3 8 - Payback Period and Average Rate of Return - IB Business Management

Investment Appraisal: Understanding Payback Period and ARR

Introduction to Investment Appraisal

• The video introduces the topic of investment appraisal, emphasizing its relevance in finance and its mathematical components.

• Three methods of investment appraisal are highlighted: Payback Period, Average Rate of Return (ARR), and Net Present Value (NPV). The focus for this video is on Payback Period and ARR.

Concept of Investment Appraisal

• An example is provided where a business considers expanding its factory at a cost of £200 million, expecting an increase in revenue by £50 million per year.

• Another scenario discusses extending a product's life cycle through new versions, weighing costs against potential revenue increases over time.

Financial Perspective on Education

• The speaker compares investment appraisal to the decision to attend university, which involves significant upfront costs but potentially higher lifetime earnings.

Defining Investment Appraisal Techniques

• Investment appraisal is defined as quantitative techniques used to assess project profitability or desirability using numerical data.

• A typical cash flow scenario is presented with an initial large negative cash flow followed by smaller positive inflows over time.

Calculating the Payback Period

• The payback period is described as the time it takes for net cash inflows to exceed the initial investment. A simpler definition offered is "when do you get your money back?"

• To calculate payback, it's recommended to create an accumulated cash flow column that tracks total cash flows over time until reaching zero.

Example Calculation of Payback Period

• An example illustrates how accumulated cash flows transition from negative to positive, indicating when the payback occurs.

• It’s noted that payback happens between years two and three when accumulated cash flow reaches zero; thus, it can be estimated as 2 years and 6 months based on linear assumptions.

Handling Complex Scenarios in Payback Calculation

• More complex scenarios are discussed where different numbers complicate calculations. Accumulated cash flows must still be tracked year by year.

Understanding Payback Period and Average Rate of Return

Calculating the Payback Period

• The payback period is calculated by determining how long it takes to recover an initial investment. In this case, starting at -20 and needing 20 to reach zero, with a profit of 30 over the year results in a payback of three years and eight months.

• A timeline approach can help visualize the payback process. Starting at -20 and ending at 10 after one year illustrates that reaching zero requires only two-thirds of the year.

• To clarify, since we need to cover 20 but earn 30 in a year, we only require two-thirds of that time frame to achieve payback.

• An alternative method involves calculating monthly profits. With an annual profit of 30 divided by 12 months yielding a monthly profit of 2.5, dividing the required amount (20) by this monthly figure gives eight months for recovery.

• Another example shows that if you need to recover 75 over a period where you make 200 annually, it results in a payback period of approximately two years and four-and-a-half months.

Understanding Average Rate of Return (AR)

• The Average Rate of Return measures annual profitability as a percentage relative to initial capital costs. It’s essential for evaluating project performance.

• For instance, if inflows total 200 each year for four years against an initial cost of 500, total profits would be calculated as accumulated cash flow minus costs resulting in a profit of 300.

• The average annual profit is derived from total profits divided by the number of years; thus, with total profits being 300 over four years yields an average annual profit of 75.

• This average is then compared against initial capital: 75/500 times 100 = 15% , indicating that on average, the project returns about 15% annually based on its original cost.

• A simplified "pyramid method" can also be used for calculations: take total profits (300), divide by years (4), then divide again by initial costs (500), multiplying by 100 gives the same result efficiently.

Evaluating Payback vs. AR

• The payback method is straightforward and intuitive as it focuses on when investments are recouped; however, it overlooks cash flows beyond this point which may lead to short-term thinking regarding project viability.

• Conversely, while AR considers all cash flows across time frames providing comprehensive insights into profitability, it does not account for timing differences between those cash flows which could affect decision-making processes.

• Combining both methods allows investors to assess projects more holistically—paybacks provide quick recovery insights while AR offers broader profitability perspectives useful for comparing various investment opportunities like stocks or savings accounts.

Conclusion