In my previous blog on Payback method calculation, I mentioned that although the method can give a quick snap on the project risks and time for investment to reach the breakeven point, it does not consider the timing of net cash receipts. This problem can be overcome by discounting the net cash receipt.
We probably use this method in our everyday life. Let's assume that interest is 10% per annum on a building society investment, we can calculate what amount of money we have to invest to in order to have a certain amount of money at the end of the year.
This is called 'discounting".
* We calculate the future net cash flows
* Select the appropriate rate of interest
* Multiply the cashflow by the discount factor
The discount factor will depend on the cost of borrowing money. Table below shows a discount factor information.
Dyson J. 2010, 'Accounting for non-accounting students'. Pearsons Education UK
We can look along the top line of the appropriate rate of interest for example 10%. We then work down the 10% column until we come to the line opposite the year in which the cash would be received.
Example
Dyson J. 2010, 'Accounting for non-accounting students'. Pearsons Education UK
The discounted payback method has certain advantages. It is relatively easy to understand, not too difficult to compute, it focuses on the cash recovery of the investment and allows for the fact that cash received now may be worth more then cash received in the future. It takes more of the net cash flows into account then in the case of simple payback calculation because the discounted payback period is always longer then the simple payback method.
However, sometimes it is difficult the amount of timing of instalments due to be paid on the original investments and difficult to estimate the amount of timing of future net cash receipts and other payments. Sometimes it may be difficult to estimate the appropriate rate of interest.
The use
The discounted period method is the capital budgeting procedure used to determine the profitability of a project. It gives the number of years it takes to breakeven from undertaking an investment expenditure by discounting future cashflows and recognising the time value of money. It can measure the feasibility of a given project. It allows to determine on whether to take or not a project as it factor for the time value of money. It is more accurate then the standard payback calculation and it shows how long it will take to recoup an investment based on observing the present value of the project's projected cashflows.
When deciding on any project, a company or investor wants to know when their investment will pay off and when the money invested will cover the costs of the project. This can be useful when businesses need to choose between more then one investment project and it makes this decision easier.
It is taking the future estimated cashflows of a project and 'discounting them' to the present value. The period of time that the investment takes for the present value of future cashflows to equal the initial cost provides the indication on when the project will breakeven.
The shorter the discounted payback period, the sooner the project will generate cashflows. We need to accept the projects which have the payback periods that is shorter then the targeted timeframe.
We need to estimate the periodic cashflows and shown in table on a spreadsheet. This cash flows and the reduces its present value factor to reflect the discounting process. Assuming that the project starts with a large cash outflow or investment to begin the project, the future discounted cash inflows are netted against the initial investment outflow. We then find the point when the inflows equal the outflows.
Let's assume that a company A has a project requiring initial cash of £3,000. The project is expected to return £1,000 each period for the next 5 periods and the discount rate is 4%.
We start the calculation with -£3,000 cash outlay in the starting period. The first period will experience +£1,000 cash inflow.
Using the present value discount calculation, this figure is £1,000/1.04 = £961.54. Thus, after the first period, the project still requires £3,000 - £961.54 = £2,038.46 to break even. After the discounted cash flows of £1,000 / (1.04)2 = £924.56 in period two, and £1,000/(1.04)3 = £889.00 in period three, the net project balance is £3,000 - (£961.54 +£924.56 + £889.00) = £224.90.
We know that after receipt of the forth payment, the project will have positive balance.
The discounted payback period, is therefore, a modified version of the payback period that account the time value for money. It is used to determine the profitability and feasibility of a project or investment. Usually companies decide between few multiple projects and discounted payback period evaluate the profitability and timing of cash inflows. We estimate future cashflows and adjust for the time value for money. It is a period of time that a project takes to generate cash flows when the present value equals the initial investment costs.
we know that there are two steps of this process. First we need to discount (bring to the present value) the net cash flows that will occur in each year of the project. And second, we must subtract the discounted cash flows from the initial cost figure to obtain the discounted payback period. Once we have calculated the discounted cashflows, we can subtract them from the initial cost figure until we arrive at zero.
Bibliography:
CFI Team, 2022, "Discounted Payback Period", accessed from https://corporatefinanceinstitute.com/resources/valuation/discounted-payback-period/, accessed on 23/04/2023
Dyson J. 2010, 'Accounting for non-accounting students'. Pearsons Education UK
Kenton W., 2020, "Discounted Payback period: What it is and how to calculate it", accessed from https://www.investopedia.com/terms/d/discounted-payback-period.asp, Accessed on 23/04/2023.
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