A project costs 60,000 and returns 20,000 a year. Calculate the payback period. [2 marks]

OCR OCR H431/02 2020-style practice: A machine costs 80,000 and is expected to generate net cash flows of 25,000 a year. Calculate the payback period and the average rate of return over four years. (6)

A Component 2 calculation rewarding both methods, working and units. Payback: the machine costs 80,000 and returns 25,000 a year, so 80,000 / 25,000 = 3.2 years, that is, 3 years plus 0.2 × 12 = 2.4 months, so about 3 years and 2 to 3 months. ARR: total net cash flow over four years = 25,000 × 4 = 100,000; total profit = 100,000 - 80,000 = 20,000; average annual profit = 20,000 / 4 = 5,000; ARR = 5,00080,000 × 100 = 6.25\%. Markers reward both calculations and units. The common error in ARR is to forget to subtract the initial cost before averaging.

EnglandBusinessSyllabus dot point

How do businesses decide whether an investment is worthwhile?

Investment appraisal techniques including the payback period, the average rate of return and net present value, the calculation and interpretation of each, the role of qualitative factors, and the value and limitations of investment appraisal.

A focused answer to the OCR A-Level Business finance theme on investment appraisal, covering the payback period, the average rate of return and net present value, the calculation and interpretation of each, qualitative factors, and the value and limitations of investment appraisal.

Generated by Claude Opus 4.813 min answerUpdated 2026-06-02

Reviewed by: AI editorial process; not yet individually human-reviewed

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What this theme is asking
Payback period
Average rate of return
Net present value
Qualitative factors and limitations
Examples in context
Try this

What this theme is asking

OCR wants you to appraise an investment using the payback period, the average rate of return (ARR) and net present value (NPV), to interpret each, and to weigh qualitative factors and the limits of the techniques. NPV and ARR calculations appear in Components 2 and 3.

Payback period

To find payback, accumulate the net cash flows until they equal the initial cost. If cash flows are even, $\text{payback} = \tfrac{\text{initial cost}}{\text{annual net cash flow}}$ . Payback is simple and useful for liquidity and risk, but it ignores cash flows after the payback point and the time value of money.

Average rate of return

ARR shows the profitability of a project as a percentage that can be compared with a target return or an interest rate. Its weakness is that it uses average profit and so ignores the timing of cash flows: a project that earns most of its money early scores the same as one that earns it late, even though the early earner is preferable.

Net present value

NPV is the most complete technique because it accounts for timing and the cost of capital, which payback and ARR ignore. Its weaknesses are that it depends heavily on the chosen discount rate and on forecast cash flows that are uncertain over many years, and it is harder to calculate and explain.

Worked example: payback, ARR and NPV

A machine costs $\pounds 80{,}000$ and is expected to generate net cash flows of $\pounds 25{,}000$ a year for four years. The firm uses a discount factor of $0.91$ , $0.83$ , $0.75$ and $0.68$ for years 1 to 4.

step 1: payback period

\text{Payback} = \frac{80{,}000}{25{,}000} = 3.2 \text{ years (about 3 years and 2 to 3 months)}

step 2: average rate of return

Total net cash flow $= 25{,}000 \times 4 = \pounds 100{,}000$ . Total profit $= 100{,}000 - 80{,}000 = \pounds 20{,}000$ . Average annual profit $= \tfrac{20{,}000}{4} = \pounds 5{,}000$ .

\text{ARR} = \frac{5{,}000}{80{,}000} \times 100 = 6.25\%

step 3: net present value

Present values: $25{,}000 \times 0.91 = 22{,}750$ ; $\times 0.83 = 20{,}750$ ; $\times 0.75 = 18{,}750$ ; $\times 0.68 = 17{,}000$ . Sum of present values $= \pounds 79{,}250$ .

\text{NPV} = 79{,}250 - 80{,}000 = -\pounds 750

step 4: interpret

Payback ( $3.2$ years) is reasonable, and ARR ( $6.25\%$ ) shows modest profitability, but the NPV is slightly negative ( $-\pounds 750$ ), meaning that once the time value of money is accounted for, the project just fails to cover the cost of capital. On NPV alone the firm should reject it or seek better terms, a reminder that discounting can flip a decision that the simpler methods make look acceptable.

Qualitative factors and limitations

Numbers do not decide alone. Qualitative factors include the firm's objectives, the reliability of the forecasts, the effect on staff and customers, the risk and the firm's attitude to it, and strategic fit. All three techniques rest on forecast cash flows that are uncertain, especially over long horizons and in volatile markets, so investment appraisal should inform a decision combined with judgement, not replace it.

Examples in context

A manufacturer weighing a new automated line uses payback to check how fast it recovers the outlay (important if cash is tight), ARR to compare its profitability with a target, and NPV to test it against the cost of capital. A global firm choosing between projects in different countries leans on NPV to compare long-term cash flows fairly, while watching that the forecasts and discount rate are realistic given exchange-rate and political risk.

Try this

Q1. A project costs $\pounds 60{,}000$ and returns $\pounds 20{,}000$ a year. Calculate the payback period. [2 marks]

Cue. $\tfrac{60{,}000}{20{,}000} = 3$ years.

Q2. Analyse one reason why NPV is considered superior to payback for a long-term project. [6 marks]

Cue. NPV accounts for the time value of money and all the cash flows, whereas payback ignores both timing beyond repayment and cash after payback, developed as a chain in context.

Exam-style practice questions

Practice questions written in the style of OCR exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.

OCR H431/02 20206 marksA machine costs

\pounds 80{,}000

and is expected to generate net cash flows of

\pounds 25{,}000

a year. Calculate the payback period and the average rate of return over four years. (6)

Show worked answer →

A Component 2 calculation rewarding both methods, working and units. Payback: the machine costs $\pounds 80{,}000$ and returns $\pounds 25{,}000$ a year, so $80{,}000 / 25{,}000 = 3.2$ years, that is, 3 years plus $0.2 \times 12 = 2.4$ months, so about 3 years and 2 to 3 months. ARR: total net cash flow over four years $= 25{,}000 \times 4 = \pounds 100{,}000$ ; total profit $= 100{,}000 - 80{,}000 = \pounds 20{,}000$ ; average annual profit $= 20{,}000 / 4 = \pounds 5{,}000$ ; ARR $= \tfrac{5{,}000}{80{,}000} \times 100 = 6.25\%$ . Markers reward both calculations and units. The common error in ARR is to forget to subtract the initial cost before averaging.

OCR H431/03 202316 marksEvaluate the usefulness of net present value to a global business choosing between two long-term investment projects. (16)

Show worked answer →

A 16-mark evaluation on a four-level grid. For NPV: it discounts future cash flows back to today's value using a discount rate, so it accounts for the time value of money (a pound in five years is worth less than a pound now), which payback and ARR ignore; a positive NPV means the project earns more than the cost of capital, and the higher NPV is preferred. Chain: discounting distant cash flows gives a more realistic comparison of long-term projects than undiscounted methods. Against: NPV depends heavily on the chosen discount rate and on forecast cash flows that are uncertain over many years, especially across volatile global markets; it is harder to calculate and explain. Evaluation: NPV is the most complete technique for long-term projects but rests on uncertain forecasts and an assumed discount rate, so it should be used with payback (for risk and liquidity) and qualitative factors. A judged conclusion reaches the top band.

Related dot points

Sources & how we know this

OCR A-Level Business (H431) specification — OCR (2015)