9609 · 10.3.2
Basic methods: payback, accounting rate of return (ARR) flashcards
Revision flashcards for Cambridge 9609 Basic methods: payback, accounting rate of return (ARR) (syllabus 10.3.2). Flip, recall, then mark a real past-paper question.
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Payback period?
Time taken for cumulative net cash inflows to equal the initial investment.
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Payback decision rule?
Accept if payback ≤ target/maximum period set by the business (shorter is better).
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ARR formula?
ARR = (Average annual profit ÷ Initial investment) × 100%.
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Strength of payback?
Simple, focuses on liquidity/risk, favours faster cash recovery.
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Weakness of payback?
Ignores time value of money and cash flows after payback period.
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Weakness of ARR?
Uses accounting profit not cash flow; ignores timing of returns; arbitrary average.
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Average annual profit for ARR?
Total profit over project life ÷ number of years (or given in question).
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When might payback dominate NPV?
When business faces cash shortages and needs fast recovery of capital.
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What is the payback period?
The time it takes for the net cash inflows from an investment project to equal the initial capital cost. It measures liquidity and risk.
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How do you calculate the final part of the payback period in months?
Formula: (Amount of investment remaining to be paid back / Net cash flow in the year of payback) × 12 months.
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What is the Accounting Rate of Return (ARR)?
A measure of an investment's profitability, calculated by finding the average annual profit as a percentage of the initial investment cost.
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What is the formula for ARR?
ARR (%) = (Average Annual Profit / Initial Investment) × 100. Average Annual Profit = (Total Inflows - Initial Investment) / Project Lifespan.
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What is the most significant weakness of the payback method?
It completely ignores cash flows, and therefore profitability, that occur after the payback period has been reached.