LONG TERM DECISION MAKING CHAPTER 11

11.1 Payback Period

• The payback period is the number of years required for a project to accumulated enough cash to pay for
the cost of the initial investment
• This method of evaluating projects focuses on liquidity and how quickly cash investment in a project is
recouped.
• The shorter the payback period, the more desirable the investment

11.1.1 Advantages of payback period

✓ Risky projects with long payback periods are not favoured by this method
✓ It focuses on liquidity, and is a useful technique if a firm is facing cash constraints.

11.1.2 Disadvantages of payback period

 Cash flows which occur after the payback period are ignored
 The time value of money (inflation) is ignored
 It takes no account of the overall profitability of a project

Example 11.1
The management of Low Risk Ltd is currently evaluating the following project.
Year 0 Year 1 Year 2 Year 3 Year 4
Initial Investment £120,000
Cash inflows £40,000 £40,000 £40,000 £60,000
Required: Determine the project’s payback period.

Example 11.2
Pink Ltd is considering investing in plant machine. The cost of purchasing the machine is £18,000, and it is
expected to produce annual savings of £3,000. The machine is expected to have a useful life of ten years. Pink
Ltd considers an investment to be acceptable if it pays back within five years.
Required:
a) What is the machine’s payback period?
b) Should Pink Ltd invest in the machine?

Example 11.3
The management of Brislington Ltd is currently evaluating the following investment proposal:
Year 0 Year 1 Year 2 Year 3 Year 4
Initial Investment £120,000
Cash inflows £30,000 £80,000 £60,000 £40,000

Required: Determine the project’s payback period

Pearson LCCI LEVEL 3 ACCOUNTING (ASE20104)

LONG TERM DECISION MAKING CHAPTER 11
11.2 Net present value method
▪ Net present value (NPV) is the difference between the present value of the cash inflows from a project
and the initial amount invested in the project.
▪ The method required discounting of all cash flows to their present value. Discounting means multiplying
the cash flow by the discount factor.
▪ Present value is the cash received in future years restated to its current value, effectively adjusting for
inflation and risk
▪ If the present value of the cash inflows is less than the initial cash investment, the project is said to have a
negative net present value.

11.2.1 Advantages of payback period

✓ Gives a clear decision rule: accept positive NPV projects and reject negative NPV project.
✓ Takes the time value of money

11.2.2 Disadvantages of payback period

 Selecting an appropriate discount rate for the project can be problematic
 The method requires estimating the useful life of the project and timing of cash flows associated
with the project.

Example 11.4
Alan Ltd is considering purchasing a vehicle for £28,000. The running costs of the vehicle are estimated at
£3,000 per year but Alan Ltd will save £7,000 on distribution costs per year. The vehicle will be sold for £5,000
at the end of Year 5.
Required: Calculate the net present value
Discounting factors:
Year 1 0.893
Year 2 0.797
Year 3 0.712
Year 4 0.636
Year 5 0.567

Example 11.5
Ronnie Ltd is considering the purchase of new machinery. The purchase price of the machinery is £200,000;
the estimated useful life will be six years.
Installation costs will be an additional £20,000. The existing machinery can be sold for £50,000. Annual cost
savings will be £36,000. The scrap value of the new machinery will be £5,200.

Required: a) What is the NPV of this capital project?

b) Should the project be undertaken?
Discounting factors:
Year 1 0.870
Year 2 0.756
Year 3 0.658
Year 4 0.582
Year 5 0.497
Year 6 0.432

Pearson LCCI LEVEL 3 ACCOUNTING (ASE20104)

LONG TERM DECISION MAKING CHAPTER 11
11.3 Accounting rate of return
The accounting rate of return (ARR) related the net income generated by a project to the initial capital
investment.
It is measured as follows:

11.3.1 Advantages of payback period

✓ The method is easy to understand
✓ The calculation are simple

11.3.2 Disadvantages of payback period

 It does not take the timing of cash flows into account
 It focuses on profits and not cash flows

Example 11.6
Alex Ltd is considering purchasing a vehicle for £28,000. The running costs of the vehicle are estimated at
£4,000 per year but Alex Ltd will save £9,000 distribution costs per year. The vehicle will be sold for £5,000 at
the end of Year 5.
Required: Calculate the accounting rate of return.

TARGET PRACTICE
11.1 Jinn Ltd has to choose between three investments, details of which are as follows:

Investment A Investment B Investment C

Year Cash Flows Year Cash Flows Year Cash Flows
0 (65,000) 0 (45,000) 0 (155,000)
1–4 25,000 1–5 11,000 1 30,000
5 10,000 2 40,000
3 20,000
4 140,000
5 (60,000)
Required:
a) Calculate the net present value of each investment and state which would be preferred using the NPV
criteria.
b) Calculate the payback period for each investment and state which would be preferred using the payback
criteria
c) Calculate the accounting rate of return on each investment and state which would be preferred using ARR
d) Which is the three investments would the company undertake?
Discounting factors:
Year 1 0.909
Year 2 0.826
Year 3 0.751
Year 4 0.683
Year 5 0.621

Pearson LCCI LEVEL 3 ACCOUNTING (ASE20104)