Discounted Payback Period
The discounted payback period is a financial metric used to evaluate the time it takes for an investment to recoup its initial cost, considering the time value of money. It accounts for the present value of future cash flows, providing a more accurate measure of investment profitability. By discounting future cash flows, it helps businesses assess the risk and return of potential investments.
8 Key excerpts on "Discounted Payback Period"
eBook - ePub- Vibrant Publishers, Kalpesh Ashar(Authors)
- 2019(Publication Date)
- Vibrant Publishers(Publisher)
...Hence, it is not very effective in deciding which project is more profitable and hence, worth investing. It also does not consider cost of capital of the company while finding the payback period. In reality, a company will have a longer payback period if this cost is considered. The next method, discounted payback period, considers this aspect. Discounted Payback Period This is same as the payback period but also gives due consideration to the cost of capital. Each year’s net cash flow is discounted by the cost of capital to get discounted net cash flow. These are then added to get a Cumulative discounted net cash flow. The same example is used as above with a cost of capital of 10%. In order to discount the cash flow, the following formula is used: Discounted net cash flow = Net cash flow/(1 + k) t Where, k is the cost of capital and t is the year in which the cash flow is generated. For example, to calculate the discounted net cash flow in year 1 for Project A, we do the following: Discounted net cash flow for Project A (Year 1) = $3,000/(1 + 0.1) 1 = $2,727.27 Below is the calculation of the Discounted net cash flow for Project A and Project B: Then the Cumulative discounted net cash flow is found as below: We use the same formula to find out the payback period, but this time use Cumulative Discounted net cash flow as below: Discounted Payback of Project A = 3 + ($135/$2,049) = 3.07 years Discounted Payback of Project B = 3 + ($1,762/$2,049) = 3.86 years Since we have discounted the cash flows, the payback period has also got extended. Applying this method to the cash flows from the previous section gives the following: Discounted Payback Period = 2 + ($55,165/$79,639) = 2.69 years Net Present Value (NPV) This is the most popular and useful method in taking capital budgeting decisions. It calculates the current (or present) value of future cash flows. It is like saying how much the cash flows over the life of the project are worth today...
eBook - ePub- Kalpesh Ashar, Vibrant Publishers(Authors)
- 2022(Publication Date)
- Vibrant Publishers(Publisher)
...Hence, it is not very effective in deciding which project is more profitable and hence, worth investing in. It also does not consider cost of capital of the company while finding the payback period. In reality, a company will have a longer payback period if this cost is considered. The next method, Discounted Payback Period, considers this aspect. 4.5 Discounted Payback Period This is same as the payback period but also gives due consideration to the cost of capital. Each year’s net cash flow is discounted by the cost of capital to get discounted net cash flow. These are then added to get a Cumulative discounted net cash flow. The same example is used as above with a cost of capital of 10%. In order to discount the cash flow, the following formula is used: Discounted net cash flow = Net cash flow/(1 + k) t Where, k is the cost of capital and t is the year in which the cash flow is generated. For example, to calculate the discounted net cash flow in year 1 for Project A, we do the following: Discounted net cash flow for Project A (Year 1) = $3,000/(1 + 0.1) 1 = $2,727.27 Below is the calculation of the Discounted net cash flow for Project A and Project B: Years 0 1 2 3 4 Project A Net cash flow ($10,000) $3,000 $5,000 $4,000 $3,000 Discounted net cash flow (@10%) ($10,000) $2,727 $4,132 $3,005 $2,049 Project B Net cash flow ($5,000) $1,000 $1,000 $2,000 $3,000 Discounted net cash flow (@10%) ($5,000) $909 $826 $1,503 $2,049 Then the Cumulative Discounted net cash flow is found as given below: Years 0 1 2 3 4 Project...
eBook - ePub- Jae K. Shim, Joel G. Siegel, Allison I. Shim(Authors)
- 2011(Publication Date)
- Wiley(Publisher)
...This shows that the payback reciprocal gives a reasonable approximation of the IRR if the useful life of the project is at least twice the payback period. Discounted Payback Period Before looking at discounted cash flow methods, note that there is less reliability with discounted cash flow analysis where there is future uncertainty, the environment is changing, and cash flows themselves are hard to predict. Take into account the time value of money by using the discounted payback method. The payback period will be longer using this method because money is worth less over time. How to do it: Discounted payback is computed by adding the present value of each year's cash inflows until they equal the investment. Example 5 Assume the same facts as in Example 3 and a cost of capital of 10 percent. Net Present Value The NPV method compares the present value of future cash flows expected from an investment project with the initial cash outlay for the investment. Net cash flows are the difference between forecasted cash inflow received because of the investment and the expected cash outflow of the investment. Use as a discount rate the minimum rate of return earned by the company on its money. As reported in the June 2004 issue of Management Accounting, 45 percent of manufacturers used discount rates of between 13 percent and 17 percent, and more than 20 percent used discount rates of over 19 percent. A company should use as the discount rate its cost of capital. Rule of thumb: Considering inflation and the cost of debt, the anticipated return should be about 10 to 13 percent. Note: The net present value method discounts all cash flows at the cost of capital, thus implicitly assuming that these cash flows can be reinvested at this rate. An advantage of NPV is that it considers the time value of money...
