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A Typical Business Scenario
"The project proposal submitted by Southville Project Manager Harold Beige is the only proposal that uses the discounted payback period in the presentation of financial returns," says CEO Roger Hadson. "Miss Dewey, did you remind the other managers of this method? I wanted to see the actual future values of these returns. If you didn't, please tell them again. Management will examine the proposals next week, and as agreed upon by the directors during the last monthly meeting, managers should use the discounted payback period method in presenting the financial returns. The bank also requires us to integrate this information in our loan application. If these managers cannot submit the revisions before Wednesday of next week, I am afraid that their proposals will not be reviewed," CEO Hadson of the Leviste Project Construction, Incorporated insists.
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What is a Discounted Payback Period?
The discounted payback period is a budgeting method that considers not only the number of years it takes for the company to recover its investment (after considering inflation, interest and other matters affected by the investment), but also the time value of money.
In using this method, each investor determines his/her own discounted payback period rule, making it a highly subjective method. In general, however, a short-term investor uses a short number of years, or even months, for his/her discounted payback period rules, while a long-term investor measures his/her rules in years, or even decades.
Some of the good characteristics of the Discounted Payback Period are:
- Simple to understand
- Can adjust for risks
- Measures profitability
- Ensures liquidity
- Adjusts for time value of money
- Consistent with the wealth maximization goal
- Assumes realistic reinvestment of intermediate cash inflow
The discounted payback period answers the limitations of the simple and traditional payback period method, which plainly considers only the time required for cumulative cash inflows to recover the cash outflows, or the investment of the project.
Let us consider, for example, Mr. Harold Beige's project. Leviste spends $80,000 on this project. The annual cash inflow is $20,000. The simple payback period is 4 years computed as $80,000 divided by $20,000.
As seen above, payback period does not consider the time value of money, because the said annual return is not discounted. In order to correct this, we use the discounted cash flow in calculating the payback period.
In using the discounted payback period on Mr. Beige's project, at a 7% interest rate, the $80,000 cash investment will actually be recovered after 4.85 years as computed below. In discounting the annual cash flows in the illustration, they are simply multiplied by their present value factors.
Year Annual Cash Flow Present Value Factor Discounted Cash Flow
- First year - $20,000 multiplied by .9346 $18,692
- Second Year- $20,000 multiplied by .8734 $17,468
- Third Year -$20,000 multiplied by ..8163 $16,326
- Fourth Year - $20,000 multiplied by .7629 $15,240
- Fifth Year - $20,000 multiplied by .7130 %14,260
At the end of the fourth year, the total discounted cash flows amounted to only $67,726 or $18,692 + $17,468 + $16,326 + $15,240 + $14,260, so an additional $12,274 on the fifth year is added to $67,726 in order to arrive at the amount equal to $80,000, the cash outlay of Leviste. .85 is obtained by dividing $67,726 over $80,000.
To summarize, therefore, the discounted payback of Mr. Beige's project is approximately 4.85 years, as opposed to 4 years under the simple payback. As the required rate of return increases, the distortion between simple payback and discounted payback grows. We can now prove that the discounted payback period method is the appropriate way of knowing how many years a company is able to recover its investment.
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Conclusion: Why Decision Makers Prefer This Method
In reality, a project’s useful life is exposed to risk due to changes in political, technological, and regulatory factors. The change in consumer taste also contributes to this kind of risk. In such a scenario, the use of popular methods like the Net Present Value, Internal Rate of Return, and Profitabilty Index, which all assume a fixed life on the project, become less desirable than the Discounted Payback Period, as basis of decision making.
The Discounted Payback Period Method ensures profitability and liquidity, compared to the theoretically superior Net Present Value, that only ensures liquidity, but not profitability. The discounted method has also the edge over the highly regarded Payback Period that ensures profitability, but not liquidity. The discounted payback period method, therefore, has all the useful properties of traditional payback and at the same time, an interesting relationship with the three popular budgeting methods mentioned above. Because it considersthe time value of money and discounting cash flows at the required rate of return, the discounted payback period method really ensures profitability and liquidity of the project.
Just like CEO Hadson, decision makers want to know the actual value of a project's returns, with the consideration of the time value of money. In that way, the company is able to grasp two important variables in the choice of projects: return and risk.