Accounting Business Reporting for Decision Making

CHAPTER 12 Capital investment 507

Decision rule for payback period

The decision rule with PP varies among entities, but most have maximum periods beyond which they

would not invest. Just as with ARR standards, the maximum periods might be based on past performance

in that individual entity, or on industry averages. The maximum periods generally vary quite markedly.

For example, the payback period for a major mining venture, like those undertaken by BHP Billiton and

Bass Strait Oil Company, is much longer than the payback period built into the pricing and investment

decisions related to a newly developed herbicide or pharmaceutical ingredient. Similarly, the purchase

of a new Airbus A380 would take several years (and many flights) to pay back its initial purchase price.

However, one thing is certain: the longer the PP, the greater the risk, because there is a far greater chance

that some of the assumptions on which the investment decision was made will change.

Advantages and disadvantages of PP

The advantages of the PP measure are that it:

• is simple to calculate


• is easy to understand


• provides a crude measure of incorporating awareness of risk into the decision, as projects with rela-

tively high early cash surpluses will have smaller PPs.

The disadvantages of the PP method are that it:

• ignores the time value of money, as the PP method treats all cash inflows equally


• also ignores all cash inflows after payback has occurred, so that inherently more profitable invest-

ments may be rejected in favour of less profitable short-term investments given that the time horizon

of analysis is restricted to the period up until the initial investment is recouped. For example, with the

Coconut Plantations Company no consideration is given to cash flows beyond the payback period.

Similarly to the ARR, the PP is considered to be too simplistic a measure to be used by itself as a

decision-support tool. Again, it does not recognise that funds received early in the life of a project are

worth more than funds received later.

VALUE TO BUSINESS

•   The accounting rate of return is based on accounting profits, and the payback period is based on

cash flows.

•   The accounting rate of return (ARR) has immediate appeal to accountants and managers who are

accustomed to dealing with profit figures and asset values. This measure expresses the average

profit over the period of the investment as a percentage of the average investment.

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

inflows. If two investments are equally profitable, most entities would prefer the investment where

the outlaid cash was recouped earlier.

•   Both measures are simplistic and may be useful for quick analyses to sort out projects for further

analysis.

12.4 Net present value

LEARNING OBJECTIVE 12.4 Discuss and calculate net present values (NPV) and apply the decision rule.

As discussed in the previous section, ignoring the time value of money is a major defect of both the

ARR and PP tools. Discounted cash-flow techniques overcome this problem by specifically recognising

that $1 received in the future is worth less than $1 received now. Suppose Andrew, a friend, borrowed

$1000 from you, and your expectation was that he would repay you in a day or so. After asking him for

the money several times, Andrew promises to repay the funds at the end of one year. If he does so, is