Question 1

Is a project with a shorter payback period always the better choice?

Accepted Answer

Not necessarily. Whilst a shorter payback period indicates lower risk and faster cash recovery, it ignores profitability. A project with a longer payback period might generate significantly higher profits over its entire lifespan, making it a better long-term investment. A business must consider its objectives; if survival and cash flow are critical, short payback is preferred. If long-term profit is the goal, ARR or other methods might be more important.

Question 2

Can I just use the cash flow figures provided in the data to calculate ARR?

Accepted Answer

No, this is a very common error. ARR is based on 'profit', not 'cash flow'. You must first calculate the total profit of the project by adding up all the net cash inflows and then subtracting the initial capital cost. After finding the total profit, you divide it by the project's lifespan in years to find the average annual profit, which you then use in the ARR formula.

Question 3

Do Payback and ARR account for the effects of inflation and interest rates over time?

Accepted Answer

No, neither of these basic methods accounts for the 'time value of money'. They both treat £100 of cash flow or profit in year 5 as having the same value as £100 today. In reality, due to inflation and potential interest earnings, money received in the future is worth less than money received today. More advanced techniques, such as Net Present Value (NPV), are required to account for this.

Basic methods: payback, accounting rate of return (ARR)

What you need to know

Simple investment tests