25.5.A. Traditional Techniques (Non-discounted Methods)

1. Payback Period (PBP)

   • Definition: Time it takes to recover the initial investment.
   • Formula:

   $\text{Payback Period} = \frac{\text{Initial Investment}}{\text{Annual Cash Inflow}}$

   • Advantages:
     • Simple and easy to understand.
     • Good for assessing liquidity.
   • Disadvantages:
     • Ignores time value of money.
     • Does not consider cash flows after payback period.

The Payback Period (PBP) measures how quickly an investment can be recovered. The formula divides the initial investment by the amount of cash inflows generated annually. For example, if a company invests $10,000 and receives$2,000 every year, it will take 5 years (10,000 ÷ 2,000) to recover that investment.

This technique is advantageous because it is straightforward and helps companies assess how quickly they recoup their investments, which can be essential for short-term financial planning. However, it has limitations, such as the fact that it does not take into consideration the time value of money—meaning money today is worth more than the same amount in the future—and it disregards any cash inflows that occur after the payback period.

Think of it like a friend who lends you money to start a small lemonade stand. If you agree to pay them $1,000, and your stand earns$100 every day, it will take you 10 days to repay your friend. While you can easily see when you'll pay them back, you don't consider how the $1,000 could grow if invested elsewhere or what happens after those 10 days.

2. Accounting Rate of Return (ARR)

   • Definition: Measures return based on accounting profits.
   • Formula:

   $\text{ARR} = \frac{\text{Average Annual Profit}}{\text{Initial Investment}} \times 100$

   • Advantages:
     • Simple and based on accounting data.
   • Disadvantages:
     • Ignores time value of money.
     • Uses accounting profit, not cash flow.

The Accounting Rate of Return (ARR) is a method used to evaluate an investment by comparing the average annual profit it generates to the initial investment cost. The formula involves dividing the average annual profit by the initial investment and multiplying by 100 to express it as a percentage.

For example, if your total profit over 5 years from an investment of $10,000 is$5,000, your ARR would be calculated as (5,000 ÷ 10,000) × 100 = 50%. While this method is straightforward and relies on easily accessible accounting data, it does not consider how the timing of profits may affect their value. Investments could yield different profits at different times, impacting overall profitability.

Imagine you open a small bakery and invest $10,000. If, at the end of five years, you averaged an annual profit of$2,000, your ARR would be 20%. This gives you a basic idea of your returns, but it doesn't show you the ups and downs in profits or take into account that an investment now might yield more in a few years due to inflation.

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