Traditional methods of evaluating long-term projects

Meaning. Traditional methods of evaluating long-term projects are the non-discounting techniques: they do not discount future cash flows. There are two, the payback period and the accounting rate of return.

1. Payback period

Concept. The time taken for the cumulative net cash inflows to equal the initial outlay.

• Even inflows: payback = initial investment / annual cash inflow.
• Uneven inflows: add the inflows year by year and find the point where the total reaches the outlay, taking the fraction of the last year in proportion.

Decision rule. Management fixes a cut-off period; a project whose payback is within the cut-off is accepted and others are rejected.

Illustration (our own figures). Outlay ₹10,00,000; cash inflows for four years:

The outlay is recovered during year 3. Payback = 2 years + (10,00,000 - 7,00,000) / 5,00,000 = 2.6 years. With a cut-off of three years the project is accepted.

Merits. It is simple in concept and application; it highlights early recovery and so gives an idea of liquidity; and a shorter payback is read as lower risk, since distant inflows are less certain.

Limitations. It ignores the time value of money; it ignores inflows after the payback point; the cut-off is arbitrary; and it favours short-lived projects and so is not a measure of profitability. It suits a firm that is short of funds or faces an unstable period and wants its money back early.

2. Accounting (average) rate of return, ARR

Concept. The annualised net income earned on the funds invested in a project, stated as a percentage of the investment. ARR = average annual profit after tax / investment. The investment may be taken as the initial outlay or as the average investment, which is half of (cost less salvage value) plus the salvage value; whichever basis is chosen should be used for all projects compared. Profit here is the accounting profit, not cash flow.

Decision rule. Accept a project whose ARR is above the minimum rate the management has set, and rank projects by ARR, the highest first.

Illustration (our own figures). Cost ₹10,00,000, salvage value ₹1,00,000, life four years, profit after tax and depreciation:

Average annual profit = 7,00,000 / 4 = ₹1,75,000. Average investment = (10,00,000 + 1,00,000) / 2 = ₹5,50,000. ARR = 1,75,000 / 5,50,000 = 31.82%. On the initial investment the same project shows 17.50%, so the basis used must always be stated.

Merits. It is simple, it uses data that the accounts already produce, and, unlike payback, it takes in the profits of the whole life of the project and so gives a measure of profitability.

Limitations. It ignores the time value of money and treats all cash flows as equal; it rests on accounting income, which differs from cash flow; the choice of depreciation method changes the profit and book value used; and it leaves out working capital and other outlays that are not in the book value of the project.

Comparison and conclusion.

Both are quick and easy to apply but share the weakness that they pay no regard to the size and timing of the whole cash-flow stream, which is why the discounted cash flow methods are preferred as the main tests.