If the estimate exceeds the target, accept the project. If it is lower, reject the project. Depreciation should be accounted for. Estimated average profit after depreciation*100 ARR = Estimated average investments Appendix 2: Financial Calculations PAYBACK METHOD AND DISCOUNTED CASH FLOW (DCF) Payback is normally defined as the period, usually expressed in years, which it takes the cash inflows from an investment project to equal the cash outflow. Depreciation is not accounted for in this model. The ARR method of investment appraisal ignores the timing of cash flows and the actual cost of capital. Payback considers the time it takes to recover the original investment cost, but ignores total cash flow over a project lifetime. The payback time for a particular investment is illustrated in Figure A2.4. Discounted cash flow (DCF) takes into account both the time value of money and total cash flows over a project lifetime. It is therefore often argued that DCF is a superior method to both ARR and payback. NET PRESENT VALUE Present value (PV) can be defined as the present cash equivalent of a sum of money receivable or payable at the stated future date, discounted at a specified rate of return. Compound interest: P = current investment i = annual interest rate, compounded each year Pn = value of the investment after n years After one year the value of the investment increases to P1 =Po+iP0=Po(1+i) After two years, the investment value has increased to P2 = Po(1 + = P (1 + i)2 In general, Pn = Po(1 +i)" Discounting a future value: The present value P of a future amount Pn is found from the above equation: In general, Cost of investment (cash out) Payback time Accumulated cash inflow Figure A2.4 Pay back time Understanding Changing Telecommunications - Building a Successful Telecom Business Figure A2.5 Assumed annual Telecom project (net) cash flows PV of a series of regular equal cash flows: n cash flows (payments or receipts), each of amount A, at the end of years 1, 2, 3 according to Figure A2.5. Po = A(1+i)-1+A(1+i)-