Agriculture Reference
In-Depth Information
Another weakness of the payback method is a failure to account for the time value of
money. Thus, $1 of cash fl ow received three years from today is given the same “weight” in
payback analysis as $1 received today. As discussed in the section on time value of money,
cash fl ows received after one period need to be discounted. So if all the cash fl ows have
equal value regardless of when they are received, the cash fl ows received in three years are
overvalued relative to those received in one year. Other methods for evaluating investments
have been developed to help address these limitations of the payback period.
Simple rate of return
The
simple rate of return
method refers to the profi t generated by the investment as a percent-
age of the investment. The most common variation of this method uses the average return and the
average investment to give a more accurate analysis. The simple rate of return calculation is:
Simple Rate of Return
(
Average Annual Return
Average Investment
m
)
/
m
ve age
ves
Simple rate of return is perhaps the most commonly used method of capital budgeting. This
method considers net earnings over the entire expected life of the investment. It is easy to
understand and is consistent with ROE goals imposed by management. In fact, many fi rms
have estimated ROE standards that serve as a cutoff point for investment projects. Unless an
investment proposal exceeds these minimal standards, it will not be seriously considered. A
standard of 15 to 25 percent is common for many food and agribusiness fi rms.
To illustrate the calculations of the simple rate of return, the two investment alternatives
BF&G is considering will be used. The net returns expected from this $300,000 applicator
investment decline over its life because of increasing maintenance and repair costs. BF&G
estimates that average net profi t after depreciation for the new applicator equals $89,200 and
the calculations are shown in
Table 13.5.
The average rate of return would be:
SimpleRate of ReturnAverage Annual Return
(
Average Investment
m
)
/
m
ve age
ves
=
(
)
$,
/$
89
2
15
0
,
)
59
%
00
BF&G would rank this investment alternative higher than those with returns under 59 percent.
Next, the cash fl ows from the additional grain storage and handling equipment are
presented and the simple rate of return is calculated.
So, the simple rate of return for the fertilizer applicator is higher (59 percent) than the rate
of return for the additional grain storage (35 percent). Consequently, if the simple rate of
return is used to analyze the two investment alternatives, then the fertilizer applicator would
be selected over the additional grain storage. However, the simple rate of return has limita-
tions much like the payback period method.
The chief limitation of the simple rate of return method is that it fails to consider the
timing of cash fl ows. When the initial net cash fl ow is high, but falls off quickly, the situation
is far different than when the initial net cash fl ow is low, but increases over time. A conse-
quence of this problem is that incorrect conclusions may be drawn because the method fails
to consider that a dollar returned now is signifi cantly more valuable than a dollar of cash
fl ow received several years later. Also, the simple rate of return is a rate and is infl uenced by
the size of the investment. So, an investment project may be very small, but have a very high
