Once the stream of costs and benefits has been defined, it must be evaluated to determine whether the project is worthwhile or not. Several criteria have been proposed for such evaluation, of which the important ones are:
1. Payback period
2. Average rate of return
3. Net present value
4. Internal rate of return
Pay back Period:
The payback period is the length of the time required to recover the initial cash outlay on the project. For example, a project involves a cash outlay of Rs 600,000 and generates cash inflows of Rs 100,000, Rs 250,000, Rs 250,000 and Rs 200,000 in the first second third and fourth years respectively. In this case, the payback period is 3 years because the sum of cash inflows during 3 years is equal to the initial outlay. When the annual cash inflow is a constant sum, the payback period is simply the initial outlay divided by the annual cash inflow. For example, a project which has a initial cash outlay of Rs 1,000,000 and a constant annual cash inflow of Rs 300,000 has a payback period of Rs 1,000,000 / Rs 300,000 = 3 1/3 years
To figure out the payback period of MN Enterprise’s capital project, let us look at the cumulative cash flow, till it turns positive.
(Rs in million)
Year Cash flow Cumulative cash flow
0 –100.00 –100.00
1 34.00 — 66.00
2 32.50 –33.50
3 31.37 – 2.13
4 30.53 + 28.40
Since the cumulative cash inflow is negative at the end of year 3 but positive at the end of year 4, the payback period is between 3 and 4 years.
According to the payback period criteria the shorter the payback period, the more desirable the project. Firms using this criterion generally specify the maximum acceptable payback period. If this is n years, only projects with a playback period of n years or less are deemed worthwhile.
Evaluation: A widely used investment criterion, the payback period, seems to offer the following advantages:
1. It is simple, both in concept and placation. It does not use complicated concepts or tedious calculations and has few hidden assumptions.
2. It is a rough and ready method for dealing with risk. If favors projects which generate substantial cash inflows in earlier years while discriminating against those which bring substantial cash inflows in later years. Now, if risk tends to increase with futurity and in general this may be true the payback criterion can be helpful in weeding out risky projects.
3. Since it emphasizes earlier cash inflows, it is a sensible criterion when the firm is pressed with problems of liquidity.
The limitations of payback criteria however make very serious:
1. It fails to consider the time value of money. In the payback calculation, cash inflows are simply added without suitable discounting. This violates the most basic principles of financial analysis, which stipulate that cash flows occurring at different points of time can be added or subtracted only after suitable compounding or discounting.
2. It ignores cash flows beyond the payback period. This lead to discrimination against projects which generates substantial cash inflows in later years.
3. It is a measure of a project’s capital recovery not its profitability.
4. Though it measures a project’s liquidity, it does not indicate the liquidity position of the firm as a whole which is more important.
Average Rate of return:
The average rate of return also called the accounting rate of return is defined as:
Profit after tax / book value of the investment: The numerator of this ratio is the average annual post tax profit over the life of the investment; the denominator is the average book value of investment committed to the project. To illustrate the calculation of average rate of return, consider the data for the project of MN Enterprises.
(Rs in million)
Year Book value of investment Profit after Tax
1 100.00 14.00
2 80.00 17.50
3 65.00 20.12
4 53.75 22.09
5 45.31 23.57
The average rate of return is:
1 /5 (14 + 17.5 + 20.12 + 22.09 + 23.57) = 28.31 per cent
1 /5 (100 + 80 + 65+ 53.75 + 45.31)