Page 14 - DMGT302_FUNDAMENTALS_OF_PROJECT_MANAGEMENT

Unit 1: Introduction to Projects

Average Rate of Return: Often mistaken as the reciprocal of the payback period, the average rate Notes
of return is the ratio of the average annual profit (either before or after taxes) to the initial or
average investment in the project. Because average annual profits are usually not equivalent to
net cash inflows, the average rate of return does not usually equal the reciprocal of the payback
period. Assume, in the example just given, that the average annual profits are $15,000:

Average rate of return = $15,000/$100,000 = 0.15
Neither of these evaluation methods is recommended for project selection though payback
period is widely used and does have a legitimate value for cash budgeting decisions. The major
advantage of these models is their simplicity, but neither takes into account the time value of
money. Unless interest rates are extremely low and the rate of inflation is nit, the failure to
reduce future cash flows or profits to their present value will result in serious evaluation errors.
Other Profitability Models: There are a great many variations of the models just described.
These variations fall into three general categories: (1) those that sub-divide net cash flow into
the elements that comprise the net flow; (2) those that include specific terms to introduce risk (or
uncertainty, which is treated as risk) into the evaluation; and (3) those that extend the analysis to
consider effects that the project might have on other projects or activities in the organization.

Several comments are in order about all the profit, profitability numeric models. First, let us
consider their advantages:
1. The undiscounted models are simple to use and understand.

2. All use readily available accounting data to determine the cash flows.
3. Model output is in terms familiar to business decision-makers.
4. With a few exceptions, model output is on an “absolute” profit/profitability scale and
allows “absolute” go/no-go decisions.
5. Some profit models account for project risk.
The disadvantages of these models are the following:
1. These models ignore all non-monetary factors except risk.
2. Models that do not include discounting ignore the timing of the cash flows and the time
value of money.
3. Models that reduce cash flows to their present value are strongly biased toward the short
run.
4. Payback type models ignore cash flows beyond the payback period.
5. The internal rate of return model can result in multiple solutions.
6. All are sensitive to errors in the input data for the early years of the project.

7. All discounting models are nonlinear, and the effects of changes (or errors) in the variables
or parameters are generally not obvious to most decision-makers.
8. All these models depend for input on a determination of cash flows, but it is not clear
exactly how the concept of cash flow is properly defined for the purpose of evaluating
projects.
In our experience, the payback period model, occasionally using discounted cash flows, is one of
the most commonly used models for evaluating projects and other investment opportunities.
Managers generally feel that insistence on short payout periods tends to minimize the
uncertainties associated with the passage of time. While this is certainly logical, we prefer
evaluation methods that discount cash flows and deal with uncertainty more directly by

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