Evaluation Criteria: Discounted Cash Flow (DCF)

 1 ) Payback period (PB)

Payback is the number of years required to recover the original cash outlay invested in a project. The project would be accepted if its pay back period is less than the maximum or standard payback period set by management. As a ranking method, it gives highest ranking to the project, which has the shortest payback period and lowest ranking to the project with highest payback period.

a) Constant annual cash inflows

If the project generates constant annual cash inflows, the payback period can be computed by dividing cash outlay by the annual cash inflow.

Payback = Initial Investment/ Annual Cash Inflow 

Assume that a project requires an outlay of Rs 50,000 and yields annual cash inflow of Rs 12,500 for 7 years. The payback period for the project is: 50,000/12,500 = 4 years
 

b) Unequal cash flows

In case of unequal cash inflows, the pay back period can be found out by adding up the cash inflows until the total is equal to the initial cash outlay. 

Suppose that a project requires a cash outlay of Rs 20,000, and generates cash inflows of Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000 during the next 4 years. What is the project’s payback? 3years+12×(1,000/3,000)months 3years+4months


2) Discounted payback period (DPB)

When deciding on any project to embark on, a company or investor wants to know when their investment will pay off, meaning when the cash flows generated from the project will cover the cost of the project. 

The basic method of the discounted payback period is taking the future estimated cash flows of a project and discounting them to the present value. This is compared to the initial outlay of capital for the investment.

 To begin, the periodic cash flows of a project must be estimated and shown by each period in a table or spreadsheet. These cash flows are then reduced by their present value factor to reflect the discounting process. This can be done using the present value function and a table in a spreadsheet program.

Assuming the project starts with a large cash outflow, or investment to begin the project, the future discounted cash inflows are netted against the initial investment outflow. The discounted payback period process is applied to each additional period's cash inflow to find the point at which the inflows equal the outflows. At this point, the project's initial cost has been paid off, with the payback period being reduced to zero.


3) Accounting Rate of Return (ARR)

The accounting rate of return (ARR) is a formula that reflects the percentage rate of return expected on an investment or asset, compared to the initial investment's cost. The ARR formula divides an asset's average revenue by the company's initial investment to derive the ratio or return that one may expect over the lifetime of an asset or project. ARR does not consider the time value of money or cash flows, which can be an integral part of maintaining a business.

ARR factors in any possible annual expenses, including depreciation, associated with the project. Depreciation is a helpful accounting convention whereby the cost of a fixed asset is spread out, or expensed, annually during the useful life of the asset. This lets the company earn a profit from the asset right away, even in its first year of service.

The formula for the accounting rate of return is as follows:
ARR = Average Annual Profit / Initial Investment

As an example, a business is considering a project that has an initial investment of $250,000 and forecasts that it would generate revenue for the next five years. Here's how the company could calculate the ARR:

Initial investment: $250,000
Expected revenue per year: $70,000
Time frame: 5 years
ARR calculation: $70,000 (annual revenue) / $250,000 (initial cost)
ARR = 0.28 or 28%
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