Calculating ARR and Payback period

Your firm is considering two projects with the following cashflow:

Year	Project A	Project B
0	-500	-500
1	167	200
2	180	250
3	160	170
4	100	25
5	100	30

Assumption: Straight line depreciation is used = (Initial Investment - residual value) / n = (500 - 0)/5 = 100

				Project A	Project B
Nominator
Average profits before depreciation				(167+180+160+100+100)/5 = 707/5 = 141.4	(200+250+170+25+30)/5 = 675/5 = 135
Average annual profit after depreciation				141.4 - 100 = 41.4	135 - 100 = 35
Denominator
Average Investment				500/2 = 250	500/2 = 250
Annual Rate of Return (ARR)				41.4 / 250 * 100 = 16.56%	35/250 *100 = 14%

If the company's ARR target was set at 20%, then both projects will be rejected.
If the company's ARR target was set at 15%, then project A will be accepted and project B will be rejected.
If the company's ARR target was set at 10%, then the project with the highest ARR will be selected, thus project A will be selected.

Year	Project A	Cumulative CF	Project B	Cumulative CF
0	-500	-500	-500	-500
1	167	-333	200	-300
2	180	-153	250	-50
3	160	7	170	120	<------ Break even point
4	100	107	25	145
5	100	207	30	175

Payback period / Break even point
Project A	2 years	11.475	months
Project B	2 years	3.53	months

If the company's payback target was 2 years, then both projects will be rejected.
If the company's payback target was 2.5 years, Project B will be selected and Project A will be rejected.
If the company's payback target was 3 years, the project with the shortest payback period will be selected, thus Project B will be selected.