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

In the exam, always show your workings clearly. State the payback period in years and months for full marks. For example, '2 years and 8 months' is a much better answer than '2.67 years'. This demonstrates a full understanding of the calculation method.

A common mistake is to use average annual cash flow instead of average annual profit. Remember to subtract the initial investment from the total cash inflows to find the total profit before you calculate the average. Always state your final answer as a percentage.

Always conclude evaluation with: "Neither method discounts future cash flows, so NPV is preferred for wealth-maximising decisions unless liquidity dominates."

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.

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.

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.