Accounting Rate of Return and Payback Period The Accounting Rate of Return and Payback Period use different types of financial reporting in their calculations. Accounting Rate of Return uses account profit whereas Payback uses Cash Flow. First, a comparison between these two financial reporting methods will be made. Accounting Profit Vs Cash Flows · Cash flows are an objective measure of corporate performance · Accounting profit is calculated by applying the accruals concept and thus: · Includes certain subjective non-cash flows i.e. · Depreciation · Change in provisions · Excludes certain cash flows i.e .: · Changes in working capital · Capital costs and proceeds Income Statement Turnover 1000 Cost of sales (450) Operating costs (300) Operating profit 250 Interest payable (50) Profit before tax 200 Tax payable (40) Profit after tax 160 Cash £ Cash received from customers +900 Cash paid to suppliers -500 Cash paid to suppliers and employees -200 +200 Interest paid -40 +160 Tax paid -50 +110 Non-Cash Accruals £ Trade receivables +100 Inventories and trade payables +50 Trade payables, depreciation and provisions -100 +50 Interest accrual -10 +40 Tax prepayment +10 +50 Depreciation . Depreciation is an accounting estimate to spread the initial cost of a non-current asset over several accounting periods · Choice of methods: · Straight line · Reducing balance · E.g. an asset costs £200k, has an expected life of 3 years & an expected residual value of £50k · Annual expense using the straight-line method: · (200 cost - 50 residual) + 3 years = £50k per annum
Working Capital · Components: · Inventories (stock) · Trade receivables (debtors) · Trade payables (creditors) · At the start of a project: · Purchase inventories- cash outflow · Pay suppliers before paid by customers- cash outflow · At the end of a project: · Net working capital investment is released- cash outflow Converting Accounting Profits to Cash Flows Year 0 1 2 3 Accounting profit forecasts +25 +50 +75 deduct initial cost of investment -200 1 - add expected disposal proceeds +50 add back straight line depreciation expense +50 +50 +50 deduct working capital required -25 to start project add working capital released at +25 end of project Cash flow forecasts -225 +75 +100 +200 Relevant Cash Flows • Relevant cash flows: · Incremental (change as a result of the decision to accept or reject a project) · Included in all investment appraisal methods · Irrelevant cash flows: · Non-incremental (do not change as a result of the decision to accept or reject a project) i.e. · Sunk or committed costs · Arbitrary overhead allocations . Only included in the ARR investment appraisal method and excluded from all other methods
· Other irrelevant items: · Depreciation- non cash flow · Changes in provisions- non cash flow · Interest- financing item · Debt capital repayments- financing item · Dividends- financing item · Incremental (relevant) cash flow = cash flow if the project is accepted minus the cash flow if the project is rejected ·