102 Session 8

discounted payback period

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251
 Jargon: payback period
• The payback period is the time it takes for you to “get your money back”, ignoring
anything you pay or gain from interest.
• Ie, assuming you pay for a project from money you keep in a hole in the ground ie
you pay and get no interest (????), it’s the time taken for your store of money to first
get back to where it started.

Cashflows Net effect on cash kept in hole in

ground
10

5 20

0 10

-5 0 1 2 3 4 5 6 7 0
0 1 2 3 4 5 6 7
-10 -10

-15 -20
Time Time

• In the above example, the net cashflow is zero at time 4 so the payback period is 4
years.
252
 Jargon: discounted payback period
• The payback period doesn’t mean much because we don’t keep money in a sock in
ground and it does have a time value.
• Ie the payback period doesn’t show when, say a bank account (starting with nothing)
would go back “into the black” because it ignores the interest paid.
• The discounted payback period is the time it takes for you to “get back in the black”,
allowing for a interest, assuming that you any cash coming in immediately reduces your
loan.
Cashflows Balance in account (10% interest)

10 15
10
5
5
0 0
-5 0 1 2 3 4 5 6 7 -5 0 1 2 3 4 5 6 7
-10
-10
-15
-15 -20
Time Time

• In the above example, an account starting with zero is back to zero just after time 5
so the discounted payback period is just over 5 years.
253
 Jargon: discounted payback period
• The present value of a bank balance of zero is still zero!
• So, in practice, we can just as well answer:
“When is the present value of the cashflows first zero?” as
“When does the bank balance actually get back to zero?”
• So, in practice, to calculate the discounted payback period, we just calculate the
discounted value of the cashflows, and find out when they first add up to zero.
PV (value at time 0) of cashflows PV (at time 0) of total cashflows to
date = PV of "account"
5 10
5
0
0
0 1 2 3 4 5 6 7
-5 -5 0 1 2 3 4 5 6 7
-10
-10
-15
-15 -20
Time Time

• These charts are just the “discounted” versions of the charts on the previous slide.
This time interest is allowed for by discounting, rather than by rolling the amounts up
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Apr 2002 Q10

255
Apr 2002 Q10(i)

6
4
2 Consider two projects which both
0 have initial investment of 10.
-2 0 1 2 3 4 5
-4 First project pays amounts
-6
with present value 5, for 5 years.
-8
-10
-12

6
4 Second project pays amounts
2
with present value 5, for 2 years.
0
-2 0 1 2 3 4 5
-4 What is discounted payback period
-6 of each project?
-8
-10
Which project would you prefer? Why?
-12 256
Apr 2002 Q10(ii)

3
1.04^10 is about 1.5.
2
So accumulated value of project is
1
about ...... – 1.5 = 2m, and present value
0
is about ......./1.5 = 1.3m.
Present value is exactly PV (in) – PV (out)
0

10

-1

-2
= ..... * 1.04-10 – 1 = 1.364m
0.4
0.2 Total revenue ≈ ..... * (0.08 + 0.045) =1.25m
0
0 1 2 3 4 5 6 7 8 9 10
paid at about t = 5 years.
-0.2
-0.4
Discounted value of revenue ≈ 1.25 / 1.04^....
-0.6 = 1.03 => present value ≈ 1.03 – .... = 0.030m
-0.8 Present value is exactly PV (in) – PV (out)
-1
-1.2
= ....... ā10 +0.01(Iā)10 – 1
257
= (1+i)ā1[ 0.07a10 +.......(Ia)10] – 1 = 0.007309m
Apr 2002 Q10(ii)

3
1.04^10 is about 1.5.
2
So accumulated value of project is
1
about 3.5 – 1.5 = 2m, and present value
0
is about 2/1.5 = 1.3m.
Present value is exactly PV (in) – PV (out)
0

10

-1

-2
= 3.5 * 1.04-10 – 1 = 1.364m
0.4
0.2 Total revenue ≈ 10 * (0.08 + 0.045) =1.25m
0
0 1 2 3 4 5 6 7 8 9 10
paid at about t = 5 years.
-0.2
-0.4
Discounted value of revenue ≈ 1.25 / 1.04^5
-0.6 = 1.03 => present value ≈ 1.03 – 1 = 0.030m
-0.8 Present value is exactly PV (in) – PV (out)
-1
-1.2
= 0.07ā10 +0.01(Iā)10 – 1
258
= (1+i)ā1[ 0.07a10 +0.01(Ia)10] – 1 = 0.007309m
Apr 2002 Q10(iii)

