Question 2 OR (b)
The discounted payback period
3 marks
- Time to write
- About 6 minutes
Question
Question 2 OR (b) · 3 marksExplain the Discounted Pay-Back Period as a capital budgeting technique.
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
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Read off the question and its marks
Read from the question
- ExplainEach point stated, then explained in a line or two.
Write it in this order
- 1 Meaning of the discounted payback period 1 mark 1 min
- 2 Method of computation 1 mark 2 min
- 3 Merits and limitations 1 mark 2 min
- Check: every ask answered, key terms underlined 1 min
Easy marks
- Meaning of the discounted payback period (step 1, 1 mark): a definition in one or two lines. It opens the answer, so it takes a minute or two.
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Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Meaning. The discounted payback period is the time a project takes to recover its initial outlay from its cash inflows discounted at the required rate of return (the cost of capital). It is the payback period worked out on present values instead of nominal cash flows.
1Rekha puts her savings into a juice cart—the jar on the counter starts empty.
Payback periodThe number of years a project takes to recover its initial investment from its cash inflows.
2Orange by orange, the jar fills back towards what the cart cost her.
Why it is a measure of liquidityHow quickly the funds locked in a project come back and can be put to other uses.
3The jar full, the counting stops—the measure never looks at all the selling still to come.
Why it is not a measure of profitabilityIt ignores the cash inflows after the payback period, however large.
Method. Discount each year's cash inflow at the required rate, add the present values cumulatively, and find the year (and the fraction of a year) in which the cumulative present value equals the outlay. Projects with a discounted payback within the period management sets are acceptable; shorter is better.
- It corrects the main defect of simple payback, since it takes account of the time value of money, and is therefore considered superior to it.
- It is always longer than the simple payback, and the gap widens as the required rate rises; for example, a project paying back in 5 years on its cash flows may take about 10 years on discounted flows at 15%.
- Like simple payback, it still ignores the cash flows after the payback point, so it measures recovery, not overall profitability.
Where the 3 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Meaning of the discounted payback period | 1 |
| 2 | Method of computation | 1 |
| 3 | Merits and limitations | 1 |
| Total | 3 |
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