Corporate Accounting and Financial Management · Capital Budgeting

Non-Discounting Techniques of Capital Budgeting: Payback and ARR

Updated 11 October 2026 · Fact-checked

Payback period is the time a project takes to recover its initial investment from cash inflows. Accounting rate of return (ARR) is average annual accounting profit divided by investment, as a percentage. Both ignore the time value of money. Discounted payback fixes this by discounting cash flows before finding recovery time.

Understand Non-Discounting Techniques: Payback and ARR

Capital budgeting asks one question: is a project worth the money you put in? Non-discounting techniques answer it without adjusting cash flows for the time value of money. They are simple, which is why they are still widely used.

Payback period is the number of years needed to get back your initial outlay from the project's cash inflows. A shorter payback means faster recovery and lower risk. The firm sets a cut-off period. If the project's payback is within the cut-off, accept it. For mutually exclusive projects, pick the shortest payback.

Discounted payback does the same job but first discounts each cash inflow at the cost of capital. It is the time taken for the present value of inflows to equal the outlay. It is always longer than or equal to the ordinary payback when the discount rate is positive.

Accounting rate of return (ARR) uses accounting profit, not cash flow. You take the average annual profit after depreciation and tax, and divide by an investment base. The base is either the initial investment or the average investment. Accept the project if ARR is above the target rate. Among rival projects, choose the highest ARR.

The main weakness of both ordinary payback and ARR is that they ignore the time value of money. Payback also ignores cash flows after the recovery point. ARR uses profits, not cash. Know these merits and limitations well, as they are often asked in theory questions.

Key rules to remember

Payback period (equal annual inflows): Payback = Initial investment ÷ Annual cash inflow; Use only when yearly inflows are the same. Cash inflow means profit after tax plus depreciation (and other non-cash charges).
Payback period (unequal inflows): Payback = Full years before recovery + (Unrecovered amount at start of the year ÷ Cash inflow of that year); Work from cumulative cash inflows. Assumes inflows arise evenly within the year.
Discounted payback period: Same as payback, but using Present value of inflows = Cash inflow × PV factor; Cumulate discounted inflows until they equal the initial outlay.
Accounting rate of return (on average investment): ARR = Average annual profit after tax ÷ Average investment × 100; Average investment = (Initial investment + Salvage value) ÷ 2. Some books add working capital that is released at the end; follow the question.
Accounting rate of return (on initial investment): ARR = Average annual profit after tax ÷ Initial investment × 100; Use this when the question says initial or original investment.
Average annual profit: Average profit = Sum of profits after depreciation and tax over the life ÷ Number of years; Profit is after depreciation. Cash inflow is not the same as profit.
Payback reciprocal: Payback reciprocal = Annual cash inflow ÷ Initial investment × 100; A rough estimate of IRR only if the life is at least twice the payback and inflows are equal.

How to solve Non-Discounting Techniques: Payback and ARR questions

Use this order for any payback, discounted payback or ARR question.

1Read what is asked: payback, discounted payback or ARR. Note the cost of capital, tax rate, depreciation method and salvage value.
2Find the initial outlay, including any working capital the question says is invested.
3Compute annual depreciation, then profit after depreciation and tax for each year.
4For payback methods, convert to cash inflow: profit after tax plus depreciation. For ARR, stay with profit.
5For payback, build a cumulative inflow column. For discounted payback, multiply each inflow by its PV factor first, then cumulate.
6Find the year where cumulative inflow crosses the outlay and apply the fraction formula to get years and months.
7For ARR, find average profit and the investment base asked for (initial or average), then divide and convert to a percentage.
8Compare with the cut-off or target rate, state accept or reject, and add one line on limitations if marks allow.

Quickest way: Cumulative column method

When to use it: Use it when inflows are uneven or when you must find payback and discounted payback in one question.

Draw three columns: year, inflow, cumulative inflow. Add a fourth for discounted inflow if needed.
Keep subtracting from the outlay and stop at the first year where the balance turns zero or positive.
Fraction = balance still to recover at the start of that year ÷ that year's inflow.
For ARR, add up all profits once, divide by the life, then divide by the base. Do not compute yearly ARR.
Convert decimals of a year to months by multiplying by 12.

Common mistakes in Non-Discounting Techniques: Payback and ARR

Using profit instead of cash inflow in payback.
The question gives profit after tax and students plug it straight in.
Fix: Add back depreciation to profit after tax before computing payback. Use profit only for ARR.
Forgetting to deduct depreciation when finding profit for ARR.
Students start from cash inflow figures given in the question.
Fix: If cash inflows are given, subtract depreciation to get profit before using ARR.
Mixing the investment base in ARR.
Both initial and average investment are common, and the question wording is skimmed.
Fix: Check the wording. Use average investment = (cost + salvage) ÷ 2 only if the question says average. Otherwise use initial investment.
Applying the equal-inflow formula to uneven inflows.
Dividing outlay by average inflow looks quick.
Fix: Use the cumulative method whenever inflows differ between years.
Discounted payback computed on undiscounted cumulative inflows.
Students discount only the outlay, or forget to discount at all.
Fix: Multiply every inflow by its PV factor, then cumulate. The outlay at year 0 is not discounted.
Saying payback considers the whole life of the project.
Confusion with NPV or IRR in theory answers.
Fix: Write that payback ignores cash flows after the payback point and ignores time value of money, though discounted payback does consider the latter.

