May 5, 2012

PM0012 [Project Financing & Budgeting] Set2 Q5

Question 5: Write short note on: 
    a) Payback period
    b) Discounted cash flow



Answer:

a) Payback period


Payback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment. For example, a $1000 investment which returned $500 per year would have a two year payback period. The time value of money is not taken into account. Payback period intuitively measures how long something takes to "pay for itself." All else being equal, shorter payback periods are preferable to longer payback periods. Payback period is widely used because of its ease of use despite recognized limitations, described below.

The term is also widely used in other types of investment areas, often with respect to energy efficiency technologies, maintenance, upgrades, or other changes. For example, a compact fluorescent light bulb may be described as having a payback period of a certain number of years or operating hours, assuming certain costs. Here, the return to the investment consists of reduced operating costs. Although primarily a financial term, the concept of a payback period is occasionally extended to other uses, such as energy payback period (the period of time over which the energy savings of a project equal the amount of energy expended since project inception); these other terms may not be standardized or widely used.

The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not account for the time value of money, risk, financing or other important considerations, such as the opportunity cost. Whilst the time value of money can be rectified by applying a weighted average cost of capital discount, it is generally agreed that this tool for investment decisions should not be used in isolation. Alternative measures of "return" preferred by economists are net present value and internal rate of return. An implicit assumption in the use of payback period is that returns to the investment continue after the payback period. Payback period does not specify any required comparison to other investments or even to not making an investment.

It is period is the period in which the total investment in permanent assets pays back itself. This method lists the various investments that are ranked according to the length of their pay-back period and the investment with a shortest payback period is preferred. The payback period can be ascertained in the following manner: 

                                Investment
 Payback period =  -----------------------
                               Flow/year Cash


b) Discounted cash flow:


All organizations face one constant constriction of making use of limited resources to meet their unlimited ambitions. As the demand for higher shareholders‟ worth increases, the pressures on these resources also increase in turn forcing the management to make rational decisions when investing on resources. The project valuation technique ensures suitable cash flow statements and proper usage of the resources.

Discounted Cash Flow (DCF) facilitates the evaluation process. DCF framework helps in accessing the profitability of a proposed project. Commonly every project's value is estimated using a discounted DCF valuation, and the one with the highest value, as measured by the Net Present Value (NPV) is selected.

The evaluation involves estimation of the size and timing of all the incremental cash flows obtained from the project. This analysis is crucial in determining the economic viability of a proposed project and the estimated rate of return that the providers of the capital can attain.

In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs) – the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question.

Using DCF analysis to compute the NPV takes as input cash flows and a discount rate and gives as output a price; the opposite process – taking cash flows and a price and inferring a discount rate, is called the yield. Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management.



 (DCF) is a method to estimate the project, company or assets investment opportunity by means of the conception of time value for money. In DFC method, the project‘s value is the future estimated cash flows discounted at a rate that reflect the risk of the projected cash flow. A common practice is to use the DCF method to value companies or projects. There are three major discounted cash flow analyses for project evaluation and selection.
They are: 
Internal Rate of Return (IRR)
Net Present Value (NPV) 

Profitability Index (PI)

DFC is based on free cash flow which is a reliable method to cut through the unpredictability and guesstimates involved in reported earnings. The free cash flow models examine the money left for investors regardless of the cash outlay whether counted as an expense or turned into an asset on the balance sheet. The DFC model applies as a sanity check. 

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