How do businesses decide whether an investment is worthwhile using payback, ARR and net present value?
Investment appraisal: the payback period, the average rate of return (ARR), and net present value (NPV) using discounted cash flow, with their calculation, use and limitations.
A focused answer to the WJEC A-Level Business Unit 3 content on investment appraisal, covering the payback period, the average rate of return and net present value using discounted cash flow, with their calculation, use and limitations and worked examples.
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What this dot point is asking
WJEC Unit 3 covers the three investment-appraisal methods: the payback period, the average rate of return (ARR) and net present value (NPV) using discounted cash flow. This is heavily quantitative, so the marks reward correct calculation of each method, correct interpretation (the decision rule), and a realistic view of each method's strengths and weaknesses - especially NPV's handling of the time value of money.
The answer
Why appraise investments
Payback period
The payback period is the time taken for an investment's net cash inflows to repay its initial cost. You add the cash inflows cumulatively until they equal the cost. Payback is simple, quick and useful for liquidity (how soon the money comes back), which matters to firms short of cash. Its weaknesses are that it ignores cash flows after payback (and so total profitability) and the time value of money.
Average rate of return (ARR)
Net present value (NPV)
Net present value (NPV) recognises that money received in the future is worth less than money today (the time value of money). Each future cash flow is multiplied by a discount factor (which falls the further into the future the cash flow is, based on a chosen discount rate) to find its present value. The present values of all the inflows are added, and the initial cost is subtracted:
NPV = (sum of discounted cash inflows) - initial investment.
A positive NPV means the project earns more than the discount rate and is worthwhile; a negative NPV means it does not. NPV is the most complete method because it considers all cash flows and their timing, but it depends on the chosen discount rate and on estimated future cash flows, and it is more complex.
Examples in context
Example 1. Payback for a cash-conscious firm. A small firm short of cash favours the investment with the shortest payback period, because getting its money back quickly protects its liquidity, even if another project is more profitable in the long run. The example shows why payback, despite ignoring later cash flows, matters most to firms that cannot afford to wait, and why the "best" method depends on the firm's priorities.
Example 2. NPV deciding between two projects. A larger firm comparing two long-term projects uses NPV because it values cash flows over time. Project X has a higher total return but most of it arrives late, while Project Y returns cash sooner; after discounting, Y's NPV is higher because near-term cash is worth more. The example illustrates NPV capturing the time value of money that payback and ARR miss, which is why it is the most complete appraisal method.
Try this
Q1. Define the term payback period. [2 marks]
- Cue. The length of time it takes for the net cash inflows from an investment to recover the initial cost of that investment.
Q2. A project costs £50,000 and earns total profit of £30,000 over five years. Calculate its average rate of return (ARR). [3 marks]
- Cue. Average annual profit = £30,000 / 5 = £6,000. ARR = (£6,000 / £50,000) x 100 = 12%.
Exam-style practice questions
Practice questions written in the style of WJEC exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
WJEC 20196 marksA machine costs £40,000 and generates net cash flows of £10,000, £15,000, £15,000 and £20,000 over four years. Calculate the payback period.Show worked answer →
Cumulative cash flow: after year 1 = £10,000; after year 2 = £25,000; after year 3 = £40,000.
The £40,000 cost is exactly recovered at the end of year 3, so the payback period is 3 years.
(If recovery fell mid-year, divide the amount still needed by that year's cash flow and multiply by 12 for the months.) Markers reward the cumulative method shown and the correct payback period.
WJEC 20218 marksEvaluate the use of net present value (NPV) as a method of investment appraisal.Show worked answer →
For: NPV uses discounted cash flow to account for the time value of money, considers all the cash flows over the project's life, and gives a single figure - a positive NPV means the project earns more than the discount rate and is worthwhile.
Against: it depends on the chosen discount rate and on estimated future cash flows that may be wrong, it is more complex to calculate, and the further-ahead figures are least reliable.
A strong evaluation concludes that NPV is the most complete method because it values money over time, but its accuracy depends on the assumptions, so it is best used alongside payback and ARR and with judgement. Markers reward a supported judgement.
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Sources & how we know this
- WJEC GCE AS/A level Business specification — WJEC (2015)