eBook - ePubReturn on Investment Manual
Tools and Applications for Managing Financial Results
- Robert Rachlin(Author)
- 2019(Publication Date)
- Routledge(Publisher)
...However, whichever method is used it is important to be consistent for all projects and that the acceptable payback time be reflected accordingly. For example, a before-tax basis would lower the payback period since cash flows would be higher and thus result in a speedier payback. Conversely, an after-tax basis would result in lower cash flows and a longer payback period. Other guidelines used by this company include a required ten-year cash flow projection and that the payback calculation must start from the date of any significant cash expenditure so that the time value of money can be considered and reflected in the return on investment rate (IRR). For example, the following hypothetical cost saving project with the estimated cash flows results in a payback period of 3.125 years. Discounted Payback Applying the discounted cash flow concept (to be discussed later in the chapter), payback can now reflect the time value of money. Assuming the previous data, let us apply a 16% discount rate (see discount tables in Appendix A), with results as shown in Table 20-3. The discounted payback is approximately 16% over the four years, since after four years there is still a $900 balance to be recovered. Payback Reciprocal One way of relating the payback period to the rate of return is to use the payback reciprocal. This represents a rough estimate of the rate of return where the project’s life is at least twice the payback period. It is calculated as follows using the data previously presented: Payback Reciprocal Equation Average annual cash flows Investment = $ 40, 000 $ 120, 000 = 33.3 % In this case, a three-year payback period is equivalent to a minimum rate of return of 33.3%. Note that when the payback period is multiplied by the rate of return (.333 x 3), the answer will always equal 1; therefore, they reciprocate each other...
eBook - ePub- Rob Dransfield(Author)
- 2013(Publication Date)
- Routledge(Publisher)
...The annual cash flows are accumulated and the payback period is reached when the cumulative cash flow reaches zero. The formula for payback can thus be set out in the following way: We can illustrate this for an investment project (Project A) that costs £45,000 and where the project is expected to yield £15,000 in the first year, £25,000 in the second year and £20,000 in the third year. The column in Table 17.1 showing cumulative cash flow shows the net cash outflow or inflow in specific years. Table 17.1 Illustrating payback for Project A We use the term Year 0 to signify the start of the project (when there is the initial cash outlay). The payback period can then be calculated from these data in the following way. We know that the payback will take place between Year 2 and Year 3. Case Study An alternative cash flow Analysts have identified an alternative way of investing the £45,000 outlined above (Project B). This will yield the following cash flows: £5,000 in Year 1, £40,000 in Year 2 and £10,000 in Year 3. Which of the projects should the company invest in if it is going to use the payback method? Show your working. The payback will be particularly helpful in comparing the time taken to pay back alternative projects. The project with the shortest payback period is the best investment proposition, as the shorter timescale reduces the risk of unforeseen circumstances. Key Term Payback method – a way of appraising investment projects in terms of the amount of time that it takes to pay back an initial cash investment in terms of cash inflows from the project. 17.4 Discounted cash flow to find net present value A second technique for appraising an investment is to use discounted cash flow. The discounted cash flow approach is a way of valuing the future returns on investment by assessing the value of these returns in terms of their present value...
