what it is and how to calculate it – WAU
Discounted payback is an indicator used to evaluate the return time, as well as the risks and the viability of an investment. It differs from simple payback by discounting the cost of capital in cash flows, that is, the values of inflows and outflows are based on the present time.
Suppose you are thinking about expanding your business or investing in a new venture, but you are not sure if this is a good idea. How to “predict” the risks or viability of this project?
What you are looking for is the payback, that is, the time required for your initial investment to be fully covered by the accrued earnings. This calculation can be made based only on the company’s cash flow projections, however, to obtain a more realistic result, we must discount the costs involved in the business operations.
In this article we discuss:
The discounted payback is very useful for evaluating marketing and business projects, and its calculation is quite simple, even for those who are averse to financial mathematics. The most important thing, however, is that your understanding is essential to predict possible losses and manage your investments more safely.
Continue reading to check out all about this concept!
What is discounted payback and how to calculate it?
The payback, or payback period, is the time required for the accumulated return on an investment to equal the amount invested. The basic calculation, also called simple payback, is based only on the first cash flow projection, whereas the discounted payback considers changes in money over time according to the company’s cost of capital.
To be clearer, let’s start by calculating the simple payback of a fictitious business.
How to calculate simple payback
Imagine that you are the owner of a very busy small gym and, watching the increase in demand for this type of service, consider the possibility of opening a second establishment in another region of the city.
This expansion, however, will require a significant investment, after all, it will be necessary to rent a new location, renovate, buy equipment, hire people, close sales and deal with all the expected bureaucratic requirements. Even if the return is clearly visible, how long would you recover the money invested in that new address?
We have an advantage in this case: you already have a successful establishment whose history can serve as a basis for calculating the payback. For didactic purposes, we will set the annual revenue foreseen in R $ 100 thousand and the investment needed to open the new academy in R $ 200 thousand.
From these data, we can illustrate the return on your investment as follows:
To simplify further, we can use the simple payback formula: payback = initial investment / gain in the period. In this case, we will have:
- payback = 200 thousand / 100 thousand;
- payback = 2.
In this example, the payback, or the time required to recover your investment, is 2 years. If that period is reasonable to keep your finances balanced, that business probably represents an opportunity to expand your venture.
However, even if we substituted the exposed variables for real values, this calculation would present a major limitation: he does not consider the company’s operating costs or the interest provided for in financing and investments. To draw a more accurate projection, we must choose the discounted payback.
How to calculate discounted payback
Before we list the formulas and move on to the next example, we need to clarify some basic terms like Cost of Capital, Minimum Attractiveness Rate and Net Present Value.
We are not going to go too deep into expressions and accounting calculations, but some concepts need to be clarified so that your understanding is complete, okay?
Cost of Capital
The cost of capital represents the cost that the investor must bear to keep his money invested in a company. This cost involves both third party capital (financing, loans and investor resources) and the company’s own capital (resources of partners or shareholders), as well as currency value projections (inflation).
Note that it is not advantageous for an investor to put his money in a business that is not able to offer a return greater than that guaranteed by a conservative investment, right? In this sense, a substitute variable tends to be used in the calculation of the discounted payback: the Minimum Attractiveness Rate, or TMA.
Minimum Attractiveness Rate
The TMA is the maximum interest rate that a debtor proposes to pay when financing or minimum rate of return that an investor requires to accept making an investment. It is usually higher than the yield on risk-free assets – such as fixed income securities – and is formed from three basic components:
- opportunity cost: return generated by other investment alternatives, usually interest-based securities based on the Selic rate;
- project risk: the rate must cover the risk involved in the operation, that is, the greater the risk, the greater the expected return;
- liquidity: estimated capacity or time for the asset to be converted into cash or to change its position in the market.
Net present value
The Net Present Value, described in the equations only as NPV, is the variable that differs the discounted payback from its simple formula. This value is nothing more than the statement of present value of cash flow (PV) less the cost of capital or, as in our example, the TMA.
