BUS202: Principles of Finance

Discounted payback period is the amount of time to cover the cost, by adding positive discounted cash flow coming from the profits of the project.

TERM

• Weighted average cost of capital

  The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere.

Payback period in capital budgeting refers to the period of time required for the returnon an investment to "repay" the sum of the original investment. The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not account for the time value of money, risk, financing, or other important considerations, such as the opportunity cost.

Compared to payback period, the discounted payback period takes the time value of money into consideration. It is the amount of time that it takes to cover the cost of a project, by adding positive discounted cash flow coming from the profits of the project.

That is, we want Net Present Value greater than 0. The income of the project will be discounted to assess the loss in value due to time (inflation or opportunity cost) to find how long it would take to recover the initially money invested.

Whilst the time value of money can be rectified by applying a weighted average cost of capital discount, it is generally agreed that this tool for investment decisions should not be used in isolation. An implicit assumption in the use of payback period is that returns to the investment continue after the payback period. Payback period does not specify any required comparison to other investments or even to not making an investment.

Let take a look at one example. In the following situation, the cash flows are as presented.

Year 0: -2000, year 1: 1000, year 2: 1000, year 3: 2000.

Assuming the discount rate is 10%, we would apply the following formula to each cash flow. Discounted Cash Flow at 10%: Year 0: -2000, year 1: 909, year 2: 827, year 3: 1503.

The next step is to compute the cumulative discounted cash flow, by summing the discounted cash flow for each year. Accumulated discounted cash flows: Year 0: -2000, year 1: -1091, year 2: -264, year 3: 1239.

We see that between years 2 and 3 we will recover our initial investment. To calculate specifically when we could see how long it took to recover the 264 remaining by end of year 2 as followed: 264/1503 = 0.1756 years. Thus, it will take a total of 2.1756 years to recover the initial investment.