Discussion on Project Liquidity

Module 3 - Discussion: Project Liquidity

Discounted (recovery) Payback period it is the amount of time that must elapse so that the sum of the cash flows discounted is equal to the initial investment. Consider the value of money over time. It's easy to understand. It does not accept investments with a negative NPV. It is inclined towards liquidity. This “method” determines the moment in which the money is recovered from an investment, taking into account the effects of the passage of time on the money. It is a liquidity criterion, which is equivalent to the simple recovery term or Payback, but discounting the cash flows. It is about subtracting the discounted cash flows from the initial investment until the investment is recovered and that year it will be the discounted Payback. It represents the time it takes to recover the investment, taking into account the moment in which cash flows occur. It also has some problems as it does not take into account the cash flows that occur from each period after having recovered the investment. Therefore, it is configured as an adequate method to evaluate risky investments that allows completing the analysis performed with profitability criteria (VAN or TIR).

Disadvantages of the discounted recovery Payback period '' Indicates that an investment will be acceptable if its discounted recovery period is less than the number of years previously specified.''

Advantages of the discounted recovery Payback period It is based on an arbitrary cutoff point. Ignore the cash flows that transpose the cutoff date. It is biased against long-term projects, such as research and development projects, and against new projects.

Therefore, decision criteria for an investment will be accepted if your discounted recovery period is less than the number of years previously specified. That is, as in the recovery period will be accepted those projects that are recovered before the time provided by the administration of the company.

References:

Peavler, R. (2018, January 24). Learn About Calculating Discounted Cash Flows in Payback Period. Retrieved January 28, 2018, from https://www.thebalance.com/discounted-payback-period-as-a-capital-budgeting-method-392913

Borad, S. B. (2018, January 06). Discounted Payback Period | Definition, Formula, Advantages and Disadvantages. Retrieved January 28, 2018, from https://efinancemanagement.com/investment-decisions/discounted-payback-period

Answer to classmate I:

Let’s suppose we made an investment of 1,000 euros in year 1 and, in the next four years, at the end of each year we received 400 euros. The discount rate that we will use to calculate the value of the flows will be 10%. Our undiscounted cash flow scheme will be: -1000/400/400/400/400 to calculate the value of each of the periods we will take into account the year in which we receive them:

Year 1 = 400/(1+0,1) = 363,64 Euros

Year 2= 400/(1+0,1)^2 = 330,58 Euros€

Year 3= 400/(1+0,2)^3= 300,53 Euros

Year 4 = 400/(1+0.1)^4= 273,2 Euros

In year 1 we received 400 euros, which discounted a year of the investment (year zero) are worth 363.63 euros. Discounting all cash flows we obtain the following discounted cash flow scheme: -1000 / 363.64 / 330.58 / 300.53 / 273.2 If we add the flows of the first three years we get 994.75 euros. For what remain to recover 5.25 euros. Now we apply the simple payback formula: Discounted Payback = 3 years + 5.25 / 273.2 = 3.02 years According to this investment scheme it will take 3.02 years to recover the money disbursed. According to the simple payback they would be: 1000/400 = 2.5 years If we compare the discounted payback, we can see that the simple payback will tell us that we are recovering the investment before (2.5 years), while the reality is that we will spend 3.02 years using 10% as a discount rate. This is obviously because money has less value in the future, as long as the discount rate is positive.

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