When evaluating potential investments, sometimes you need a quick filter, not a deep analysis. Non-discounted appraisal methods provide just that. They are simple, back-of-the-napkin calculations that help screen out obviously poor projects before they consume more analytical resources. Their main weakness is that they ignore the time value of money, but their strength lies in their speed and simplicity. We'll look at two of the most common methods: the Payback Period and the Accounting Rate of Return.

The Payback Period answers one straightforward question: How long will it take to get my initial investment back? It's a measure of risk and liquidity, not profitability. A shorter payback period means your capital is tied up for less time, reducing the risk that market conditions or technology could change and render the project obsolete before it has paid for itself.

For projects with consistent, even cash inflows each year, the calculation is simple division.

For example, a $500,000 investment in a new machine that generates $125,000 in cash savings annually has a payback period of 4 years. The real world, however, is rarely so neat. Most projects generate uneven cash flows, requiring a cumulative approach to find the payback point.

In the table above, the initial $200,000 is paid back sometime during Year 3. At the end of Year 2, $60,000 is still unrecovered. The project generates $90,000 during Year 3. Assuming cash flows are even throughout the year, we can find the exact point of payback.

While the Payback Period focuses on cash and time, the Accounting Rate of Return (ARR) uses accounting profits from the income statement to measure a project's profitability relative to the investment size. It's expressed as a percentage, making it easy to compare against a company's target rate of return. Unlike payback, it considers the project's entire life, but it still ignores the time value of money.

The numerator, Average Annual Profit, is the total net income the project is expected to generate over its life, divided by the number of years. Remember to subtract annual depreciation from revenue to get the accounting profit.

The denominator can be calculated in two ways. Using the initial investment is simpler. However, using the average investment is more common and often more accurate, as it accounts for the fact that the book value of the asset declines over time due to depreciation.

Payback Period and ARR are best used as initial screening tools. A company might set a policy that all projects must have a payback period of under five years or an ARR of at least 15%. Any project that doesn't meet these minimum thresholds is rejected immediately.

However, these methods are less effective for ranking competing projects. Why? Because they completely ignore the time value of money. A project that pays back in 3 years but generates no cash afterward could look better than a project that pays back in 4 years but generates massive cash flows for 10 years after that. For final, nuanced decisions, discounted methods like Net Present Value (NPV) are far superior.

Think of them as the first cut. They quickly and easily weed out the non-starters, allowing you to focus your more intensive analytical efforts on the projects that have a real chance of creating value.