The Discounted Payback in Investment Appraisal: A Case Study

Abstract

The purpose of this paper is to study a Monte Carlo simulation of the discounted payback, and its application to investment appraisal. The underlying project in the case study has a useful life of 10 years with an initial outlay of $2,000, and with stochastic, independent, and normally distributed cash inflows. These cash inflows are simulated from the same normal frequency distribution, i.e. from a distribution with the same average of $400 and standard deviation of $80. The number of Monte Carlo simulation runs is set at 300. The empirical analysis presents descriptive statistics of the nine parameters of concern in the simulations. It also tests for normality of these nine generated series. In addition, it carries out simple hypothesis testing. In most cases the theoretical values are known in advance and testing makes sure that these expectations are statistically met by the simulations. A model of the discounted payback, in terms of the average cash flow, is derived and is estimated. The model is tested by non-linear regression analysis with great success. The final part of the empirical analysis assesses the information content of the discounted payback in predicting the net present value and compares it with the explanatory power of the internal rate of return. The paper concludes by highlighting the importance and usefulness of the discounted payback despite its many detractors.