How do the payback and accounting rate of return methods appraise a long-term investment, and what are the strengths and weaknesses of each?
Capital investment appraisal using the payback period and the accounting rate of return (ARR), the interpretation of the results to choose between projects, and the advantages and limitations of each method including the treatment of the time value of money.
A focused answer to the SQA Higher Accounting investment appraisal content, covering the payback period and the accounting rate of return, how each is calculated and used to choose between projects, and the advantages and limitations of each method.
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What this dot point is asking
The SQA wants you to appraise a long-term investment, such as buying a machine, using two methods: the payback period and the accounting rate of return. You must calculate each, use the results to choose between competing projects, and discuss the advantages and limitations of each method, including the issue of the time value of money.
Why appraise an investment
A capital investment ties up a large sum for years, so a business should check that the expected returns justify the outlay before committing. Appraisal methods provide a structured comparison, helping managers rank competing projects and decide whether any project is worth undertaking at all. The two methods the SQA examines look at the question from different angles: speed of cash recovery and overall profitability.
The payback period
A shorter payback is preferred: cash is back in hand sooner, the business is less exposed to risk and uncertainty in later years, and liquidity is protected. Payback is widely used precisely because it is simple and speaks to cash flow.
The accounting rate of return
A higher ARR is better, and it can be compared directly with a target rate of return the business sets. Because ARR uses the project's whole life, it captures profitability that payback ignores.
Strengths and weaknesses
Payback is simple, easy to understand and useful for managing cash and risk, but it ignores everything after the payback point and treats early and late cash as equal, ignoring the time value of money. ARR uses all years and is easy to compare against a target, but it relies on accounting profit rather than cash flow and likewise ignores the time value of money. Because each method has blind spots, a business often uses both, and at higher levels would add discounted methods that allow for the time value of money.
Try this
Q1. A project costs £60,000 with inflows of £20,000 a year. Calculate the payback period. [2 marks]
- Cue. £60,000 / £20,000 = 3 years exactly.
Q2. Average annual profit is £8,000 and average investment is £40,000. Calculate the ARR. [2 marks]
- Cue. £8,000 / £40,000 x 100 = 20%.
Q3. State one limitation shared by both payback and ARR. [1 mark]
- Cue. Both ignore the time value of money, treating later cash as worth the same as earlier cash.
Exam-style practice questions
Practice questions written in the style of SQA exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
SQA Higher style6 marksA machine costs £100,000 and is expected to generate net cash inflows of £30,000, £40,000, £40,000 and £30,000 over four years, with no residual value. Calculate the payback period and the accounting rate of return based on average annual profit.Show worked answer →
Cumulative cash inflows: end of year 1 £30,000; year 2 £70,000; year 3 £110,000. Payback occurs during year 3 once £100,000 is reached: £30,000 needed in year 3 out of its £40,000, so 30,000 / 40,000 = 0.75 of the year. Payback = 2 years and 9 months (2 marks).
Total cash inflows = £30,000 + £40,000 + £40,000 + £30,000 = £140,000. Total profit = inflows - cost = £140,000 - £100,000 = £40,000. Average annual profit = £40,000 / 4 = £10,000 (2 marks).
Average investment = £100,000 / 2 = £50,000 (no residual value). ARR = average annual profit / average investment = £10,000 / £50,000 = 20% (2 marks). Markers reward the payback timing and the ARR with a stated basis.
SQA Higher style4 marksExplain one advantage and one limitation of the payback method, and explain why payback ignores something that the time value of money would take into account.Show worked answer →
Advantage: payback is simple to calculate and understand, and by favouring projects that return cash quickly it helps a business manage liquidity and reduce risk (2 marks).
Limitation: payback ignores all cash flows after the payback point, so a project that pays back quickly but earns little afterwards can be wrongly preferred to one that pays back later but earns much more (1 mark).
Payback also ignores the time value of money: it treats a pound received in year four as equal to a pound received in year one, whereas in reality earlier cash is worth more because it could be reinvested or because of inflation (1 mark). Markers reward an advantage, a limitation and the time value point.
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Sources & how we know this
- SQA Higher Accounting Course Specification — SQA (2023)