 Financial analysts use various quantitative techniques to determine the financial worth of a project in terms of its liquidity and solvency. Both discounted cash flow based models and undiscounted cash flow based models are used in this process. Generally, undiscounted cash flow models are used to determine solvency of the project whereas the discounted cash flow models are used to determine the project's profitability. In this list, the first model is the payback period. Payback period tells us the time that is required to recover back the project investment. This model is based on cash flows and the model is very much easy to understand and use in determining the payback time period. This payback model is the indicator of a project liquidity. It has a certain criteria to accept and reject the proposal of a project. If the calculated payback period is less than the required payback period, then the project can be accepted. Whereas if the computed payback period is greater than the required payback period, the project may not be accepted. But if we have equal cash inflows like in the form of an annuity, then how can we determine the payback period? Let us assume we have a cash investment of Rs 60,000 and annual cash inflow of Rs 15,000. Then the payback period can simply be computed by dividing the investment over the annual inflows. So dividing Rs 60,000 over Rs 15,000, the answer comes to four. This means that the payback period on this project is the period of four years. But if we have uneven cash inflows, then how payback period can be determined? Let us assume we have an initial investment on a machine of Rs 6,000 and for a period of five years we have uneven cash flows like 3,000, 1,000, 2,500, 1,500 in the last year. Then how can we determine the payback period on this project? We need to determine cumulative cash inflows. These cumulative cash inflows when equal to the initial cash outflow, that will be the project's payback period. Let go for it. In the first year, we have annual cash inflow of 3,000, but we need a recovery of 6,000. So we have to enter into the second year. But in the second year, the cash inflow is Rs 1,000. Now we have after two years, accumulative cash flows of 4,000. We need more, an amount of Rs 2,000 to have a recovery of 6,000 in full. But in the year three, the cash inflows are 2,500. So we are not required to work for the whole year. We have to work during the fraction of the year to determine that fraction. We divide the required amount of Rs 2,000 over the annual cash inflow of 2,500. The resulting figure is 0.8. Now we add this 0.8 to the initial two years. The resulting figure is 2.8 years. So this means that we need 2.8 years on this project to recover its initial cash investment of Rs 6,000. There are certain drawbacks associated with this simplest technique. The first is that the payback period measures the profit, measures the liquidity of the project and not the profitability. Then it ignores three important factors. It ignores time value of money, project risk factor and cash flows beyond the payback period. In the recent example, we have seen that we just needed Rs 2,000 to break even our investment of Rs 6,000 whereas in the third year, the cash flows are 2,500. But the payback method considers only first Rs 2,000 in the 80% period of the third year. For the rest of the period, there is an earning of Rs 500 but the payback period did not consider that extra amount. Then this method is unable to distinguish between profitable and unprofitable investment because this payback period method does not consider profitability. Like net present value and IRR, there is no economic criteria embedded in this technique so it has no economic rule to determine the acceptance and rejection of any given project. Then it is recommended that besides assessing the liquidity of a project through payback period, the profitability of the project should also be measured and determined and accessed through other techniques like IRR and NPV. To avoid the drawbacks of payback period, there is a refined version of it and that is the discounted payback period. It works in similar mode like the payback period with a little difference that instead of using gross cash inflows, it uses present value of these cash inflows. The descent criteria is same as the descent criteria with the payback period. That is, if the payback period computed is lesser than the required payback period, we can accept the project, otherwise not. The determination of payback period where the cash inflows are even like an annuity, the process is the same. We determine present value of annuity and divide the initial cash outlaw over the present value of cash inflows. The resulting figure is the payback period. But if we have uneven cash inflows during the life of the project, then how we can determine the payback period? The process is again same as the process we considered in the payback period. But the difference is that we now require to determine present value of individual cash inflows throughout the life of the period and the cumulative cash flows of present values will determine the payback period. Let's take the example we carry from the previous. We have Rs 6000 as initial investment and we have the same cash inflows each year. Then if we determine the present value of individual cash inflows, we see that till year 2006, this means that at the end of three years, we have cumulative cash flows of 5491. Now we require Rs 509 more in order to break even our initial investment of Rs 6000. But in year four, the cash inflows are discounted at 0.823 and the present value is 823. So we divide 509 over 823. The resulting figure is 0.62 or 62. This means that we require 3.62 years in order to break even on this project given the cash flows are used as discounted cash flows to determine the payback period. But this discounted payback period is not free from certain drawbacks. An important drawback is that if there is a negative NPV, then no discounted payback period can be determined because the recovery of initial investment will not be possible. Then like discounted payback period, this discounted payback period also ignores the cash flows occur beyond the payback period. Then it is not a good measure of profitability as it considers only the solvency aspect and not the profitability. Then there may be a project that may yield though a negative NPV but during the life of the project some positive cash flows may also be there. But this discounted payback period does not consider all of them. And we have average accounting return. In average accounting return, the model is very easy to determine the profitability rate of the capital project. It is based on accounting number and not on the cash flow data. Like payback period, it also ignores the time value of money and the project risk. As we know that there is a cut-off rate in NPV and IRR but for average accounting rate of return there is no such cut-off rate. Therefore, this method is unable to distinguish between profitable investment and an unprofitable investment as we have seen in the case of payback period. To determine average accounting rate of return, we simply divide average net income of a certain period of time over the average book value of the capital project. On the screen, you can see there is an investment cost of $100,000 and we have five years income data. In the last column, we have net income of each year. If we average the net income of five years, the figure is $18,000. If we divide this $18,000 net income over the average book value of $100,000, the resulting return is the 18%.