3
Present value is exactly 1.364m
2

1
But right up until t=......, no revenue had
0
appeared, so discounted payback
period=10.
0

10

-1

-2

0.4
0.2 Present value is exactly 0.007309m.
0
0 1 2 3 4 5 6 7 8 9 10
-0.2
-0.4
So a little before t=....., the NPV was zero.
-0.6
-0.8 Thus discounted payback period occurred a
-1
-1.2
little before t=....... Ie DPP < ......
259
Apr 2002 Q10(iii)

3
Present value is exactly 1.364m
2

1
But right up until t=10, no revenue had
0
appeared, so discounted payback
period=10.
0

10

-1

-2

0.4
0.2 Present value is exactly 0.007309m.
0
0 1 2 3 4 5 6 7 8 9 10
-0.2
-0.4
So a little before t=10, the NPV was zero.
-0.6
-0.8 Thus discounted payback period occurred a
-1
-1.2
little before t=10. Ie DPP < 10.
260
Apr 2002 Q10(iv)

1
Which project would you rather end up
0
with?
0

10

-1

-2
Why? (What’s your criteria?)
0.4
0.2
0
0 1 2 3 4 5 6 7 8 9 10
-0.2
-0.4
-0.6
-0.8
-1
-1.2
261
Apr 2002 Q10 Model answer

262
Apr 2000 Q12

263
Apr 2000 Q12

Guess:
100

50
First year’s production contributes approx
(12.1 price – 9 * 1.09 cost plus interest)
0
* .......... (cars) * 1.09-3 = 9m
0 0 1 2 3 4 5 6 7 8
-50

-100 Development costs are about ....m

So guess about ..../9 years of production
needed ie 4 years production to pay back
development costs.
⇒Production starts at t = 2
⇒Guess DPP = 2 + ..... = 6 years 264
Apr 2000 Q12

Guess:
100

50
First year’s production contributes approx
(12.1 price – 9 * 1.09 cost plus interest)
0
* 5000 (cars) * 1.09-3 = 9m
0 0 1 2 3 4 5 6 7 8
-50

-100 Development costs are about 33m

Guess about 33/9 years of production needed
ie 4 years production to pay back development
costs.
⇒Production starts at t = 2
⇒Guess DPP = 2 + 4 = 6 years 265
Apr 2000 Q12(i) Model answer

266
Apr 2000 Q12(ii)

Any change to the discount rate has a greater

effect on PV of cashflows made ..............
(Discount rate has no effect on PV of cashflows
paid on very first day of project).

100 Decrease in discount rate ................... PV of

50 cashflows.
0
0 0 1 2 3 4 5 6 7 8
Revenue comes ....... than outgoings, so change in
-50 discount rate will ................ the value of revenue
-100 ....... than outgoings.

So NPV of project will ..........., and time taken for

NPV to turn positive will ..............
267
Ie DPP will ................... with lower discount rate.
Apr 2000 Q12(ii)

Any change to the discount rate has a greater

effect on PV of cashflows made later on.
(Discount rate has no effect on PV of cashflows
paid on very first day of project).

100 Decrease in discount rate increases PV of

50 cashflows.
0
0 0 1 2 3 4 5 6 7 8
Revenue comes later than outgoings, so change in
-50 discount rate will increase the value of revenue
-100 more than outgoings.

So NPV of project will increase, and time taken for

NPV to turn positive will decrease.
268
Ie DPP will decrease with lower discount rate.
Apr 2000 Q12(ii) Model answer

269
Sep 2000 Q12(ii)

270
Sep 2000 Q12(ii) Model answer

271
Specimen Q15(ii-iii)

272
Specimen Q15(ii) Model answer

273
Specimen Q15(iii) Model answer

274
Sep 2003 Q13(i-ii)

275
Sep 2003 Q13(i-ii)

276
 Key questions
Get 100% on Apr 2000 # 12
and April 2002 # 10.

It doesn’t matter how many times you see the

answers.

Cover the answers up & do them again until

someone you explain it to can follow your
reasoning.

277
 Next session:
Time weighted rate of return
and
Linked internal weight of return

END
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