Case 3: Calculating Payback and Discounted Payback in a Malaysian Scenario

Background:
You are a financial analyst working in Kuala Lumpur, Malaysia, and you have been tasked
with evaluating two investment opportunities for a local business. Your job is to
calculate the payback period and discounted payback period for each option and discuss
their respective shortcomings.

Case Details:
Investment Option 1:
The business is considering investing in a new production line. The initial investment is
RM1,000,000, and the expected annual cash flows for the next five years are as follows:
Year 1: RM200,000, Year 2: RM250,000, Year 3: RM300,000, Year 4: RM350,000, Year 5:
RM400,000.

Investment Option 2:
The second investment option is a real estate project. The initial investment is
RM2,000,000, and the expected annual cash flows for the next eight years are as follows:
Year 1: RM400,000, Year 2: RM450,000, Year 3: RM500,000, Year 4: RM550,000, Year 5:
RM600,000, Year 6: RM650,000, Year 7: RM700,000, Year 8: RM750,000.

Questions:

1. Calculate the payback period for each investment option.

Show your step-by-step calculations.

2. Calculate the discounted payback period for each investment option, assuming a
discount rate of 10%.
Walk through the calculations.

3. Discuss the shortcomings of using payback period as an investment evaluation

metric.

4. Discuss the shortcomings of using discounted payback period as an investment

evaluation metric.
Answers:

Question 1: Calculate the payback period for each investment option.

Investment Option 1:
Payback Period = Initial Investment / Annual Cash Flow
Payback Period = RM1,000,000 / RM200,000 = 5 years

Investment Option 2:
Payback Period = Initial Investment / Annual Cash Flow
Payback Period = RM2,000,000 / RM400,000 = 5 years

Question 2: Calculate the discounted payback period for each investment option,
assuming a discount rate of 10%.

Investment Option 1:
Discounted Payback Period = Initial Investment / Discounted Annual Cash Flow
Discounted Payback Period = RM1,000,000 / (RM200,000 / (1 + 0.10)^1 + RM250,000 /
(1 + 0.10)^2 + RM300,000 / (1 + 0.10)^3 + RM350,000 / (1 + 0.10)^4 + RM400,000 / (1
+ 0.10)^5)
Discounted Payback Period ≈ 3.69 years

Investment Option 2:
Discounted Payback Period = Initial Investment / Discounted Annual Cash Flow
Discounted Payback Period = RM2,000,000 / (RM400,000 / (1 + 0.10)^1 + RM450,000 /
(1 + 0.10)^2 + RM500,000 / (1 + 0.10)^3 + RM550,000 / (1 + 0.10)^4 + RM600,000 / (1
+ 0.10)^5 + RM650,000 / (1 + 0.10)^6 + RM700,000 / (1 + 0.10)^7 + RM750,000 / (1 +
0.10)^8)
Discounted Payback Period ≈ 5.35 years

Question 3: Discuss the shortcomings of using payback period as an investment

evaluation metric.

The payback period is a simple metric for assessing investment projects, but it has
several shortcomings:

1. It doesn't account for the time value of money, which means it ignores the fact
that money received in the future is worth less than money received today.
2. It doesn't consider cash flows beyond the payback period, making it limited in
assessing long-term profitability.
3. It doesn't provide information about the project's overall profitability or return
on investment.
4. It doesn't consider the risk associated with different cash flow patterns.
5. It can lead to incorrect decisions, especially when comparing projects with
different durations or investment amounts.
Question 4: Discuss the shortcomings of using discounted payback period as an
investment evaluation metric.

The discounted payback period addresses some of the shortcomings of the regular
payback period but still has limitations:

1. It considers the time value of money by discounting cash flows, but it may not
provide a clear indication of the project's overall profitability.
2. Like the payback period, it doesn't account for cash flows beyond the payback
period, limiting its ability to assess long-term profitability.
3. It assumes a fixed discount rate, which may not reflect the project's risk or
changing market conditions.
4. It may not be suitable for comparing projects with different durations or
investment amounts.

In conclusion, while the discounted payback period is an improvement over the regular
payback period, both metrics have limitations, and it's essential to consider additional
financial metrics and qualitative factors when evaluating investment opportunities.