The "discounted payback period" is a modification of the simple payback version where the time value of money is considered in the calculation. In discounted payback period calculation, different metrics are used to measure the amount of time the project will take to "break-even."In some cases, the discounted payback is measured to the point of time where the net cash flows generated from the project cover the initial cost of the project.Simple and discounted payback periods are both used to measure the profitability and feasibility of an investment project.Underlying Meaning of Discounted Payback PeriodThe discounted payback period is used to ... Read More

All typical investments have the following three types of cash flows −Initial investmentYearly net cash flowsTerminal cash flowsInitial InvestmentThe initial cost is the cost of assets in the beginning phase of a project. It is the net outlay in the given period when an asset is purchased.Gross Outlay or Original Value (OV) is a major element of initial investment which includes the costs of accessories and spares, and freight and installation charges. The OV is included in the block of an asset to calculate the depreciation. Original value minus depreciation is the book value (BV) of the asset.A lumpsum investment ... Read More

The Profitability Index (PI) shows a parallel between the expenses and profits of a certain project. It is obtained by dividing the net present value of the property’s future cash flows by the initial investment.When the profitability index is over 1.0, it is positive and the investment will generate profits.If the PI is less than 1.0, then it is negative where the investment will probably fail.In other words, the profitability index is the ratio between the net present value of future cash flows and the initial investment.A profitability index number of 1.0 is likely the lowest desired number for investors. ... Read More

The "cost of debt" can let one understand what they are paying for the benefit of having fast access to cash. The cost of debt is calculated by adding up all loans, balances on credit cards, and other financing tools the company has. The interest rate expense for each year is found and added. Next, the total interest is divided by the total debt to get the cost of debt.Cost of Debt FormulaThere are multiple ways to calculate the cost of debt, depending on pre-tax or post-tax rates. The pre-tax cost of debt is calculated with the above method and ... Read More

The method that is used to calculate the cost of capital for divisions can also be used to determine the cost of capital of projects. It’s hard to find comparable projects that resemble each other in all aspects. The risk profiles of companies depend on their operating leverage. This should be remembered while determining the beta of a project. The variability of a project’s earning can also be used to determine the beta.A simple way to incorporate risk differences into similar projects is to add or subtract the risk associated with the project. So, the weighted average cost of capital ... Read More

Although being a disputed matter in the financial world, the cost of capital is an important measure that helps the managers in decision-making in the correct manner. The following are the reasons why the cost of capital is an important measure −Evaluation of InvestmentThe cost of capital is used in both NPV and IRR methods of investment evaluation.In the NPV method, a project is accepted if it has a positive NPV. The project’s NPV is usually calculated by discounting its cash flows by the cost of capital. In this sense, the cost of capital is the discount rate used to ... Read More

The Dividend Growth ModelThe dividend growth model is an approach that assumes that dividends grow at a constant rate in perpetuity. The value of one stock equals next year's dividends divided by the difference between the total required rate of return and the assumed constant growth rate in dividends.In other words, the dividend growth model is actually a mathematical formula that investors often use to determine a good fair value for a company's stock depending on its current dividend and its expected future dividend growth.The basic formula for the dividend growth model is as follows −$$\mathrm{𝐏𝐫𝐢𝐜𝐞 =\frac{𝐂𝐮𝐫𝐫𝐞𝐧𝐭\:𝐀𝐧𝐧𝐮𝐚𝐥 \:𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝}{𝐃𝐞𝐬𝐢𝐫𝐞𝐝\: 𝐑𝐚𝐭𝐞 \:𝐨𝐟 ... Read More

The cost of capital is the lowest rate of return the companies should earn before generating value. Before earning profits, a company must generate sufficient income to cover the cost of capital it uses to fund the operations.The cost of the capital contains both costs of debt and the cost of equity. A company’s cost of capital depends upon the method the company chooses to fund the business operations which is also known as the capital structure. A company may rely solely on debt or on equity of a mix of the two to fund its operations.As a choice of ... Read More

The Accounting Rate of Return (ARR) is a widely used technique for investment evaluation. However, like all other measurement processes, it has both merits and demerits.Merits of Using ARRFollowing are some of the merits of using ARR in evaluating an investment −Simplicity − The ARR method is one of the easiest methods to evaluate an investment. Unlike NPV and IRR methods, it does not involve critical and complex computations. Moreover, being simple to understand, ARR is widely used for audiences who have less knowledge of finance. Simplicity makes ARR the preferred choice of investment evaluation for non-finance managers.Use of accounting ... Read More

Despite being a popular tool of investment evaluation, payback is not applicable in all investment evaluation projects. In this article, we will highlight some of the shortcomings of using the Payback Period in evaluating an investment.Cash Flows after PaybackThe payback period fails to consider the cash inflows after the payback period is over. As in the calculation of payback, the year in which the cash inflows become positive is considered as the payback year, and the cash inflows occurring in subsequent years are ignored. This leads to the erroneous calculation of cash inflows and returns on investment.Missing the calculations of ... Read More