In an enterprise, an entrepreneur should know the period for the return of the investment done. This information is very important to plan and start the business. The shorter the period of return the more beneficial as it reduces the risk factors. Let us look into two separate methods to calculate the period of return.
Pay Back Period (PBP)
PBP is thus simply the number of years that it will take the business to earn back the amount of initial investment or reach a breakeven point (BEP). This is calculated as total investment divided by the net cash flow of each year until BEP is maintained. For example an initial investment of Rs. 200,000 is done. The expected net cash inflow per year is expected to be Rs. 50,000 then using the formula of total investment divided by the net cash inflow per year we get 4 years.
PBP = Total initial investment / Annual net cash inflow
This means that the investment of Rs. 200,000 with annual net cash inflow of Rs. 50,000 the amount will be earned back in 4 years. This is a simple method that people from all background can calculate and can be used in simple terms. But this method has limitations as it does not consider the time value of money. Therefore a discounted pay back period is used for this purpose.
Discounted Pay Back Period
Discounted pay back period does the same thing as pay back period. It calculates the no of years for return of investment. The difference is that it deducts the expected net cash flow from the initial investment by converting it into the present value or year zero value (starting date of year one where investment is done). It does this because it considers the time value of money. Time value of money says that Rs. 100 today is more valuable than Rs. 100 one year later due to its earning capacity within that one year period. This is why the net cash inflow one year hence cannot be directly deducted from the initial investment but rather converted to the year zero value (discounted cash flow) and then deducted. "Under the discounted rate of return method a discounted rate is computed to determine the present value of the money to be recovered from the project during its future service life.” (Haglund, 1964)
Let us take Rs. 200,000 as initial investment and Rs. 50,000 as expected net cash inflow for the next 6 years. Let us assume the discounted rate to be 10% then the discounted cash flow will be calculated as follows.
Now the discounted pay back period will be
= 5+15205/26730
= 5.6 years.
Thus pay back period is before the expected number of years so it is good to accept the project. Less pay back period is better.
These examples have looked at constant expected cash flow annually. Things are a bit different for non-constant cash flow in which the process will be the same. In PBP however the cumulative cash flow are added until there is BEP.
The PBP and discounted PBP both calculate the years required for return on investment. As we can see discounted period is longer than simple pay back period but discounted period is more accurate.
Reference
Haglund, B. E. (1964). Discounted rate of return on capital investments. Journal of Accountancy, 84.
For further actions, you may consider blocking this person and/or reporting abuse
We're a place where students share, stay up-to-date, learn and grow.
In an enterprise, an entrepreneur should know the period for the return of the investment done. This information is very important to plan and start the business. The shorter the period of return the more beneficial as it reduces the risk factors. Let us look into two separate methods to calculate the period of return.
Pay Back Period (PBP)
PBP is thus simply the number of years that it will take the business to earn back the amount of initial investment or reach a breakeven point (BEP). This is calculated as total investment divided by the net cash flow of each year until BEP is maintained. For example an initial investment of Rs. 200,000 is done. The expected net cash inflow per year is expected to be Rs. 50,000 then using the formula of total investment divided by the net cash inflow per year we get 4 years.
This means that the investment of Rs. 200,000 with annual net cash inflow of Rs. 50,000 the amount will be earned back in 4 years. This is a simple method that people from all background can calculate and can be used in simple terms. But this method has limitations as it does not consider the time value of money. Therefore a discounted pay back period is used for this purpose.
Discounted Pay Back Period
Discounted pay back period does the same thing as pay back period. It calculates the no of years for return of investment. The difference is that it deducts the expected net cash flow from the initial investment by converting it into the present value or year zero value (starting date of year one where investment is done). It does this because it considers the time value of money. Time value of money says that Rs. 100 today is more valuable than Rs. 100 one year later due to its earning capacity within that one year period. This is why the net cash inflow one year hence cannot be directly deducted from the initial investment but rather converted to the year zero value (discounted cash flow) and then deducted. "Under the discounted rate of return method a discounted rate is computed to determine the present value of the money to be recovered from the project during its future service life.” (Haglund, 1964)
Let us take Rs. 200,000 as initial investment and Rs. 50,000 as expected net cash inflow for the next 6 years. Let us assume the discounted rate to be 10% then the discounted cash flow will be calculated as follows.
Now the discounted pay back period will be
= 5+15205/26730
= 5.6 years.
Thus pay back period is before the expected number of years so it is good to accept the project. Less pay back period is better.
These examples have looked at constant expected cash flow annually. Things are a bit different for non-constant cash flow in which the process will be the same. In PBP however the cumulative cash flow are added until there is BEP.
The PBP and discounted PBP both calculate the years required for return on investment. As we can see discounted period is longer than simple pay back period but discounted period is more accurate.
Reference
Haglund, B. E. (1964). Discounted rate of return on capital investments. Journal of Accountancy, 84.