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The discounted payback period (DPP) is the amount of time that it takes (in years) for the initial cost of a project to equal to discounted value of expected cash flows, or the time it takes to break even from an investment.It is the period in which the cumulative net present value of a project equals zero.
Cumulative Discounted cash flows will start with a negative value due to the original cost of investment, but as cash is generated each year after the original investment the discounted cash flows for those years will be positive, and the cumulative discounted cash flows will progress in a positive direction towards zero. When the negative cumulative discounted cash flows become positive, or recover, DPP occurs.
Discounted payback period is calculated by the formula:
DPP = Year before DPP occurs + Cumulative Discounted Cash flow in year before recovery ÷ Discounted cash flow in year after recovery
Discounted Payback Period helps businesses reject or accept projects by helping determine their profitability while taking into account the time-value of money.This is done via the decision rule: If the DPP is less than its useful life, or any predetermined period, the project can be accepted. If the DPP is greater than the specified period or the project's useful life, the project should be rejected. The DPP also helps compare mutually exclusive projects, as the project with the shorter DPP should be accepted.
The Discounted Payback method still does not offer concrete decision criteria to determine if an investment increases a firms value. In order to calculate DPP, an estimate of the cost of capital is required. Another disadvantage is that cash flows beyond the discounted payback period are ignored entirely with this method.
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 by using cost of capital 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 of the cash flows in question.
Discounting is a financial mechanism in which a debtor obtains the right to delay payments to a creditor, for a defined period of time, in exchange for a charge or fee. Essentially, the party that owes money in the present purchases the right to delay the payment until some future date. The discount, or charge, is the difference between the original amount owed in the present and the amount that has to be paid in the future to settle the debt.
In finance, the net present value (NPV) or net present worth (NPW) is the summation of the present (now) value of a series of present and future cash flows. Because NPV accounts for the time value of money NPV provides a method for evaluating and comparing products with cash flows spread over many years, as in loans, investments, payouts from insurance contracts plus many other applications.
The internal rate of return (IRR) is a measure of an investment’s rate of return. The term internal refers to the fact that the internal rate excludes external factors, such as inflation, the cost of capital, or various financial risks.
In economics and finance, present value (PV), also known as present discounted value, is the value of an expected income stream determined as of the date of valuation. The present value is always less than or equal to the future value because money has interest-earning potential, a characteristic referred to as the time value of money, except during times of negative interest rates, when the present value will be more than the future value. Time value can be described with the simplified phrase, "A dollar today is worth more than a dollar tomorrow". Here, 'worth more' means that its value is greater. A dollar today is worth more than a dollar tomorrow because the dollar can be invested and earn a day's worth of interest, making the total accumulate to a value more than a dollar by tomorrow. Interest can be compared to rent. Just as rent is paid to a landlord by a tenant, without the ownership of the asset being transferred, interest is paid to a lender by a borrower who gains access to the money for a time before paying it back. By letting the borrower have access to the money, the lender has sacrificed the exchange value of this money, and is compensated for it in the form of interest. The initial amount of the borrowed funds is less than the total amount of money paid to the lender.
A company's earnings before interest, taxes, depreciation, and amortization is an accounting measure calculated using a company's net earnings, before interest expenses, taxes, depreciation, and amortization are subtracted, as a proxy for a company's current operating profitability.
In corporate finance, free cash flow (FCF) or free cash flow to firm (FCFF) is a way of looking at a business's cash flow to see what is available for distribution among all the securities holders of a corporate entity. This may be useful to parties such as equity holders, debt holders, preferred stock holders, and convertible security holders when they want to see how much cash can be extracted from a company without causing issues to its operations.
In finance, the terminal value of a security is the present value at a future point in time of all future cash flows when we expect stable growth rate forever. It is most often used in multi-stage discounted cash flow analysis, and allows for the limitation of cash flow projections to a several-year period. Forecasting results beyond such a period is impractical and exposes such projections to a variety of risks limiting their validity, primarily the great uncertainty involved in predicting industry and macroeconomic conditions beyond a few years.
Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to effect a sale of a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes such as in shareholders deadlock, divorce litigation and estate contest. In some cases, the court would appoint a forensic accountant as the joint expert doing the business valuation.
Capital budgeting, and investment appraisal, is the planning process used to determine whether an organization's long term investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure. It is the process of allocating resources for major capital, or investment, expenditures. One of the primary goals of capital budgeting investments is to increase the value of the firm to the shareholders.
In finance, return is a profit on an investment. It comprises any change in value of the investment, and/or cash flows which the investor receives from the investment, such as interest payments or dividends. It may be measured either in absolute terms or as a percentage of the amount invested. The latter is also called the holding period return.
In business and for engineering economics in both industrial engineering and civil engineering practice, the minimum acceptable rate of return, often abbreviated MARR, or hurdle rate is the minimum rate of return on a project a manager or company is willing to accept before starting a project, given its risk and the opportunity cost of forgoing other projects. A synonym seen in many contexts is minimum attractive rate of return.
The modified internal rate of return (MIRR) is a financial measure of an investment's attractiveness. It is used in capital budgeting to rank alternative investments of equal size. As the name implies, MIRR is a modification of the internal rate of return (IRR) and as such aims to resolve some problems with the IRR.
Valuation using discounted cash flows is a method for determining the current value of a company using future cash flows adjusted for time value of money. The future cash flow set is made up of the cash flows within the determined forecast period and a continuing value that represents the cash flow stream after the forecast period. Discounted Cash Flow valuation was used in industry as early as the 1700s or 1800s, widely discussed in financial economics in the 1960s, and became widely used in U.S. Courts in the 1980s and 1990s.
Payback period in capital budgeting refers to the period of time required to recoup the funds expended in an investment, or to reach the break-even point. For example, a $1000 investment made at the start of year 1 which returned $500 at the end of year 1 and year 2 respectively would have a two-year payback period. Payback period is usually expressed in years. Starting from investment year by calculating Net Cash Flow for each year: Net Cash Flow Year 1 = Cash Inflow Year 1 - Cash Outflow Year 1. Then Cumulative Cash Flow = Accumulate by year until Cumulative Cash Flow is a positive number: that year is the payback year.
The modified Dietz method is a measure of the ex post performance of an investment portfolio in the presence of external flows.
The rate of return on a portfolio is the ratio of the net gain or loss which a portfolio generates, relative to the size of the portfolio. It is measured over a period of time, commonly a year.
Accounting rate of return, also known as the Average rate of return, or ARR is a financial ratio used in capital budgeting. The ratio does not take into account the concept of time value of money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents out of each dollar invested (yearly). If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. More than half of large firms calculate ARR when appraising projects.
Strategic financial management is the study of finance with a long term view considering the strategic goals of the enterprise. Financial management is nowadays increasingly referred to as "Strategic Financial Management" so as to give it an increased frame of reference.
In corporate finance, free cash flow to equity (FCFE) is a metric of how much cash can be distributed to the equity shareholders of the company as dividends or stock buybacks—after all expenses, reinvestments, and debt repayments are taken care of. Whereas dividends are the cash flows actually paid to shareholders, the FCFE is the cash flow simply available to shareholders. The FCFE is usually calculated as a part of DCF or LBO modelling and valuation. The FCFE is also called the levered free cash flow.
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