Worked examples

Example 1

A project costs ₹5,00,000 and has no salvage value. Expected annual cash inflows are: Year 1 ₹1,50,000; Year 2 ₹2,00,000; Year 3 ₹2,00,000; Year 4 ₹1,00,000. Cost of capital is 10%. PV factors at 10%: Year 1 0.909, Year 2 0.826, Year 3 0.751, Year 4 0.683. Find the payback period and the discounted payback period.

Show the solution

Cumulative inflows: Year 1 ₹1,50,000; Year 2 ₹3,50,000; Year 3 ₹5,50,000.
Outlay is recovered during Year 3. Balance at start of Year 3 = 5,00,000 − 3,50,000 = ₹1,50,000.
Payback = 2 + (1,50,000 ÷ 2,00,000) = 2.75 years, or 2 years 9 months.
Discounted inflows: Year 1 = 1,50,000 × 0.909 = ₹1,36,350. Year 2 = 2,00,000 × 0.826 = ₹1,65,200. Year 3 = 2,00,000 × 0.751 = ₹1,50,200. Year 4 = 1,00,000 × 0.683 = ₹68,300.
Cumulative discounted inflows: Year 1 ₹1,36,350; Year 2 ₹3,01,550; Year 3 ₹4,51,750; Year 4 ₹5,20,050.
Recovery occurs in Year 4. Balance at start of Year 4 = 5,00,000 − 4,51,750 = ₹48,250.
Discounted payback = 3 + (48,250 ÷ 68,300) = 3 + 0.706 = 3.71 years, about 3 years 8.5 months.

Answer: Payback period is 2.75 years (2 years 9 months). Discounted payback period is about 3.71 years. The discounted figure is longer because later inflows are worth less today.

Example 2

A machine costs ₹6,00,000 with a life of 5 years and salvage value of ₹1,00,000. Depreciation is on straight-line basis. Profit after depreciation and tax for the five years is: ₹60,000; ₹80,000; ₹1,00,000; ₹70,000; ₹40,000. Compute the ARR on initial investment and on average investment, and the payback period.

Show the solution

Total profit = 60,000 + 80,000 + 1,00,000 + 70,000 + 40,000 = ₹3,50,000.
Average annual profit = 3,50,000 ÷ 5 = ₹70,000.
ARR on initial investment = 70,000 ÷ 6,00,000 × 100 = 11.67%.
Average investment = (6,00,000 + 1,00,000) ÷ 2 = ₹3,50,000.
ARR on average investment = 70,000 ÷ 3,50,000 × 100 = 20%.
Annual depreciation = (6,00,000 − 1,00,000) ÷ 5 = ₹1,00,000.
Cash inflows = profit + depreciation: Year 1 ₹1,60,000; Year 2 ₹1,80,000; Year 3 ₹2,00,000; Year 4 ₹1,70,000; Year 5 ₹1,40,000 (salvage value is ignored for payback here since recovery occurs earlier).
Cumulative: Year 1 ₹1,60,000; Year 2 ₹3,40,000; Year 3 ₹5,40,000; Year 4 ₹7,10,000.
Recovery occurs in Year 4. Balance at start of Year 4 = 6,00,000 − 5,40,000 = ₹60,000. Payback = 3 + (60,000 ÷ 1,70,000) = 3.35 years.

Answer: ARR is 11.67% on initial investment and 20% on average investment. Payback period is about 3.35 years (3 years 4 months).

Exam tips

Read whether the question gives profit or cash inflow. This one check decides most marks.
Show the cumulative column in the answer. Examiners give method marks even if one figure is off.
State the base used for ARR in your answer, such as average investment, and show the formula.
In theory questions, write merits and limitations in two short lists. Add a line on how discounted payback improves on payback.
Give the decision at the end: accept or reject against the cut-off or target rate.

Practice questions from Capital Budgeting

Non-Discounting Techniques: Payback and ARR in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Non-Discounting Techniques: Payback and ARR: frequently asked questions

What is the difference between payback period and ARR?

Payback measures how fast you recover the investment using cash inflows. ARR measures average profitability using accounting profit as a percentage of investment. Neither adjusts for the time value of money. Payback focuses on liquidity and risk, ARR on return.

How is discounted payback different from payback period?

Discounted payback discounts each cash inflow at the cost of capital before cumulating, so it accounts for the time value of money. Ordinary payback does not. With a positive discount rate, discounted payback is longer. Both still ignore cash flows after the recovery point.

Should I use initial or average investment for ARR?

Follow the question. If it says average investment, use (initial cost + salvage value) ÷ 2. If it says initial or original investment, use the cost. If it does not specify, state your assumption and show the working.

Is payback period a good method for choosing projects?

It is simple and favours liquidity, so it is useful as a screening tool or where risk is high. But it ignores time value and later cash flows, so it can reject profitable long-term projects. That is why it is usually used with NPV or IRR.