Which Capital Investment Methods Ignore Time Value of Money?

When a business undertakes a long-term expenditure, such as purchasing new equipment or constructing a facility, it engages in a capital investment project. A core concept in evaluating these projects is the time value of money, which recognizes that a dollar received today is worth more than a dollar received in the future. While many sophisticated methods exist to analyze these investments, some techniques simplify the process by ignoring the time value of money. These approaches are often used for initial screening due to their simplicity and will be the focus of this article.

The Payback Period Method

The payback period is a capital budgeting technique that calculates the time required for an investment to generate sufficient cash inflows to recover its initial cost. Because of its simplicity, it is often used as an initial screening tool to assess liquidity and investment risk by identifying projects with an unacceptably long payback timeframe.

The formula for a project with even annual cash inflows is the Initial Investment divided by the Annual Cash Inflow. For instance, if a company invests $200,000 in a new machine that is expected to generate $50,000 in cash each year, the payback period is four years ($200,000 / $50,000). This calculation provides a clear timeline for when the initial outlay will be recouped.

The calculation becomes a cumulative process for uneven cash flows. Consider a project with an initial cost of $200,000 that generates $60,000 in year one, $80,000 in year two, and $70,000 in year three. After two years, $60,000 of the investment remains unrecovered. Since the third year’s cash flow of $70,000 exceeds this amount, the payback occurs within that year. The total payback period is 2.86 years (2 + $60,000 / $70,000).

This method’s primary limitation is that it ignores any cash flows generated after the payback period is reached. A project could generate significant returns in its later years, but this method would not capture that value. Furthermore, it treats all cash flows as equal, regardless of when they are received, which means the time value of money is disregarded.

The Accounting Rate of Return Method

Another evaluation tool that does not incorporate the time value of money is the Accounting Rate of Return (ARR). Unlike the payback method, which focuses on cash flows, ARR uses accounting information from the income statement. It measures the average annual net operating income a project is expected to generate as a percentage of the initial investment, shifting the focus from cash recovery to profitability.

The formula for ARR is the Average Annual Operating Income divided by the Initial Investment. For example, a company considers a $500,000 investment in equipment with a five-year life and no salvage value. The equipment is expected to increase annual revenues by $200,000 and annual operating expenses (excluding depreciation) by $60,000. The annual straight-line depreciation would be $100,000 ($500,000 / 5 years).

The annual operating income from the project is calculated as the increase in revenue minus the increase in expenses and depreciation. In this case, it is $200,000 – $60,000 – $100,000, which equals $40,000 per year. The ARR is then calculated as $40,000 / $500,000, which results in an 8% return. This figure can be compared to a minimum required rate of return set by the company.

The ARR method’s primary flaw is its reliance on an average of profits over the project’s life. By averaging income, the method treats profits earned in later years as having the same value as profits earned in year one. This approach can be misleading because it does not account for the fact that earlier profits are more valuable as they can be reinvested sooner.

The Significance of the Time Value of Money in Project Evaluation

Ignoring the time value of money means overlooking economic realities that impact an investment’s true profitability. Two factors are inflation and opportunity cost. Inflation erodes the purchasing power of money over time, meaning a dollar received in the future will buy less than a dollar today.

Opportunity cost represents the potential return an investor gives up by choosing one investment over another. Money received sooner can be reinvested to generate additional earnings. By treating all future dollars as equal, these methods fail to account for this lost earning potential. A project that returns cash quickly provides more opportunities for reinvestment than one that pays back more slowly.

This conceptual gap is why more sophisticated techniques like Net Present Value (NPV) and Internal Rate of Return (IRR) were developed. These methods address the time value of money by discounting future cash flows back to their present value, providing a more accurate picture of an investment’s worth. While the payback period and ARR offer simplicity for initial screening, their disregard for the time value of money makes them less reliable for final investment decisions.