Discounted Payback Method Query

Shane732

Couple of quick queries that I am hoping somebody might be able to help me with...

When doing a payback method calculation:

If an outflow is payable at the end of a year should it be put into the next year for the purpose of the discount? (i.e. if something is payable at the end of year one should it be subject to a discount of 1 or say 0.90......?)

If specific capital outflows are mentioned (initial investment payable over a number of years and fixtures and fittings to be purchased at specific times I assume they should be split into their respective years and subject to the appropriate discount?).

Cheers!

SBWife

End I'd year payments are discounted - treat end of year 1 as beginning of year 2.

Treatment of outlays appears correct, normally it's easiest to figure out each years' cash flow then discount this one number at the appropriate rate rather than discount each item, there's less arithmetic involved.

hivizman

Shane732 wrote: »

Couple of quick queries that I am hoping somebody might be able to help me with...

When doing a payback method calculation:

The discounted payback method is a hybrid of the standard payback method and discounted cash flow (DCF) investment appraisal. Future net cash inflows are discounted back to time t=0 using a given discount rate, and then the payback method is applied to the discounted cash inflows. A time horizon is specified, and investments are accepted if the sum of the discounted cash inflows over the time period determined by the specified time horizon are greater than the amount initially invested. Alternatively, investments are ranked in order of their discounted payback period, which is the period it takes for the discounted cash inflows to equal the initial investment.

As you are discounting anyway, it's probably better to use the DCF approach properly, as this approach can be shown to have economic validity (maximising owner's or shareholder value is achieved by maximising discounted net cash flows). But the discounted payback method provides a rough and ready way of selecting investment projects, particularly when investment funds are limited.

Shane732 wrote: »

If an outflow is payable at the end of a year should it be put into the next year for the purpose of the discount? (i.e. if something is payable at the end of year one should it be subject to a discount of 1 or say 0.90......?)

The standard approach is to take the initial investment as time t=0. Cash flows after this, whether inflows or outflows, are normally associated with the end of the period in which the cash is received or paid (note that the periods need not be years - they can be quarters, months, weeks or even days). The exception to this is that cash flows at the beginning of the next period are considered to have taken place at the end of the previous period. For example, if a payment is made on 1 January 2013, this would be considered as having been made on 31 December 2012 (assuming that the various periods end on 31 December). Something payable at the end of year one should be discounted for one year.

Shane732 wrote: »

If specific capital outflows are mentioned (initial investment payable over a number of years and fixtures and fittings to be purchased at specific times I assume they should be split into their respective years and subject to the appropriate discount?).

Cheers!

The problem of dealing with investments split over several periods is one of the reasons for not using the payback method, whether discounted or not. The method really works only with a single initial investment followed by subsequent net cash inflows. However, there are two basically equivalent ways of treating split investments. First, you can discount the cash outflows in periods later than time zero and add the discounted amounts to the initial investment at time zero. Then you discount the cash inflows and work out the discounted payback period. The other method is to deduct cash outflows relating to the investment from cash inflows (in the same way as you deduct cash outflows relating to operating expenses) and compare the initial investment with the discounted net cash flows. The two methods usually give the same answer - they differ if there are substantial cash outflows, such as dismantling and restoration costs, at the end of the investment, as the second method will tend to ignore these.

However, with such a complex pattern of cash flows, you are better using the DCF method properly and not bothering with payback.

Shane732

hivizman wrote: »

The discounted payback method is a hybrid of the standard payback method and discounted cash flow (DCF) investment appraisal. Future net cash inflows are discounted back to time t=0 using a given discount rate, and then the payback method is applied to the discounted cash inflows. A time horizon is specified, and investments are accepted if the sum of the discounted cash inflows over the time period determined by the specified time horizon are greater than the amount initially invested. Alternatively, investments are ranked in order of their discounted payback period, which is the period it takes for the discounted cash inflows to equal the initial investment.

As you are discounting anyway, it's probably better to use the DCF approach properly, as this approach can be shown to have economic validity (maximising owner's or shareholder value is achieved by maximising discounted net cash flows). But the discounted payback method provides a rough and ready way of selecting investment projects, particularly when investment funds are limited.



