A) Simple payback
|Cash flows (£000s)||Proposal 1||Proposal 2||Proposal 3||Proposal 4|
Year 0 is the initial investment
Proposal 1 will be paid back in 2 years.
Proposal 2 costs £95
Year 3 £5 left to pay back
5(amount needed for investment to be paid back)/60 (year 4 return) x 12 (number of months in a year) = 0.9 rounded up = 1month. Total payback time = 3 years and 1 month
80/90 x 12 = 10.6 = 2 years and 11 months payback time
B) Average rate of return
Total net profit/number of years/initial cost x 100
£70/5/80×100 = 17.5%
C) Discounted cash flow (net present value)
|Cash flows (£000s)||Proposal 1||Discount table 20%||Present value|
Makes up for the interest that could have been earned if the business put the money in a bank.
Times the each year of the proposal by the discount figure
If the net present value is positive then the project should go ahead.
E) Limitations of these techniques
- Complicated – May be difficult for the user to make/understand.
- Difficult to select most appropriate discount rate – If the rate is set too high then it may reduce the profitability of the project thus leading to the proposal being rejected.
- NPV very sensitive to initial investment