Accounting Business Reporting for Decision Making

506 Accounting: Business Reporting for Decision Making

• consistent with the ROA measure, which entities often try to increase in an attempt to maximise

owners’ wealth.

The disadvantages of the ARR method are that:

• it ignores the time value of money and the timing of profits


• it ignores the importance of cash as the ultimate resource without which entities cannot survive (enti-

ties must have sufficient cash to meet their obligations on time, no matter how asset-rich they are)

• profits and costs may be measured in different ways.

Overall, the ARR is considered by most managers to be too simplistic a measure to be appropriate by

itself as a decision-support tool for the application of scarce investment funds. The fact that the timing

of cash flows and subsequent profits is ignored is seen as a major deficiency. The method, for example,

cannot differentiate between two equally profitable projects but with unequal timing of the profits. (In

reality, the project with cash surpluses early in its life is preferable to another project with cash receipts

received later in its life.)

12.3 Payback period

LEARNING OBJECTIVE 12.3 Explain and use the payback period (PP) method.

Entities invest in order to make profits. Investments normally require the outlay of cash and, as noted

above, cash is important to entities that want to survive. Thus, the time it takes to recoup cash expended

on investment is important. If two investments were potentially equally profitable, most entities would

prefer the investment where the outlaid cash was recouped earlier.

The payback period (PP) is the period of time necessary to recoup the initial outlay with net cash

inflows. Hence, the expected net cash inflows each year are added until the sum is equal to or greater

than the initial outlay. The number of years of cash surpluses necessary to be earned to equal the initial

investment is the PP. This is demonstrated in illustrative example 12.3.

ILLUSTRATIVE EXAMPLE 12.3

Calculating the payback period

For the Coconut Plantations’ proposal, we know the initial investment in equipment is $120 000. By the

end of year 1, $30 000 net cash flows have been received and, by the end of year 2, a further $60 000

in net cash flows should have been received, making $90 000 in total, with a further $30 000 cash

necessary to repay the initial investment. Given that we need $30 000 of the $50 000 in year 3 to pay

back the initial investment exactly, we can say the payback period is about 2.6 years (see table 12.2).

(Assuming funds are received consistently at about $1000 surplus each week, it will take 30 weeks or

0.6 years to earn the required $30 000 surplus.)

TABLE  12.2 Payback decision rate

Year Net cash flow $ Cumulative net cash flow ($)

0 (120 000) (120 000)

1 30 000 (90 000)

2 60 000 (30 000)

Payback occurs between

years 2 and 3

3 50 000 20 000

4 100 000 120 000