Question

Exercise 3.21 DISCOUNTED PAYBACK

Your company is considering a high-risk project that could yield strong revenues but will involve a significant up-front investment. Because of this risk, top management is naturally concerned about how long it is likely to take to pay off that investment so that they can begin to realize profits. This project will require an investment of $200,000 and your five-year projection for inflows is: Year 1 – $50,000, Year 2 – $75,000, Year 3 – $125,000, Year 4 – $200,000, and Year 5 – $250,000. Your firm’s required rate of return is 18%. How long will it take to pay back your initial investment?

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Answer 1

Discounted Payback Period for the Project

- The Payback Period Method refers to the period in which the proposed project will generate the cash inflows to recover the Initial Investment costs. It considers only three components such as Initial Investment costs, Economic life of the project and the annual cash inflows

- Payback period is the number of years taken to recover the total amount of money invested in the project. If the payback period is less than the enterprises required number of years, then the project should be accepted, Else it is rejected

Year	Cash Flows ($)	Present Value Factor at 18%	Discounted Cash Flow ($)	Cumulative net discounted Cash flow ($)
0	-2,00,000	1.000000	-2,00,000	-2,00,000
1	50,000	0.847458	42,373	-1,57,627
2	75,000	0.718184	53,864	-1,03,763
3	1,25,000	0.608631	76,079	-27,684
4	2,00,000	0.515789	1,03,158	75,473
5	2,50,000	0.437109	1,09,277	1,84,751

Discounted Payback Period = Years before full recover + (Unrecovered cash inflow at start of the year/cash flow during the year)

= 3.00 Years + ($27,684 / $103,158)

= 3.00 Years + 0.27 Years

= 3.27 Years

“Hence, it will take 3.27 Years to pay back the initial investment”

NOTE    

The Formula for calculating the Present Value Factor is [1/(1 + r)ⁿ], Where “r” is the Discount/Interest Rate and “n” is the number of years.