114 Financial Management

The limitations of the payback criteria, however, are very serious:

It fails to consider the time value of money. Cash inflows, in the payback
calculation, are simply added without suitable discounting. This violates the most
basic principle of financial analysis which stipulates that cash flows occurring at
different points of time can be added or subtracted only after suitable compoundingg
Idiscounting
It ignores cash flows beyond the payback period. This leads to discrimination
against projects which generate substantial cash inflows in later years. To illustrate,
consider the cash flows of two projects, A and B:

Year Cash flow of A Cash flow of B

-1,00,000 1,00,000
50,000 20,000

30,000 20,000

20,000 20,000

10,000 40,000

10,000 50,000

6 60,000

The payback criteria prefers A, which has a payback period of 3 years, in comparison
to B, which has a payback period of 4 years, even though B has very substantial cash
inflows in years 5 and 6.

Since the payback period is a measure of a projects' capital recovery, it may

divert attention from profitability. Payback has harshly, but not unfairly, been
described as the "fish bait test since effectively it concentrates on the recovery
of the bait (the capital outlay) paying not attention to the size of the fish (the
ultimate profitability), if any."

Though it measures a project's liquidity, it does not indicates the liquidity position
of the firm as a whole, which is more important.

Accounting Rate of Return

The accounting rate of return, also referred to as the average rate of return or the
simple rate, is a measure of profitability which relates income to investment, both
measured in accounting terms. Since income and investment can be measured variously,
there can be a very large number of measures for accounting rate of return.

The measures that are employed commonly in practice are:

Average income after tax

A. ---***************
Initial investment