Payback period

Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment. It is one of the simplest investment appraisal techniques.FormulaThe formula to calculate payback period of a project depends on whether the cash flow per period from the project is even or uneven. In case they are even, the formula to calculate payback period is:Payback Period =Initial Investment

Cash Inflow per Period

When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the following formula for payback period:Payback Period = A +B

C

In the above formula,Ais the last period with a negative cumulative cash flow;Bis the absolute value of cumulative cash flow at the end of the period A;Cis the total cash flow during the period after ADecision RuleAccept the project only if its payback period is LESS than or equal to the target payback period.

Accounting rate of return

Accounting rate of return (also known as simple rate of return) is the ratio of estimated accounting profit of a project to the average investment made in the project. ARR is used in investment appraisal.

FormulaAccounting Rate of Return is calculated using the following formula:ARR =Average Accounting Profit

Average Investment

Average accounting profit is the arithmetic mean of accounting income expected to be earned during each year of the project's life time. Average investment may be calculated as the sum of the beginning and ending book value of the project divided by 2. Another variation of ARR formula uses initial investment instead of average investment.Decision RuleAccept the project only if its ARR is equal to or greater than the required accounting rate of return. In case of mutually exclusive projects, accept the one with highest ARR.