Capital Expenditure, Payback and Accounting Rate of Return

A factory, a fleet of trucks or a new product line is a large commitment: the money goes out at once and the benefit comes back slowly over many years, if at all.

Companies that make such decisions by instinct tend to regret them, so they use a structured process: a capital budget that fits the strategy, a forecast of the cash flows of each proposal, and one or more tests of whether the return is enough for the risk. This topic opens the study of investment appraisal.

It defines capital expenditure and the features of investment decisions, sets out the process of capital budgeting, explains why capital projects are strategic, and covers the first two appraisal methods, the accounting rate of return and the payback period, with decision rules, worked calculations and a fair account of what each method fails to show. The next topic covers relevant cash flows in investment appraisal.

The nature of capital projects was tested in November Diet, 2025, Question 6(b) (5 marks), which asked which characteristics make capital project decisions strategic. Investment appraisal is the largest area of the paper at 25% of the marks. Read working capital funding strategies first.

Capital expenditure and investment appraisal

Capital expenditure is spending on non-current assets such as buildings and equipment, or on a new business; it creates an asset on the statement of financial position (possibly an investment in a subsidiary). Revenue expenditure does not create a long-term asset: it is written off as an expense in the period or creates a short-term asset such as inventory. Capital expenditure on projects may be small or very large.

A distinction is made between essential spending to replace worn-out assets and keep operations going and discretionary spending on new business initiatives intended to earn a suitable return; examination questions usually concern the discretionary kind.

Investment appraisal is the evaluation of proposed capital projects to decide whether the spending is worthwhile. As a general rule, a project should be undertaken only if it is expected to give a suitable financial return and the investment risk is acceptable.

Capital budgeting

Capital expenditure should give a long-term return and be consistent with the company’s corporate and financial objectives, so it is made within a capital budget, for example a five-year plan reviewed each year, with more detailed plans for the next year or two. Approved projects are included in the budget, and new ideas that meet the appraisal criteria may be approved if they fit within the spending limits. Appraisal therefore involves:

1. generating proposals in line with strategic objectives;
2. forecasting the relevant cash flows of each project;
3. evaluating the projects;
4. implementing those that meet the criteria for a satisfactory return; and
5. monitoring performance against the expectations.

Why capital projects are strategic

• Large outlay: they commit a big share of the company’s resources, and a wrong decision ties funds in unproductive assets.
• Long-term effect: cash flows run for many years and lock the company into a course of action.
• Irreversibility: specialised assets are hard to sell, so a mistake leaves sunk costs and idle capacity.
• Risk and uncertainty: long lives expose the project to market, technological, economic and regulatory change.
• Strategic fit: projects set the future direction of the business, such as new markets, technology or capacity, and must match the strategy.
• Competitive position: good projects build cost efficiency or differentiation; poor ones weaken the company.
• Stakeholders: the effect reaches employees, customers and the community as well as shareholders.

Features of an investment project

Most projects involve the purchase of an asset with an expected life of several years, paid for at the start; returns come from additional profit over its life; the asset may have a residual value at the end; and the project may need an investment in working capital.

Alternatively the project may be the purchase of a business or a new venture, with an initial outlay and returns over a long time.

The four methods

Four methods are used: the accounting rate of return, the payback period and the two discounted cash flow (DCF) methods, net present value and internal rate of return. Each looks at a different aspect: the effect on accounting return, the time to recover the cash, or the return on the investment taking account of the size and timing of the cash flows. The discounted methods are covered in later topics.

The accounting rate of return

The accounting rate of return (ARR) is the accounting profit from the project, usually before interest and tax, as a percentage of the capital invested. It measures the return of a particular project, as return on capital employed does for the whole company, and is based on accounting profits and the accounting value of the assets. The preferred form is:

ARR = average annual profit ÷ average investment × 100%

where the profit is after depreciation and average investment = (initial cost + residual value) ÷ 2. (A version using the initial investment as the denominator is used only if the question says so.) Decision rule: accept a project whose ARR is above the minimum target; among several, choose the highest ARR provided it exceeds the target.

