As a ranking method, it gives highest ranking to the project, which has the shortest payback period and lowest ranking to the project with highest payback period.

Evaluation of Payback Certain virtues:Simplicity Cost effective Short-term effects Risk shield LiquiditySerious limitations: Cash flows after payback Cash flows ignored Cash flow patterns Administrative difficulties Inconsistent with shareholder value

Payback Reciprocal and the Rate of ReturnThe reciprocal of payback will be a close approximation of the internal rate of return if the following two conditions are satisfied:1.The life of the project is large or at least twice the payback period.2.The project generates equal annual cash inflows.

DISCOUNTED PAYBACK PERIODThe discounted payback periodis the number of periods taken in recovering the investment outlay on the present value basis. The discounted payback period still fails to consider the cash flows occurring after the payback period.Discounted Payback Illustrated

ACCOUNTING RATE OF RETURN METHODThe accounting rate of return is the ratio of the average after-tax profit divided by the average investment. The average investment would be equal to half of the original investment if it were depreciated constantly.A variation of the ARR method is to divide average earnings after taxes by the original cost of the project instead of the average cost. or

ExampleA project will cost Rs 40,000. Its stream of earnings before depreciation, interest and taxes (EBDIT) during first year through five years is expected to be Rs 10,000, Rs 12,000, Rs 14,000, Rs 16,000 and Rs 20,000. Assume a 50 per cent tax rate and depreciation on straight-line basis.

Calculation of Accounting Rate of Return

Acceptance RuleThis method will accept all those projects whose ARR is higher than the minimum rate established by the management and reject those projects which have ARR less than the minimum rate.This method would rank a project as number one if it has highest ARR and lowest rank would be assigned to the project with lowest ARR.

Evaluation of ARR MethodThe ARR method may claim some meritsSimplicity Accounting data Accounting profitability Serious shortcomingsCash flows ignored Time value ignored Arbitrary cut-off

Conventional & Non-Conventional Cash FlowsA conventional investment has cash flows the pattern of an initial cash outlay followed by cash inflows. Conventional projects have only one change in the sign of cash flows; for example, the initial outflow followed by inflows, i.e., – + + +.Anon-conventional investment, on the other hand, has cash outflows mingled with cash inflows throughout the life of the project. Non-conventional investments have more than one change in the signs of cash flows; for example, – + + + – ++ – +.

NPV vs. IRRConventional Independent Projects:In case of conventional investments, which are economically independentof each other, NPV and IRR methods result in same accept-or-reject decision if the firm is not constrained for funds in accepting all profitable projects.

NPV vs. IRR•Lending and borrowing-type projects: Project with initial outflow followed by inflows is a lending type project, and project with initial inflow followed by outflows is a lending type project, Both are conventional projects.