Page 175 - DMGT521_PROJECT_MANAGEMENT

Project Management

Notes = (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 1.
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 period is calculated
as the moment in which the cumulative positive cash flow exceeds the total cash outflow.

Notes 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 Endeavour.

Self Assessment

Fill in the blanks:
1. ………………… in capital budgeting refers to the period of time required for the return on
an investment to “repay” the sum of the original investment.

2. Payback period as a ………………… of analysis is often used because it is easy to apply and
easy to understand for most individual.
3. The payback period is considered a method of analysis with serious limitations and
………………… for its use.
4. Payback period intuitively ………………… how long something takes to “pay for itself.”

10.2 Accounting Rate of Return

Accounting rate of return or simple rate of return is the ratio of the estimated accounting profit
of a project to its average investment. It is an investment appraisal technique. ARR ignores the
time value of money.

Formula:
Accounting Rate of Return is calculated as follows:
Average Accounting Profit
ARR =
Initial Investment
Average accounting profit is the arithmetic mean of accounting income expected to be earned
during each year of the project’s life time. Initial investment is sometimes replaced by average
investment due to the reason that the book value of the project usually declines over its life time.
Average investment is calculated as the sum of the beginning and ending book value of the
project divided by 2.

Notes 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.

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