Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
nal investment in terms of discounted future cash flows. Each cash flow is discounted back to the beginning of the investment at a rate that reflects both the time value of money and the uncertainty of the future cash flows. This rate is the cost of capital—the return required by the suppliers of capital (creditors and owners) to compensate them for the time value of money and the risk associated with the investment. The more uncertain the future cash flows, the greater the cost of capital.
From the perspective of the investor, the cost of capital is the required rate of return (RRR), the return that suppliers of capital demand on their investment (adjusted for tax deductibility of interest). Because the cost of capital and the RRR are basically the same concept but from different perspectives, we sometimes use the terms interchangeably in our study of capital budgeting.
Returning to Investments A and B, suppose that each has a cost of capital of 10%. The first step in determining the discounted payback period is to discount each year’s cash flow to the beginning of the invest- ment (the end of the year 2000) at the cost of capital:
Investment A Investment B End of Year
Value at the Year
Value at the
End of Year
Cash Flow End of 2000
Cash Flow
End of 2000
620,921 How long does it take for each investment’s discounted cash flows
to pay back its $1,000,000 investment? The discounted payback period for A is four years:
Investment A Accumulated
End of Value at the
Discounted
Year End of 2000
Cash Flows
❑ $1,000,000 investment paid back 2005
LONG-TERM INVESTMENT DECISIONS
The discounted payback period for B is five years:
Investment B Accumulated
End of Value at the
Discounted
Year End of 2000
Cash Flows
❑ $1,000,000 investment paid back This example shows that it takes one more year to pay back each invest-
ment with discounted cash flows than with nondiscounted cash flows. Discounted Payback Decision Rule
It appears that the shorter the payback period, the better, whether using discounted or nondiscounted cash flows. But how short is better? We don’t know. All we know is that an investment “breaks-even” in terms of discounted cash flows at the discounted payback period—the point in time when the accumulated discounted cash flows equal the amount of the investment. Using the length of the payback as a basis for selecting investments, A is preferred over B. But we’ve ignored some valuable cash flows for both investments.
Discounted Payback as an Evaluation Technique Here is how discounted payback measures up against the three criteria.
Criterion 1: Does Discounted Payback Consider All Cash Flows? Look again at Invest- ments C and D. The main difference between them is that D has a very large cash flow in 2005, relative to C. Discounting each cash flow at the 10% cost of capital,
Investment C Investment D End of Year
Value at the Year
Value at the
End of Year
Cash Flow End of 2000
Cash Flow
End of 2000
Capital Budgeting Techniques
The discounted payback period for C is four years:
Investment C Accumulated
End of Value at the
Discounted
Year End of 2000
Cash Flows
❑ $1,000,000 investment paid back
The discounted payback period for D is also four years, with each year- end cash flow from 2001 through 2004 contributing the same as those of Investment C. However, D’s cash flow in 2005 contributes over $6 million more in terms of the present value of the project’s cash flows:
Investment D Accumulated
End of Value at the
Discounted
Year End of 2000
Cash Flows
❑ $1,000,000 investment paid back
The discounted payback period method ignores the remaining discounted cash flows: $950,959 + $186,276 – $1,000,000 = $137,235 from Invest- ment C in year 2005 and $950,959 + $6,209,213 – $1,000,000 = $6,160,172 from Investment D in year 2005.
Criterion 2: Does Discounted Payback Consider the Timing of Cash Flows? Look at Investments E and F. Using a cost of capital of 5% for both E and F, the discounted cash flows for each period are:
LONG-TERM INVESTMENT DECISIONS
Investment E Investment F End of Year
Value at the Year
Value at the
End of Year
Cash Flow End of 2000
Cash Flow
End of 2000
235,058 The discounted payback period for E is four years:
Investment E Accumulated
End of Value at the
Discounted
Year End of 2000
Cash Flows
❑ $1,000,000 investment paid back 2005
The discounted payback period for F is five years:
Investment F Accumulated
End of Value at the
Discounted
Year End of 2000
Cash Flows
❑ $1,000,000 investment paid back The discounted payback period is able to distinguish investments with
different timing of cash flows. E’s cash flows are expected sooner than those of F. E’s discounted payback period is shorter than F’s—four years versus five years.
Capital Budgeting Techniques
Criterion 3: Does Discounted Payback Consider the Riskiness of Cash Flows? Look at Investments G and H. Suppose the cost of capital for G is 5% and the cost of capital for H is 10%. We are assuming that H’s cash flows are more uncertain than G’s. The discounted cash flows for the two investments, using the appropriate discount rate, are:
Investment G Investment H End of Year
Value at the Year
Value at the
End of Year
Cash Flow End of 2000
Cash Flow
End of 2000
155,230 The discounted payback period for G is five years:
Investment G Accumulated
End of Value at the
Discounted
Year End of 2000
Cash Flows
❑ $1,000,000 investment paid back According to the discounted payback period method, H does not pay
back its original $1,000,000 investment—not in terms of discounted cash flows:
Investment H Accumulated
End of Value at the
Discounted
Year End of 2000
Cash Flows
❑ Less than $1,000,000 paid back
LONG-TERM INVESTMENT DECISIONS
Because risk is reflected through the discount rate, risk is explicitly incorporated into the discounted payback period analysis. The dis- counted payback period method is able to distinguish between Invest- ment G and the riskier Investment H.
Is Discounted Payback Consistent with Owners’ Wealth Maximization? Discounted payback cannot provide us any information about how profitable an investment is—because it ignores everything after the “break-even” point! The discounted payback period can be used as an initial screening device—eliminating any projects that don’t pay back over the expected term of the investment. But since it ignores some of the cash flows that contribute to the present value of investment (those above and beyond what is necessary for the investment’s pay- back), the discounted payback period technique is not consistent with owners’ wealth maximization.
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
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