The Capital- Budgeting

Decision Rules:
1. Payback Period
2. Discounted Payback

Hanadi Borovac 75217

Emir Kapetanović 75219
 Contentent
Introduction 01 02 Payback Period
Definition
Formula
Example
Advantages
Limitations

Discounted period 03 04 Literature

Definition
Formula
Example
Advantages
Limitations
 Introduction
• Corporate finance is all about capital budgeting
• One of the most important concepts
• How to value different investments or operational projects
• The analyst must find a reliable way to determine the most profitable
project or investment to undertake
• Two ways corporate financial analysts do this are through analysis of the
payback period or discounted payback
Payback
Period
Definition
● The payback period refers to the amount of time it takes to recover the
cost of an investment  or how long it takes for an investor to hit break
even
● Shorter paybacks mean more attractive investments while longer
payback periods are less desirable

● Account and fund managers use the payback period to

determine whether to go through with an investment.
 Formula
• The formula to calculate the payback period of an investment depends on whether the
periodic cash inflows from the project are even or uneven.

• If the cash inflows are even (such as for investments in annuities), the formula to calculate
payback period is:
Payback Period =Initial InvestmentNet Cash Flow per Period

• When cash inflows are uneven, we need to calculate the cumulative net

cash flow for each period and then use the following formula:
Payback Period =A +BC
Where,
A is the last period number with a negative cumulative cash flow;
B is the absolute value (i.e. value without negative sign) of
cumulative net cash flow at the end of the period A; and
C is the total cash inflow during the period following period A
Example 1
Company C is planning to Example
undertake a project
requiring initial investment
of $105 million. The project
is expected to generate $25
million per year in net cash
flows for 7 years. Calculate
the payback period of the
project

Solution
Payback Period
= Initial Investment ÷ Annual Cash Flow
= $105M ÷ $25M
= 4.2 years
Example 2 Solution
Company C is planning to
undertake another project
requiring initial
investment of $50 million
and is expected to
generate $10 million net
cash flow in Year 1, $13
million in Year 2, $16
million in year 3, $19
million in Year 4 and $22
million in Year 5.
Calculate the payback
value of the project Payback Period = 3 + 11/19 = 3 + 0.58 ≈ 3.6
years
 Advantages

• Payback period is very simple to calculate.

• It can be a measure of risk inherent in a project. Since cash flows

that occur later in a project's life are considered more uncertain,
payback period provides an indication of how certain the project
cash inflows are.

• For companies facing liquidity problems, it provides a

good ranking of projects that would return money early.
 Limitations
● payback period does not take into account the time value of money which is a
serious drawback since it can lead to wrong decisions. A variation of payback
method that attempts to address this drawback is called discounted payback
period method.

● It does not take into account, the cash flows that occur after the
payback period. This means that a project having very good cash
inflows but beyond its payback period may be ignored.
Discounted
payback
 Definition
The discounted payback period is a capital budgeting procedure used to
determine the profitability of a project
A discounted payback period gives the number of years it takes to break even
from undertaking the initial expenditure, by discounting future cash flows
and recognizing the time value of money
The metric is used to evaluate the feasibility and profitability of a given
project.
 Formula
● in discounted payback period we have to calculate the present value of each
cash inflow. For this purpose the management has to set a suitable discount rate
which is usually the company's cost of capital .
● The discounted cash inflow for each period is then calculated using the
formula:
Discounted Cash Inflow = Actual Cash Inflow/(1 + i)n
Where,
i is the discount rate; and
n is the period to which the cash inflow relates
● Sometimes, the previous formula may be split into two components which are: actual
cash inflow and present value factor that is 1 / (1 + i)n.

● Discounted cash flow is then the product of actual cash flow and the present value factor.
The rest of the procedure is similar to the calculation of simple payback period except
that we have to use the discounted cash flows as calculated above instead of nominal
cash flows. Also, the cumulative cash flow is replaced by cumulative discounted cash
flow.

Discounted Payback Period = A +B/C

Where,
A = Last period with a negative discounted
cumulative cash flow;
B = Absolute value of discounted cumulative cash
flow at the end of the period A; and
C = Discounted cash flow during the period after A.
 Example
Example 1. An initial investment of
$2,324,000 is expected to generate
$600,000 per year for 6 years.
Calculate the discounted payback
period of the investment if the
discount rate is
11%.
 Discounted Payback Period
= 5 + |-106,462| ÷ 320,785
Solution = 5 + 106,462 ÷ 320,785
≈ 5 + 0.33
≈ 5.33 years
 Advantages
● Discounted payback period is more reliable
than simple payback period since it accounts for
time value of money. It is interesting to note that if
a project has negative net present value it won't
pay back the initial investment
Limitations
● It ignores the cash inflows from project after the
payback period. An attractive project having lower
initial inflows but higher terminal cash flows
might be rejected
 Conclusion
● Capital budgeting is the most important concept in
corporate finance, it is the process a business undertakes to
evaluate potential major projects or investments. Payback
period refers to the period of time it takes to recover the
cost of investment or how long it takes for an investor to hit
breakeven. A variation of payback period is called
discounted payback period. A discounted payback period
gives the number of years it takes to break even from
undertaking the initial expenditure, by discounting future
cash flows and recognizing the time value of money.
Literature
Books
● Michael Tallard, Finance for Dummies, 2012

Web pages
● https://www.investopedia.com/terms/p/payba
ckperiod.asp
● https://www.investopedia.com/terms/d/discou
nted-payback-period.asp
Thank you
for your
attention