Using accounting rate of return and payback to analyze the profits accruing to investments

Accounting rate of return (ARR)

Accounting rate of return (ARR) is the percentage rate of return expected on an asset and compares profits earned to the initial investment cost.

Payback period

The payback period is the length of time required to earn back the amount of the initial investment.

Future cash flows: Using net present value or internal rate of return techniques to evaluate cash flows

Accounting rate of return and payback period are useful because their calculations are straight-forward. However, more serious evaluation of investment opportunities requires us to consider the time value of money. For instance, in the example above, is the $600 of profit to be earned in year 3 worth $600 to the company today? Probably not. If we gave the company $600 today, it could invest that $600 and earn annual returns. By year 3, it is likely that the amount will be worth more than $600.

Objective of financial reporting

An objective of financial reporting is to help investors, creditors, and other users assess the amounts, timing, and uncertainty of prospective cash receipts.

• Amounts: How much cash will be paid out (invested) or received from a company initiative?

• Timing: In what time period (month, quarter, or year) will each cash flow be given up (invested) or received?

• Uncertainty: How likely or unlikely are we to receive this cash flow? What is the risk that the actual cash received is greater than what was forecasted?

The last piece, uncertainty, is the focus of prescriptive analytics. In data analysis, uncertainty usually takes the form of an interest or discount rate that reflects the risk of the cash flows arriving or not arriving. The higher the uncertainty or risk, the greater the interest or discount rate used in the analysis.

Net present value (NPV) and internal rate of return (IRR) techniques

Net present value (NPV) is the present value of the cash inflows less the present value of the cash outflows. When using the NPV method, we pick different rates of risk and see if it makes sense to invest at each of the various levels of expected risk.

Example: NPV

Assume you have a new piece of equipment that is expected to cost $200,000 this year (Year 0) and will result in returns of $150,000 per year for 3 years (t, t+1, and t+2). Assume also that the cost of capital (e.g., the cost of borrowing money to make the purchase) is 10%. The NPV would be calculated as follows.

Internal rate of return (IRR)

Internal rate of return (IRR) refers to the discount rate that makes the project's net present value equal to zero, or the rate of return (where the present value of cash outflows is equal to the present value of cash inflows). There is no exact formula to compute IRR. Financial calculators and Excel use an iterative technique to experiment with different rates of return until NPV is exactly zero.

Evaluating future cash flows: Capital budgeting and investment decisions

Capital budgeting is the process of evaluating potential different (typically large) investments to help identify which a company should choose.

Example: Capital budgeting

Cory Stanford Consulting is evaluating three possible investments in software. Each potential investment costs a different amount and has a different profit payoff structure over its expected 4-year life. The projected cash flows for each investment are provided below. Which investment should the company make?

Evaluating future cash flows using NPV and IRR: Lump sum or an annuity

A friend asks you for advice. When she retires at 65, should she take a one-time, $1,000,000 lump-sum payment, where a large sum is paid in a single payment, or receive $5,000 per month for life? This is all she has for retirement, so it is important.