhaps from retained profit.
Reputation and stakeholders
A new shop brings the bakery to a new street and creates jobs. A café may crowd the High Street counter at the morning rush and annoy regular customers.
Other factors come up in other cases: the effect on the environment, whether the business has any experience of the new activity, whether the space or the equipment is there, how staff feel about a change, and whether the plan fits the business's culture and values.
A plan with the better figures can still be the wrong choice. A social enterprise that closes a training room to make more profit may earn more and serve fewer of the people it exists for.
A factor needs the case: 'Staff morale may be affected' could be written about any business, so it proves nothing.
'Priti has no spare bakers, so Station Road cannot open until two more are trained, and every month of delay pushes the payback back' uses the case and links the factor to the figures.
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How this comes up: Most often as the last, long question on a case, for ten marks. The case gives the figures and plenty of other information.
| Question | Marks |
|---|---|
| After calculating a payback period or an ARR, discuss (or recommend) which of two options the business should choose, or whether it should go ahead with a plan | 10 |
| In short form: comment on a payback or ARR result | 2 |
| In short form: use two appraisal results to explain which option to choose | 2 |
The pattern for a ten-mark choice
- Read the figures. Give each option's payback and ARR, say which one each method favours, and hold them against a benchmark from the case.
- Argue the first option both ways. At least one point for and one against, each with a figure or a fact from the case.
- Argue the second option both ways. The same again.
- Bring in what the figures leave out. People, objectives, risk, finance, stakeholders: whichever the case gives you.
- Decide. Name the option, give the main reason, add a condition, and explain one limit of the information.
Three traps
- Only the numbers. Payback and ARR are the start of the answer, not the whole of it. Without the qualitative factors the case offers, the answer stays one-sided.
- Only one option. Two for and two against, spread over both options, is what balance means.
- No decision, or no limit. End with a choice, and say what the forecasts cannot tell you.
Using the information above, discuss whether Lena's Bakery Ltd should open the Station Road shop or the café corner.
Model answer plan
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