eBook - ePubMaking the Compelling Business Case
Decision-Making Techniques for Successful Business Growth
- W. Messner(Author)
- 2013(Publication Date)
- Palgrave Macmillan(Publisher)
...NPV is always (!) the most appropriate approach to calculating business cases; Sections 2.3 – 2.6 describe the most common alternative methods, highlight their weaknesses (and strengths, if at all), and explain why they are always (!) inferior to the NPV method when making decisions on investment propositions. Sometimes they are indeed appropriate to use, but the same decision can always (!) be reached with the much more straightforward NPV method. Chapter 5 is dedicated to the practical application of the NPV method. 2.3 PAYBACK AND DISCOUNTED PAYBACK METHOD Some corporations require the initial investment on any of their projects (i.e. the cash outflow in year zero) to be recoverable within a specified period. Statements by executives like “The costs need to be recovered within the same financial year” or “The investment needs to show a leverage within the same quarter” are telling signs of this pre-set investment parameter. Other companies tend to compare and judge investment alternatives on how rapidly they can recover the cash outflow, obviously trying to impress shareholders and other stakeholders with quick results. And again, some business managers try to get their pet projects approved by promising “immediate returns” to their superiors. Such requirements and approaches all refer to the payback period, which can be found by calculating the time it takes before the cumulative forecasted net cash flows from year one onwards equal the initial investment in year zero. In simple terms, the payback period is the time it takes to recover the initial spending on the investment. Figure 2.7 looks at three different mutually exclusive project alternatives. All three projects initially invest $470,000, but differ in their cash flows in subsequent years. The first project reaps a positive cash flow of $25,000 in the first four years and then decommissions the investment with a positive cash flow of $470,000 in the fifth year...
eBook - ePubAppraisal and Selection of Projects
A Multi-faceted Approach
- Utpal K. Ghosh(Author)
- 2021(Publication Date)
- CRC Press(Publisher)
...Cash flows are accumulated annually and payback period is considered to have been reached when the cumulative cash flow reaches zero. In the cash flow, when there is initial outlay, the term ‘Year 0’ is used to signify the start of the project. It should be noted that payback period uses cash flows only and not the net income. Also, it does not take care of the profitability of the project. It simply computes how fast the investment is recovered. Other parameters being equal, shorter payback periods are preferable to longer payback periods. Payback period is normally expressed in years. Table 6.3 illustrates a typical example of computation of payback period. TABLE 6.3 Computation of Payback Period Year Annual Cash Flow ($) Cumulative Cash Flow ($) 0 −40,000 −40,000 1 +12,000 −28,000 2 +14,000 −14,000 3 +8,000 −6,000 4 +8,000 +2,000 In this example, the payback period is between 3 and 4 years, and the cumulative cash flow becomes positive in the 4th year. In practice, the year in which the cumulative cash flow becomes positive is designated as the payback year. 6.4.1 A DVANTAGES The basic advantages of payback period method are briefly stated below: Payback period is easy to comprehend and calculate. This is a ‘rule of thumb’ method for appraisal of projects of minor nature that come across frequently for investment decisions. Primary aim is to get the money back as early as possible so that it can be re-invested in other projects. Thus, it is a useful capital budgeting method for cash-starved business organizations; It tries to take care of the risk factor in an investment. In cases where risk is anticipated from political, economic or any other direction, the shortest payback period should be the best option as the shortest time period reduces the risk of unforeseen happenings. 6.4.2 D ISADVANTAGES In spite of its simplicity to calculate, the payback period method has some inherent disadvantages...
eBook - ePub- Richard Kotas(Author)
- 2014(Publication Date)
- Routledge(Publisher)
...In this particular method we relate the savings of cash expenditure (or additional cash profits) to the cost of the relevant capital expenditure to decide how long it will take a project to pay for itself. The time taken is known as the pay-back period. Imagine that a person spends 5p a day on matches. One day the individual decides to purchase a lighter for £2.00. Quite clearly—if we ignore the cost of flints and the fuel—the pay-back period is 40 days. Example A restaurant maintains a manual system of accounting and control. The annual cost of the system is as follows. Salaries: £ £ (a) book-keeper 10,000 (b) cashier 8,000 (c) clerk 8,000 26,000 ——— Stationery 800 ——— Total £26,800 ——— The proprietor intends to mechanize all accounting and control procedures by purchasing suitable office machinery at a cost of £12,000. The machinery will have an effective life of five years. The annual cost of the new system is estimated as follows. Salaries: £ £ (a) book-keeper 10,000 (b) clerk/cashier 8,000 18,000 ——— Depreciation of office machinery 2,400 Stationery, maintenance, etc. 2,800 ——— Total £23,200 ——— Now, what are the annual savings of cash expenditure resulting from the new system? Surely, the answer is £26,800 less £20,800, i.e. £6,000. It should be noted that we have ignored the cost of depreciation as this does not result in a cash outlay. The pay-back period is: The cash outlay on the new office machinery will thus be recovered over a period of two years. The pay-back method has certain advantages and disadvantages. The most important advantage of this method is its simplicity. The concept of the pay-back period is easy to grasp and meaningful. Similarly, the method is easy to apply: all we have to do is divide the cost of the project by the relevant savings of cash expenditure (or additional cash profits). Other things being equal the shorter the pay-back period the more attractive the project...
