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Discounted Payback Period Rule - Time Value of Money Included If you read one of the limitations of the Payback Period rule, it says the rule does not take into account time value of money. Thus, future cash flows are not discounted and adjusted for things like interest earnings, inflation, etc. However, the Discounted Payback Period Rule fixes this problem for us. It takes into account time value of money and the discounting of future cash flows. Rule of Discounted Payback Rule? -> An investment is good or acceptable if its discounted payback period is less than some pre-determined # of years. For example, consider the following example. We are given an investment that has an initial investment of $10,000 (Year 0) and cash flows from Years 1-6. We then take these cash flows, and calculate their PRESENT VALUES. We use the time value of money template in the 2nd table to perform this calculation.
Present Values for Years 1-6
After calculating the Present Values from Years 1-6 in the 2nd table below, we now have a column for PV of Cash Flows. Now, we find the table for Cumulative Cash Flows. Take a close look at the column of Cumulative Cash Flows. For Year 1, we subtract $10,000 - 1389 = -$8611 In Year 2, we subtract -$8611 + 2143 = -$6468 In Year 3, we subtract -$6468 + 3175 = -$3293 In Year 4, we subtract -3293 + $2205 = -$1088 In Year 5, we subtract -1088 + 2042 = $+954 The Payback Period occurs in Year 4, when the cash flow turns from a Negative (-1088) to a Positive (+954). This is always true for any cash flow analysis you do. As soon as the cumulative cash flows turns from a negative to positive, that's your payback period. Thus, Discounted Payback Period = 4 Years + (1088 / 2042) = 4.53 Years Graphical Analysis of Discounted Cash Flows
The above is a bar graph showing the differences in amounts between cash flows that take into account time value of money (in RED) and cash flows that do NOT take into account time value of money (in BLUE). From this, we can note that: -> Amounts in Blue are Overstated Limitations of the Discounted Payback Period Rule 1) Since we determine a cut-off point (4.53 years in the above example), we are ignoring the possibility of growing cash flows thereafter. An investment may not seem very attractive if we just select a cut-off point and we can ignore long term investments. Example, who knows that in the example above and in Year 7, we might have a Cash Flow of $6000? This would make it a very desirable LONG TERM investment, but financial managers may not come to realize this (because they cut-off at 4.53 years). 2) With the Discounted Payback Period, investments that have a Positive Net Present Value (NPV) over the LONGER TERM will be rejected thanks to the fact that we have to set an arbitrary cut-off point (4.53 years in this case). Who knows this same investment will be generating $8000 a year in 2010?
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