When cash flow are uneven, cumulative net cash flow need to be calculate for each year. Shorter the payback period has a higher return on the capital investment, therefore many companies have a maximum acceptable payback period and will only consider those project payback period has less than target payback period.
Payback period method is popular in business to use to analyze. There are several advantages which are quite simple and easy to calculate, it reducing complexity evaluation to a simple number of years to easier understood. It can be a measure of risk inherent in particular project. Payback period show us how certain the project cash inflows are because of uncertain cash flows that occurs later in a project's life. Moreover, payback period method for the companies those facing financial problems that need to cover their money as fast as possible, is useful because it identifying projects that provide the fastest return on investment.
The serious drawback of payback period is it does not count on the time value of money it may lead to wrong decision making. Since the cash inflows of a project may be uncertain, thus a project could have an acceptable rate of return but it still not really meet the company's required minimum payback period. Payback period also does not measure the profitability of a business which is the primary goal in business. It just simply tells the managers that the required years to recover the original investment.
In conclusion, based on the result of each of the three projects by using payback period calculation Project C may be preferable for Haven Plc as Project C has shortest payback period than the other which is 2 years. However, shorter the payback period of particular investment does not always desirable than other. For instance, washing machine X has a shorter payback period and the useful life has 10 years, while washing machine Y has a longer payback period and 15 years useful life. Washing machine Y would probably be a better investment than X.
Accounting Rate of Return
Accounting rate of return (ARR) is to evaluate an investment or project's profitability that without applicable taxes and accrual interest after wipe out the money invested from returns. Accounting rate of return allows companies to estimate the investment's profitability based on investment revenue that less money invested. ARR may be calculated more than one years of an investment's lifespan. If calculated more than one years, the averages of investment and revenue are taken. The formula of ARR as below:
ARR has a profitability objective where when the purchases have made, firms can use the accounting rate of return method to track the profitability and cost effectiveness of the capital investment. This may help firms to improve decisions making and plan effectively associated to capital expenditures. Moreover, it is simple and easier way to calculate and understand by using ARR method, it can be evaluate quickly on the spot that allowing firms to take advantage of immediate opportunities.
However, there are few disadvantage of using ARR method. Accounting rate of return same as payback period that does not count on the time value of money if the alternatives have unlike cash flow patterns, ARR method can be misleading. Also, a lot of investments and projects do not have an incremental revenues and expenses constantly over their useful lives. ARR as a result, will fluctuate from years to years that particular project may occur to be desirable in some years and undesirable in others years.
In conclusion, to making a decision by using ARR method, choose the project which has higher ARR than standard and reject lower ARR if the projects are independent. Whereas, if projects are mutually exclusive, choose the project which has highest ARR and reject other projects. Base on the accounting rate of return calculation for each of three projects, shareholders of Haven Plc may choose project B as project B has a highest ARR which is 24%.
Net Present Value
The net present value (NPV) method in capital budgeting seeks to remedy some of the weakness of payback and the accounting rate of return. Net present value takes sum of all cash flows and outflow over the life of the project and makes allowance for the time value of money as well as calculates the present value of all expected future cash flow by using minimum target rate of return.
For long-term projects and investments appraisal may good to using net present value method because it account time value of money which considers potential incoming cash flow and measure the excess of cash flows. This may then to consider the problems and risks of future cash flow as well as overall net cash flow. Net present value also helps to maximize firm's value.
Net present value also has disadvantages where if the amount of investment is not equal in projects of mutually exclusive, NPV cannot make a decision accurately. It is difficult to calculate the discount rate appropriate because of uncertain in estimating discount rate may make uncertain of NPV numbers. Also, when particular projects are not equal life NPV may not give correct decision.
If the project has a higher NPV, the project is more profitable. Base on the result of NPV for each of three projects, Project A may be more preferable as it has higher NPV than the other projects which is 82.89.
Internal rate of return
Internal rate of return is the interest rate where the net present value of an investment or project is equal zero. Internal rate of return is to estimate the attractiveness of an investment or project.
Internal rate of return have numerous advantages. It consider the time value of money when estimate an investments or projects because when project's present value is zero, the calculation find out the return then will know the minimum rate of return. It will cover the costs and make a profit as long as the rate is positive. Internal rate of return method is simple to understand as the calculation gives a rate for each project. The higher internal rate of return will be the best to choose when decide from more projects, this help to make the decision easily.
However, there are several disadvantages for internal rate of return. Internal rate of return calculation ignores the dollar value thus it is not the best for comparing mutually exclusive projects. For instance, Project X may give initial investment of $10000 a 10% internal rate of return. Project Y may give initial investment of $100000 a 5% internal rate of return. With internal rate of return method, would reject the Project Y even though it result a higher profit. Beside internal rate of return is difficult to understand to calculate different rate because when the present value of cash inflow not equalize with present value of cash outflow the real value of internal rate of return may be two new rates.
In conclusion, if the project of internal rate of return higher than a company's required rate of return, the project should be accept. If internal rate of return lower than company's required rate of return, the project should be rejected. Base on the result of internal rate of return calculation for each of three projects, it seem like Project C more desirable as it has 33.0% of internal rate of return which is higher than the other two projects.
Conclusion
According to the result of using payback period method, accounting rate of return method, net present value method and internal rate of return to calculate Project A, Project B and Project C above. Although Project B has the higher accounting rate of return which is 24% and Project A has a higher net present value which is 82.89, but Project C may be desirable to choose as it net present value is 79.02 which just merely differ from Project A. Project C has a highest internal rate of return which is 33.0% compare to other Project A and B. Also, Project C has a shortest payback period which is 2 years compare to the other Projects. Therefore, Project C may more preferable for Haven Plc.
