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Q.2 Write short note on: a. Payback period b. Discounted cash flow


Answer:
a. Payback period  :
Payback period in industry and economics refers, to the time period required for the return of an investment. This is also the time, to repay the sum of the original investment. For example, for 10,000 rupees investment which provides a return of 500 rupees per year will have a payback period of two years. Payback period intuitively measures the time span something takes to "pay for itself." Shorter payback periods are more preferable than longer payback periods. Payback period is extensively used due to its ease of use in spite of its recognised limitations.

This method is also widely used in other types of investment areas. It is used with respect to energy efficiency technologies, preservation, upgrades and other changes. For example, a compact fluorescent bulb may be described of having a payback period of a certain specific number of years or operating hours, assuming certain costs. Here, the investment returns include reduced operating costs. Although 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 equals the amount of energy expended since project inception). Payback period is frequently used as a device of study as it is easily applicable and understandable for most of the individuals, regardless of academic training or field of endeavour. When used carefully for comparing similar investments, it can be quite useful. As a stand-alone tool used for comparing an investment with "doing nothing", payback period has no plain criteria for decision-making.
The calculation of payback period is as follows:
PP = The Cost of Cash Inflows / Annual Cash Inflows

b. Discounted cash flow
Discounted Cash Flow (DCF) was first formally calculated in John Burr Williams' 1938 text 'The Theory of Investment Value'. The articulation was done after the market crash in 1929, and before auditing and pubic accounting was made compulsory by Securities and Exchange Commission (SEC). As a result of the crash, investors were wary of depending on reported income, or any measures of value besides cash. Throughout the years 1980s and 1990s, the value of cash and physical assets decreased steadily and became associated with the total value of the company. According to some inferences, the tangible assets dropped to less than one-fifth of corporate value (intangible assets such as customer relationships, patents, proprietary business models, channels, etc. comprising the remaining four-fifths).
DCF is the amount a person pays today, in order to receive the expected cash flow in future years. DCF means converting future earnings to present money. One should discount the future cash flows to express their present values and to decide on the value of a firm or project under consideration as a whole. The DCF for an investment is measured by estimating the cash that you are expected to pay out, and the amount which is anticipated to receive back. The expected timeline to receive the payments should also be estimated. Each cash deal must be subtracted by the opportunity cost of capital over the time between now and the time at which the cash is paid or received. If David purchases a house for 2, 000, 00 rupees. Four years later, he expects an amount of 3,000,00 rupees while he sells his house. The value of profit on such a deal will be 3,000,00-2,000,00=1,000,00. If the particular amount is amortised for 3 years, his annual rate of returns would be 30%. He might feel satisfied in taking up a good idea.
The DCF method is an approach to valuation, where projected future cash flows are discounted at an interest rate (also called "rate of return"), that reflects the perceived riskiness of the cash flows. The discount rate reflects two things:
  • The time value of money. The investors would love to have cash quickly than waiting to be compensated for the delay.
  • A risk premium that reflects the extra return that investors demand. This is because they require the compensation for the risk which the cash flow might not turn up.

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