Criticisms of Payback and Simple Rate of Return Methods
Payback Period and Simple Rate of Return Methods are among the tools used in capital budget budgeting. Payback period measures the length of time to recoup an investment, while the simple rate of return method, also known as Accounting Rate of Return (ARR) provides the expected income for the entire life of a capital investment (Investopedia, 2014).
The formulas to calculate for these two methods are:
- Payback Period = Cost of Project / Annual Cash Inflows
Criterion: The project that has shorter payback period is deemed better.
- Simple Rate of Return= Average profit /Initial investment
Criterion: Choose the project with higher returns or exceeds the hurdle rate.
Although considered as the simplest method in appraising capital investments, one of the criticisms with the payback period method is it ignores benefits from the investment for the rest of its useful life after the payback period. Thus, it does not actually provide any measure of profitability. Moreover, it ignores the time value of money. This is crucial in analyzing future stream of cash flows given the underlying financial principle that a “dollar today is worth more than a dollar tomorrow”. Despite these criticisms, payback period is popular because it is the simplest to use. It is helpful for small businesses faced with scarce capital resources or companies with liquidity issues (Jan, 2013).
Similarly, the main setback of simple rate of return method is it does not consider the time value of money. Although it provides an estimate of return on investment, it can be misleading if a capital project has different cash flow per year as it would result in fluctuating returns per period. If there are several investment projects being considered, it can even be more deceiving. (Accounting4management.com, 2014). The other point against this method is its use of income instead of cash flows, which is considered as the best method in determining the return on investment (Bragg, 2013). Nevertheless, the simple rate of return method is still commonly used as a simplistic approach to determine whether or not to invest in a fixed asset. If the savings or incremental cash flows from that investment yield a percentage higher than a company’s certain hurdle rate it becomes a determinant in the decision-making process.
Industry that would benefit from simple rate of return for budgeting decisions
Any industry, whether in the service or manufacturing sector, such as food or textiles, can benefit using simple rate of return in their capital budgeting. It enables decision-makers to easily compare the profit potential for projects and investments that are expected to generate additional income or savings. However, when there are several projects to be considered and capital resources need to be prioritized, experts are unanimous in recommending a more sophisticated method that considers time value of money such as Net Present Value.
References
Investopedia (2014). Definition of Payback Period. Retrieved from
http://www.investopedia.com/terms/p/paybackperiod.asp
Jan, I. (2013). Payback Period. Retrieved from
http://accountingexplained.com/managerial/capital-budgeting/payback-period
Accounting4management.com (2014). Simple Rate of Return Method. Retrieved from
http://www.accounting4management.com/simple_rate_of_return_method.htm
Bragg, S. (May 2013). What is the Simple Rate of Return? Retrieved from
http://www.accountingtools.com/questions-and-answers/what-is-the-simple-rate-of-return.html
