Measuring the return on investment is an important thing in investment decisions. When an investor makes an investment, he does not only expect profit, but also wants to know how long his investment will return (payback period). In this case, the concept of payback period can help investors to find out how quickly their investment can return the capital that has been issued.
However, there is a weakness in the payback period concept, namely it does not take into account the time value of money and interest rates. Therefore, discounted payback exists as an alternative to a more accurate measure of return on investment by considering the time value of money and prevailing interest rates.
In this article, we will discuss more about the concept of discounted payback, how to calculate it, and the advantages and disadvantages of using it.
Definition of Discounted Payback
Discounted payback is a method of measuring return on investment that takes into account the time value of money and interest rates. In discounted payback, cash flows received from investments will be reduced by the discount rate which is the prevailing interest rate. Then, the cash flows that have been discounted will be accumulated until they reach a value of zero, which is when the investment has returned the capital that has been issued.
How to calculate discounted payback can be done using the following formula:
DPB = n + (PVn / CFn)
* DPB: Discounted Payback
* n: The number of years it took to reach zero
* PVn: Present value of the cash flows in year n
* CFn: Cash flows in year n
The difference between simple payback and discounted payback lies in calculating the return on investment. Simple payback only considers the number of years needed to return capital without taking into account the time value of money and interest rates, while discounted payback considers these two factors in the calculation.
The advantage of discounted payback is that this method provides more accurate measurement results in calculating investment return time. In addition, discounted payback can help investors in comparing investments with different levels of risk and returns.
However, there are also disadvantages of discounted payback, which is that it does not consider other factors that influence investment decisions such as the cost of capital and estimates of future cash flows. Therefore, discounted payback should be used as a tool in making investment decisions and not as the only determining factor.
Example of applying Discounted Payback
To clarify the concept of discounted payback, the following is an example of applying discounted payback to a real investment:
An investor wants to invest a sum of $10,000 in a project. In the project, the investor is expected to receive cash flows of $3,000 at the end of year one, $5,000 at the end of year two, and $7,000 at the end of year three. The discount rate used in the calculation is 8%.
To calculate discounted payback, we need to calculate the present value of each cash flow for the year. Based on an 8% discount rate, the present values of the cash flows in years one, two and three are as follows:
* PV1 = $3,000 / (1 + 0.08)^1 = $2,778.85
* PV2 = $5,000 / (1 + 0.08)^2 = $4,357.53
* PV3 = $7,000 / (1 + 0.08)^3 = $5,906.20
Then, we need to accumulate the present values of these cash flows until they reach zero. In this case, we start the accumulation of the first year with a value of $2,778.85, then add the present value of the cash flows in the second year ($4,357.53) to bring the accumulated total to $7,136.38. At the end of the second year, the accumulation is increased by the present value of the cash flows in the third year ($5,906.20) so that the accumulated total is $13,042.58.
In this case, the discounted payback is 2 years and 10 months, which is the amount of time it takes for it to reach zero after the third year’s cash flows are received. By using discounted payback, investors can find out how quickly their investment can return the capital that has been issued and consider whether the investment is feasible.
Factors Affecting Discounted Payback
There are several factors that can influence the use of discounted payback in making investment decisions. Here are some of these factors:
1. Discount rate
The discount rate is the main factor in calculating discounted payback. The higher the discount rate used, the more difficult it is to reach zero and the longer it takes to return the capital. Therefore, investors need to consider the appropriate discount rate in making investment decisions.
2. Estimated cash flows
The discounted payback calculation is based on estimated future cash flows. Therefore, the more accurate the estimated cash flows, the more accurate the discounted payback calculation results will be. Investors need to pay attention to the factors that affect cash flow estimates, such as market changes, regulations and technology.
3. Degree of risk
Investors need to consider the level of risk associated with the investment. The higher the level of risk, the higher the discount rate that must be used in calculating the discounted payback. This can affect the payback period and investment decisions.
4. Cost of capital
Discounted payback does not consider the cost of capital incurred by investors. Therefore, investors need to pay attention to the cost of capital in making investment decisions. If the cost of capital is high, discounted payback may not be an appropriate measurement method to use.
5. Investment objectives
Investors need to consider investment objectives in making investment decisions. Is the investment for a quick return on investment or for long-term gain? This can influence the selection of the appropriate investment return measurement method, including the use of discounted payback.
In investing, making the right and accurate decisions is very important to ensure investment success. And one method of measuring return on investment that can be used is discounted payback. This method calculates the time required to reach zero based on discounted future cash flows.
However, keep in mind that when using discounted payback, investors need to consider the appropriate discount rate, accurate cash flow estimates, investment risk level, cost of capital, and investment objectives. By considering all of these factors, investors can make appropriate and accurate investment decisions.