Chapter 6

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Atrill/Hurley Financial Management for Decision Makers Canadian Edition Chapter 6 General Excel Template Topic: Payback and Discounted Payback Period A central goal in financial management is to undertake those decisions that create value for shareholders. Therefore, it is of central importance to develop techniques that enable financial decision makers to identify those investment opportunities that generate value (as opposed to those that do not). The capital budget techniques of payback and discounted payback are widely used, despite being inferior to the techniques of NPV and IRR. Payback Period: The payback period of an investment refers to the length of time an investment will take to generate cash flows equivalent to the original cost of the investment. The decision criteria for the payback method are: If the investment achieves payback within a specified timeframe, accept it. If the investment does not achieve payback within a specified timeframe, reject it. Discounted Payback Period: The discounted payback period of an investment refers to the length of time an investment will take to generate discounted cash flows equivalent to the original cost of the investment. The decision criteria for the discounted payback method are: If the investment achieves discounted payback within a specified timeframe, accept it. If the investment does not achieve discounted payback within a specified timeframe, reject it.

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Suppose your company is attempting to evaluate a particular project with the following cash flows: Year 1 2 3 4 5 6 7 8 Cash Flow $5,000 $14,000 $12,000 $15,000 $9,000 $12,000 $20,000 $40,000

The project costs $80,000 today, the required return on investments of this type is 8%, and the required cut-off is 5 years. Calculate both the payback period and the discounted payback period for the project and determine whether or not you should undertake the project.

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Calculating Payback: Year 0 Beginning Balance -$80,000 Net Cash Flows $0 Ending Balance -$80,000

Immediate cost of investment

-$80,000

$5,000

2 3 4 5 6 7

-$75,000 -$61,000 -$49,000 -$34,000 -$25,000 -$13,000

$14,000 $12,000 $15,000 $9,000 $12,000 $20,000

$40,000

Initially, the investment "owes" the entire original cost of $80,000 (the figure is shown as a negative value to indicate that this amount is owing). -$75,000 As the investment generates cash flows in the future, the amount that the investment "owes" is reduced by the amount generated by the investment that year. -$61,000 -$49,000 -$34,000 -$25,000 -$13,000 $7,000 Eventually, the investment achieves payback the point at which the balance owing from the investment goes from negative to positive. The cash flow for the 8th period is not used in determining the payback period since it occurs after payback has been achieved. The fact that the payback method ignores some future cash flows, like this, is seen as a disadvantage of the method.

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Payback Period =

6.65

Years

From the above table, we can determine that payback is achieved at some point over the 7th year (we can make this determination because the balance goes from negative to positive during the 7th year). A related question is then, at what point over this year did payback actually occur? A common assumption of the payback criteria is that each period's cash flow is evenly spread over the period. Using this assumption, we can conclude that payback was achieved 65% of the way through the 7th year (13,000/20,000 = 0.65 = 65%). Therefore, the payback period is a total of 6.65 years. Accept or Reject? Given that the cut-off period in the example is stated to be 5 years, this investment does not achieve payback soon enough. Therefore, the payback criteria indicate that this investment should be rejected.

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Calculating Discounted Payback: The process of calculating discounted payback is identical to that of calculating payback , with one key exception. In place of using the unadjusted cash flows, the discounted payback approach first determines the present value of the future cash flows for the given investment and then uses these discounted values to determine the payback period . Step 1: Calculate the present value of the future cash flows being generated by the investment. Discount rate = 8% Year (nper) 1 2 3 4 5 6 7 8 Cash Flow Discounted (FV) Cash Flows $5,000 $4,629.63 $14,000 $12,002.74 $12,000 $9,525.99 $15,000 $11,025.45 $9,000 $6,125.25 $12,000 $7,562.04 $20,000 $11,669.81 $40,000 $21,610.76

Excel Formula
=PV($F$59,B62,,-C62) =PV($F$59,B63,,-C63) =PV($F$59,B64,,-C64) =PV($F$59,B65,,-C65) =PV($F$59,B66,,-C66) =PV($F$59,B67,,-C67) =PV($F$59,B68,,-C68) =PV($F$59,B69,,-C69)

Step 2: Calculate the discounted payback period using the present value cash flows determined in Step 1. Net Cash Beginning Flows Balance (discounted) -$80,000.00 $0.00

Year 0

-$80,000.00

$4,629.63

Ending Balance -$80,000.00 Initially, the investment "owes" the entire original cost of $80,000 (the figure is shown as a negative value to indicate that this amount is owing). -$75,370.37 As the investment generates cash flows in the future, the amount that the investment "owes" is reduced by the discounted amount generated by the investment that year.

2 3 4 5 6 7 8

-$75,370.37 -$63,367.63 -$53,841.64 -$42,816.19 -$36,690.94 -$29,128.91 -$17,459.10

$12,002.74 $9,525.99 $11,025.45 $6,125.25 $7,562.04 $11,669.81 $21,610.76

-$63,367.63 -$53,841.64 -$42,816.19 -$36,690.94 -$29,128.91 -$17,459.10 $4,151.66 Eventually, the investment achieves payback the point at which the balance owing from the investment goes from negative to positive.

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Discounted Payback Period =

7.808

Years

From the above table, we can determine that payback is achieved at some point over the 8th year (we can make this determination because the balance goes from negative to positive during the 8th year). A related question is then, at what point over this year did payback actually occur? A common assumption of the discounted payback method is that each period's cash flow is evenly spread over each period. Using this assumption, we can conclude that discounted payback was achieved 80.8% of the way through the 7th year (17,459.10/21,610.76 = 0.808 = 80.8%). Therefore, the discounted payback period is a total of 7.808 years. Accept or Reject? Given that the cut-off period in the example is stated to be 5 years, this investment does not achieve discounted payback soon enough. Therefore, the discounted payback criteria indicate that this investment should be rejected.

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