For the above project we can see that the project starts to produce a cash surplus in its third year. As £2,000 more are needed at the end of year 2 and year 3 yields £9,000, a more precise payback period can be estimated at 2 years plus 2/9 years, i.e., 2.22 years (assuming here that cash flows accumulate evenly during each year).

Companies may specify a minimum payback period for their capital investments to provide a quick and easy way to screen possible investment proposals. For instance, if the minimum payback period for the above project were 3 years then it clearly passes this criterion. The payback test has many obvious theoretical deficiencies: it fails to take into account the time value of money and is therefore inconsistent with financial theory; and it fails to evaluate the cash flows received beyond the payback period, thereby favouring short projects that produce returns early in their lives.

However, its simplicity, the difficulty of long-term forecasting of cash flows, and its emphasis on short-term cash flow (liquidity) may account for its widespread use.

Accounting Rate of Return (ARR)

Another widely used non-discounting appraisal technique is the Accounting Rate of Return (ARR). This measurement is based on profit rather than cash flow and is equivalent to the Return on Capital Employed (ROCE) or Return on Investment (ROI) statistics that are widely used for evaluation of corporate and divisional performance (see Week 6 - Ratio Analysis). The ARR calculation relates the average profit earned by the project to the average capital invested in it over the project's life: