186 ACCOUNTING FOR MANAGERS
Project 3 in particular has substantial fluctuations in ROI from year to year. Using
this method, Project 2 shows the highest return. However, it does not take into
account either the scale of the investment required or the timing of the cash flows.
Payback
This second method calculates how many years it will take – in cash terms – to
recover the initial investment, on the assumption that the shorter the payback
period, the better the investment. Based on the cash flows for each project:
žProject 1 takes four years to recover its £100,000 investment (4 @ £25,000).
žProject 2 has recovered £105,000 by the end of the third year (3 @ £35,000)
and will take less than seven months (20/ 35 =.57 of 12 months) to recover its
£125,000 investment. The payback is therefore 3.57 years.
žProject 3 recovers its investment of £200,000 by the end of the third year
(£60, 000 +£60, 000 +£80,000).
Based on the payback method, Project 3 is preferred (followed by Projects 2 and
- as it has the fastest payback. However, the payback method ignores the size
of the investment and any cash flows that take place after the investment has
been recovered.
Neither the accounting rate of return nor the payback method considers thetime
value of money, i.e. that £100 is worth more now than in a year’s time, because it can
be invested now at a rate of interest that will increase its value. For example, £100
invested today at 10% interest is equivalent to £110 in a year’s time. Conversely,
receiving £100 in a year’s time is not worth £100 today. Assuming the same rate of
interest it is worth only £91, because the £91, invested at 10%, will be equivalent to
£100 in a year’s time.
The time value of money needs to be recognized in investment appraisals in
order to compare investment alternatives with different cash flows over different
time periods. The third method of investment appraisal therefore involvesdis-
counted cash flow (DCF), i.e. it discounts the future cash flows to present values
using a discount rate (or interest rate) that is usually the firm’s cost of capital (the
risk-adjusted cost of borrowing for the investment).
There are two discounted cash flow techniques: net present value and internal
rate of return.
Net present value
Thenet present value (NPV)method discounts future cash flows to their present
value and compares thepresent value of future cash flowsto the initial capi-
tal investment.
present value (PV) of cash flows=cash flow×discount factor (based
on number of years in the future and the cost of capital)