Note, however, that in this case we are considering the present value of cash flows. Therefore, we will need to calculate compound interest for each period – which we consider here as a year. The NPV formula, therefore, is:
- NPV = VP / (1 + TMA) ^ n;
- VP = present cash flow value;
- TMA = Minimum Attractiveness Rate;
- n = period or year in question.
Suppose, now, that you intend to invest in a small market in your city and, talking to other entrepreneurs, you discover that it will be necessary to invest R $ 500 thousand In the project.
Fixing a cash flow R $ 200 thousand is 12% TMA, our discounted payback only happens in the fourth year. Check it out:
To calculate the exact moment when the payback occurs, simply divide the amount of the last negative balance by the sum of the same amount plus the first positive balance. Thus, we find the proportion that indicates the time of year when the total return takes place. Look:
- 19.64 / (19.64 + 107.46) = 0.15 (or 15% a year).
The discounted payback of this investment, therefore, will occur in approximately 4 years and 2 months.
It is worth mentioning that the exposed values are fictitious and were fixed only to simplify the understanding of the calculation. In a real situation, it will be necessary to project future cash flows from the revenues, costs and expenses provided for in preliminary financial research and analysis.
Why do this calculation?
Any company or investor that intends to invest resources in a given project – whether applying a marketing plan, expanding an establishment, or purchasing high-value machinery – performs a series of financial analyzes to estimate costs and costs. risks involved in this business opportunity.
From this point of view, it is clear that discounted payback is a security tool that not only assesses the viability of an investment, but also outlines an estimated return period that will serve as a reference for investor financial planning.
To illustrate the importance of this calculation, we will analyze a last example, still considering an initial application of R $ 500 thousand is 12% TMA. This time, however, the cash flow values will not be fixed, which brings our data closer to a real projection. Check out!
Note that in this example, by the end of the fourth year, not even half of the investment will have been paid, and given the declining cash flows, the payback is likely to never happen.
It is clear that the values cited were designed to illustrate a negative picture and, as we are talking about projections, it is impossible to say that the real results will be as expected. After all, there are factors, such as economic turbulence, new laws and market trends, that can completely change the reality of a business.
That’s why, in a payback calculation, it is recommended to make projections considering different scenarios, from the most typical to the most unlikely. The point is that very negative standards in assessments, as well as very long payback periods, indicate that the risks involved are high.
What are the advantages and disadvantages of discounted payback?
Regarding the simple method, the discounted payback has a number of advantages, without giving up simplicity:
- considers the cost of capital of companies;
- takes into account changes in money over time;
- it is suitable for the evaluation of high risk or limited life projects;
- it is more faithful to the financial reality of business.
On the other hand, the discounted payback has important limitations that compromise its effectiveness, mainly in the financial analysis of large businesses:
- does not consider possible negative cash flows after the payback period;
- despite its simplicity, the accuracy of the result depends on more complex projections.
In other words, the discounted payback alone is not able to provide such a reliable picture, although its method is capable of evaluating small businesses with some precision. Thus, large companies tend to use it as a screening factor or combine their mathematical arrangement with more sophisticated financial analysis.
How to reduce the payback period?
It is not common for a company’s cash inflows to occur in a linear manner and, in many projects, the return can occur beyond the estimated time in the projections. This means that, even if the business has a long payback period, it is possible that it will consolidate and become a good investment.
Not all investors, however, are able to wait or are willing to deal with this risk. However, considering the structure of the discounted payback calculation, we realize that what directly affects its final value are the results of cash flows and the cost of capital.
In this sense, a company can develop a cost reduction plan during the payback period, focusing on the operation of the business on its most profitable products or services. Another way out would be to negotiate a lower TMA, but that would affect liquidity and investment risk.
We can conclude that the payback stands out for being a practical tool to evaluate projects of less complexity and businesses that do not demand very high investments as small companies and startups.
In addition to the discounted payback, there are several other risk indicators, such as the IBC (Benefit / Cost Index), the IRR (Internal Rate of Return) and the Fisher Point. On the other hand, if what you want is to evaluate the profitability of a project, the calculation that provides us with the best estimates is ROI (Return on Investment).
Keep learning with us: check out our ROI article now and find out if your investments are really paying off!