3.8.1—Investment appraisal methods

Payback period measures how long net cash inflows take to recover the initial investment. Average rate of return (ARR) expresses average annual accounting profit as a percentage of the initial investment.

For equal annual net cash inflows, payback $=\text{initial investment}/\text{annual net cash inflow}$. For uneven flows, add yearly net cash inflows until recovery; if $R$ remains at the start of the recovery year and that year's flow is $F$, payback $=\text{completed years}+R/F$. For ARR, calculate $\text{total profit}=\text{total returns}-\text{initial investment}$, then $\text{average annual profit}=\text{total profit}/\text{project life}$ and $\text{ARR}=\text{average annual profit}/\text{initial investment}\times100$.

Use currency units for the investment, returns and profit; report payback in years (and convert the fractional year consistently if months are required) and ARR as a percentage. A shorter payback improves liquidity exposure, while a higher ARR indicates a stronger average accounting return, but the two rankings can disagree because they measure different things.

Payback ignores cash flows after recovery and does not measure total return; ARR uses accounting profit and ignores when returns occur. Compare projects with consistent assumptions, then evaluate forecast risk, finance, capacity, strategic fit and non-financial effects before recommending one.