The standard approach is to take the initial investment as time t=0. Cash flows after this, whether inflows or outflows, are normally associated with the end of the period in which the cash is received or paid (note that the periods need not be years - they can be quarters, months, weeks or even days). The exception to this is that cash flows at the beginning of the next period are considered to have taken place at the end of the previous period. For example, if a payment is made on 1 January 2013, this would be considered as having been made on 31 December 2012 (assuming that the various periods end on 31 December). Something payable at the end of year one should be discounted for one year.



The problem of dealing with investments split over several periods is one of the reasons for not using the payback method, whether discounted or not. The method really works only with a single initial investment followed by subsequent net cash inflows. However, there are two basically equivalent ways of treating split investments. First, you can discount the cash outflows in periods later than time zero and add the discounted amounts to the initial investment at time zero. Then you discount the cash inflows and work out the discounted payback period. The other method is to deduct cash outflows relating to the investment from cash inflows (in the same way as you deduct cash outflows relating to operating expenses) and compare the initial investment with the discounted net cash flows. The two methods usually give the same answer - they differ if there are substantial cash outflows, such as dismantling and restoration costs, at the end of the investment, as the second method will tend to ignore these.

However, with such a complex pattern of cash flows, you are better using the DCF method properly and not bothering with payback.

Cheers - very much appreciated.

I have no initial investment but a payment to be made at the end of year 1, 2 and 3 therefore I assume the best option is just to include the payment as part of the cashflow and see if I end up with a positive cashflow at the end of the period.

Shane732

Just one further question -

If there are other initial costs such as fixture & fittings etc... which must be purchase would you take these into the payback cashflow?

hivizman

Shane732 wrote: »

Just one further question -

If there are other initial costs such as fixture & fittings etc... which must be purchase would you take these into the payback cashflow?

If these are items that you would buy only if the investment was to be made, then they should be included in the calculations. Remember to allow for any residual value that the fixtures and fittings might have at the end of the investment period. If the amounts involved are relatively small compared with the cost of the investment, and you have to spend money in more than the initial period, then it may be easier to consider the expenditure on fixtures and fittings as cash outflows deducted from the cash inflows from the investment than as part of the initial investment that needs to be recovered from the future cash inflows.

However, if you are talking about initial expenditure on fixtures and fittings at the same time as the initial investment (for example, the initial investment is the cost of buying a shop, but you also have to allow for the cost of fitting the shop out), then I'd add the expenditure to the initial investment.

Shane732

I'm really struggling to get my head around this...

I've been asked to do appraisal under discounted payback method and NPV.

Discounted payback has to be within 3 years.

So I go along and work out my cashflow. I've included the staged payments in the cashflow and the purchase of equipment etc... as opposed to taking them outside the cashflow and discounting the investment cost.

I get to an end figure in the cashflow for each of the year fine.

In simple terms the cashflow is negative (i.e. there is a net cash outflow over the 3 years). Therefore the payback method isn't satisfied regardless of whether is discounted or not - correct?

The NPV calculation is driving me nuts then..... I'm basically I saying that because I have a negative cashflow I'm not going to satisfy the NPV is €300k @ 6%.

I have to be treating something incorrectly.

hivizman

Shane732 wrote: »

I'm really struggling to get my head around this...

I've been asked to do appraisal under discounted payback method and NPV.

Discounted payback has to be within 3 years.

So I go along and work out my cashflow. I've included the staged payments in the cashflow and the purchase of equipment etc... as opposed to taking them outside the cashflow and discounting the investment cost.

I get to an end figure in the cashflow for each of the year fine.

In simple terms the cashflow is negative (i.e. there is a net cash outflow over the 3 years). Therefore the payback method isn't satisfied regardless of whether is discounted or not - correct?

The NPV calculation is driving me nuts then..... I'm basically I saying that because I have a negative cashflow I'm not going to satisfy the NPV is €300k @ 6%.

I have to be treating something incorrectly.

I've sent you a PM with some further thoughts. Is this a real-world case or a course or exam question? If the latter, then it's difficult to give accurate advice without having all the details. There seem to be a lot of ambiguities. For example, should the payback period begin with the initial investment or run only from the date at which the final instalment of the investment is paid? The payback method basically assumes an initial investment followed by net cash inflows. It's not really designed to cope with investments being made over several periods. From the information you have provided, this looks like a long-term project, which should not be assessed using a tool that focuses on short-term cash flows.