1. Depreciation = (2,400,000 − 400,000) ÷ 5 = ₦400,000, so the average profit is 560,000 − 400,000 = ₦160,000.
2. Average investment.
   (2,400,000 + 400,000) ÷ 2 = ₦1,400,000.
3. ARR = 160,000 ÷ 1,400,000 = 11.4%, below 12%, so reject.
4. (On the initial investment the figure would be 6.7%, which shows how the choice of denominator matters.)

1. Average profit before depreciation.
   1,800,000 ÷ 4 = ₦450,000
2. depreciation = (1,500,000 − 300,000) ÷ 4 = ₦300,000
3. average profit = ₦150,000
4. average investment.
   (1,500,000 + 300,000) ÷ 2 = ₦900,000.
5. ARR = 150,000 ÷ 900,000 = 16.7%, above 15%, so accept.

Advantages: simple to understand and calculate; uses readily available accounting data; emphasises profitability. Disadvantages: based on accounting profit and not cash flows, which is what is invested; profits can be manipulated; it ignores the time value of money and the timing of profits; there is no objective basis for the target rate; and it is a relative measure, not an absolute one.

The payback period

The payback period is the time, usually in years, that a project takes to recover the cash invested, using the net cash returns. It uses cash flows, not profits, but ignores the time value of money and all returns after the payback date. Decision rule: accept a project whose payback is within the maximum acceptable period; among several, choose the shortest.

Constant cash flows. The project above costs ₦2,400,000 and returns ₦640,000 a year: payback = 2,400,000 ÷ 640,000 = 3.75 years.

Uneven cash flows. For the second project the cash flows are ₦520,000, ₦380,000, ₦610,000 and ₦290,000. The cumulative flow is ₦520,000 after year 1, ₦900,000 after year 2 and ₦1,510,000 after year 3, so the ₦1,500,000 is recovered during year 3. Payback = 2 + (1,500,000 − 900,000) ÷ 610,000 = 2.98 years, within a three-year limit, so accept.

Advantages: simple; uses cash flows; focuses on liquidity and early recovery, which reduces exposure to long-term risk. Disadvantages: ignores cash flows after payback, so it may reject a highly profitable long project; ignores the time value of money; the maximum period is arbitrary; and it measures recovery, not profitability.

The ideas in more depth

Why accounting profit is a poor guide to the return

Accounting profit includes depreciation, which is an allocation of cost and not a cash flow, and the timing of the profit can be moved by accounting choices. A project can show an attractive ARR while draining cash. The ARR is nonetheless useful because managers are often judged on accounting returns, so a project that harms reported return may be resisted, as in the agency problem studied earlier.

Why payback is still widely used

Payback is easy to explain, it favours projects that return cash quickly (useful when the future is uncertain or cash is short), and it is a good first screen. Its weakness is that it can say nothing about the value created. In practice it is used together with a discounted method, and a variant, the discounted payback period, is covered in a later topic.

Sources and references

• No accounting standard governs investment appraisal. Capital expenditure is accounted for under International Accounting Standard (IAS) 16 Property, Plant and Equipment.

These points are stated as at 5 November 2026.

Worked examples

1. Average profit.
   560,000 − 400,000 = ₦160,000.
2. ARR.
   160,000 ÷ 1,400,000 = 11.4%.

1. Payback.
   2,400,000 ÷ 640,000 = 3.75 years.

1. After 2 years. ₦900,000 recovered; ₦600,000 remains.
2. Payback.
   2 + 600,000 ÷ 610,000 = 2.98 years.

How to answer in the exam

• State which denominator you use for ARR and deduct depreciation from the profit before depreciation.
• Use cash flows, not profits, for payback and interpolate within the year of recovery.
• Compare with the target or maximum period and say accept or reject.
• Comment on the limits: time value, cash after payback, accounting manipulation.

Common mistakes in the exam

• Using profit before depreciation in ARR.
• Forgetting the residual value in average investment.
• Including the scrap value in cash flows before the year in which payback occurs.
• Dividing the whole project cost by only the first year’s cash flow when flows are uneven.
• Calling payback a measure of profitability.
• Accepting a project on payback alone.

Quick revision

• Capital expenditure creates a non-current asset; appraisal sits in a capital budget.
• ARR = average profit after depreciation ÷ (cost + residual) ÷ 2.
• Payback = years to recover the investment from cash flows.
• Both ignore the time value of money.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

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