PAYBACK PERIOD, AVERAGE RATE OR RETURN AND PROFITABILITY INDEX

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Payback period:

●       The length of time required for an investment to recover its initial outlay in terms of profits or savings.

●       The shortest payback period is generally considered to be the most acceptable.

●       The longer the money is tied up, the less opportunity there is to invest it elsewhere.

●       Focus on early payback can enhance liquidity.

●       Investment risk can be assessed through payback method.

●       NPV (Net Present Value) is calculated in terms of currency while Payback method refers to the period of time required for the return on an investment to repay the total initial investment.

●       A major criticism of the payback period method is that it ignores the "time value of money," the principle that describes how the value of a dollar changes over time.



Accounting OR Average rate of return:

●       The accounting rate of return (ARR) is the percentage rate of return expected on investment or asset as compared to the initial investment cost.

●       ARR does not consider the time value of money or cash flows, which can be an integral part of maintaining a business.

●       ARR divides the average revenue from an asset by the company's initial investment to derive the ratio or return 

●       ARR is used mainly as a general comparison between multiple projects to determine the expected rate of return from each project.

●       It factors in any possible annual expenses or depreciation expense that's associated with the project.

●       ARR does not differentiate between investments that yield different cash flows over the lifetime of the project

●       ARR doesn't consider the time value of money (TVM). 

The accounting rate of return does not consider the increased risk of long-term projects and the increased uncertainty associated with long periods.

Profitability index:

●       The profitability index (PI), alternatively referred to as value investment ratio (VIR), or profit investment ratio (PIR), describes an index that represents the relationship between the costs and benefits of a proposed project

●       The PI is helpful in ranking various projects because it lets investors quantify the value created per each investment unit. 

●       A company would want to accept any project with a profitability index greater than one because investing in that project would be a profitable venture.

●       The profitability index indicates whether an investment should create or destroy company value. 

●       The profitability index also considers the risk involved in future cash flows with the help of cost of capital.


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