Measurement and Decision-Making Under Non-Discounted Cash Flow Techniques
Non-discounted cash flow (NDCF) project appraisal approaches are extremely easy to grasp. These methods need the fewer calculations and are simple to implement in practise. The word “non-discounted” means that the time value of money has not been taken into account, i.e., the current and future values of money are perceived as the same. Cash inflows, as well as potential cash outflows, are not brought up to date with their current value.
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Pay Back Period (PBP)
The most commonly used strategy is the payback period, which is known as the number of years it takes to recover the cost of an investment. This is simple to figure out, but it’s usually done before taxes and only after accounting depreciation. As a result, the payback period can be perceived as a metric of liquidity rather than profitability since it ignores income gained after the time period has passed.
The payback period is the amount of time it takes to recoup the project’s initial investment. For example, if a project costs ₹6,00,000 and produces cash inflows of ₹1,00,000, ₹1,50,000, ₹1,50,000, and ₹2,00,000 in the first, second, third, and fourth years, the project is considered a success.
Since the number of cash inflows for four years equals the initial outlay, the payback period is four years. The payback period is essentially the initial outlay divided by the annual cash inflow when the annual cash inflow is a constant amount. For example, a project which has an initial cash outlay of ₹10,00,000 and constant annual cash inflow of ₹3,00,000 has a payback period of ₹10,00,000/₹3,00,000 = 3.1/3 years.
Firms that use this criterion usually state the maximum payback period that is permissible. If this value is ‘n’ years, projects with a payback period of ‘n’ years or less are considered worthwhile, whereas projects with a payback period of more than ‘n’ years are deemed unworthy. Long-term payback projects are typically those that are part of longterm planning and decide a company’s future. However, they do not deliver their highest returns for many years, and as a result, the payback approach is skewed towards investments that are most critical to long-term performance.
Advantages of payback period are as follows:
- The payback period is easy to calculate and need fewer inputs, managers are quickly able to calculate the payback period of the projects.
- The payback period needs very few inputs and is relatively easier to calculate than other capital budgeting methods.
- The payback period is crucial information that no other capital budgeting method reveals. Usually, a project with a shorter payback period also has a lower risk.
- The payback method is very useful in the industries that are uncertain or witness rapid technological changes.
Limitations of payback period are as follows:
- It fails to consider the time value of money. Cash inflows, in the payback calculation, are simply added without suitable discounting.
- It ignores cash flows beyond the payback period. This leads to discrimination against projects which generate substantial cash inflows in later years.
- Since the payback period is a measure of a projects’ capital recovery, it may divert attention from profitability.
- Though it measures a project’s liquidity, it does not indicate the liquidity position of the firm as a whole, which is more important.
Discounted Payback Period
A capital budgeting tool for calculating a project’s viability is the discounted payback period. By discounting potential cash flows and considering the time value of money, a discounted payback period calculates the number of years it takes to break even on an initial investment. The more simplified payback period formula, which simply divides the total cash outlay for the project by the average annual cash flows, doesn’t provide an accurate answer to the question of whether to take on a project because it assumes only one, upfront investment, and does not factor in the time value of money.
The formula to calculate the discounted payback period is:
DPP = y + abs(n) / p
y = the period preceding the period in which the cumulative cash flow turns positive,
p = discounted value of the cash flow of the period in which the cumulative cash flow is => 0,
abs(n) = absolute value of the cumulative discounted cash flow in period y.
Example 1: Calculate the discounted payback period using the following details:
Initial Investment ₹1,00,000
Cost of Capital @ 12% p.a.
Expected Cash Inflows
|Year||Cash Inflows (₹)||Discounting Factor @ 12%||Discounted Cash Flows (₹)||Cumulative DCF (₹)|
The recovery was made between 2nd and 3rd year.
Discounted Payback Period = 2 years + 1,00,000 62,183 × 12
= 2 years + 37,817
53,378 × 12
= 2 years 8
A simple method of calculating the internal rate of return is the payback reciprocal which is 1 divided by the payback period. This payback reciprocal yields an approximation of the rate of return on an investment, though only when annual cash flows are uniformly even over the lifetime of the investment, and the cash flows from the project will continue forever.
Since it is quite unlikely that cash flows will continue uninterrupted for a long way into the future, the payback reciprocal tends to overstate the actual rate of return. Instead, it is more realistic to evaluate a project based on the net present value method or the internal rate of return.
Example 2: A financial analyst is reviewing a possible investment of ₹50,000, which will generate positive cash flows of ₹10,000 per year. The payback period is 5 years, since cash flows of ₹50,000 will accumulate over the next five years. The payback reciprocal is 1 / 5 years, or 20%. The calculated internal rate of return using this reciprocal is 15% if the assumed cash flow period is 10 years, and reaches 20% only when the assumed cash flows cover a period of 30 years.
Accounting Rate of Return (ARR)
A financial ratio used in capital budgeting is the accounting rate of return, also known as the average rate of return, or ARR. The time value of money is not taken into account in the ratio. The annual rate of return (ARR) is calculated using the net income provided by the proposed capital expenditure. ARR stands for annualised rate of return. If the ARR is 7%, for example, the project is supposed to gain seven cents for every dollar invested (yearly).
The project is appropriate if the ARR is equal to or greater than the desired rate of return. It should be rejected if it is less than the target rate. When comparing investments, the higher the annual return on investment (ARR), the more appealing the investment. The main benefit of ARR is that it is simple to calculate and comprehend.
The biggest drawback of ARR is that it ignores the time factor when considering the time value of capital or the risks associated with long-term investments. The ARR is based on benefit estimation and can be easily manipulated by altering depreciation methods. When comparing different size investments, the ARR may provide misleading details.
The formula of ARR is as follows:
AverageAnnual Profit After Tax
Average or Initial Investment × 100
Average EBIT 1 t ( )
− × 100
Where, Average Investment = Initial Investment SalvageValue
Example 3: A project costing 10 lacs. EBITD (Earnings before Depreciation, Interest and Taxes) during the first five years is expected to be ₹2,50,000; ₹3,00,000; ₹3,50,000; ₹4,00,000, and ₹5,00,000. Assume 33.99% tax and 30% depreciation on WDV Method.
Computation of Project ARR:
|Particulars||Yr 1||Yr 2||Yr 3||Yr 4||Yr 5||Average|
|Less: Tax @ 33.99%||—||13,596||69,000||1,00,984||1,45,467||65,809|
Book Value of Investment:
Average Annual Profit After Tax ×100
Average or Initial Investment
4,71,427 × 100
= 33.99% (90,000 – 50,000)