Evaluation Criteria: Non-Discounted Cash Flow


As discussed before, there are majorly two evaluation criteria for evaluating an investment decision. This blog post will be discussing the second evaluation criteria: Non-Discounted Cash Flow. 

A non-discount method of capital budgeting is one that does not consider the time value of money. In other words, all currency earned in the future are assumed to have the same value as today's currency.

One example of a non-discount method is the payback method, since it does not consider the time value of money. The payback method simply computes the number of years it will take for an investment to return cash that is equal to the amount invested. The computed number of years is referred to as the payback period.

To illustrate, let us assume that a company invests ₹1,00,000 today in a project that is expected to generate cash of ₹50,000 for two years followed by ₹10,000 per year for four additional years. Its payback period is two years (₹50,000 + ₹50,000).

In yet another example, let us assume that another investment of ₹100,000 generates cash of ₹20,000 per year for two years and then provides cash of ₹40,000 per year for six additional years, its payback period is approximately 3.5 years (₹20,000 + ₹20,000 + ₹40,000 + half of ₹40,000).

Payback period is one of the simplest tools that a firm can use to evaluate an investment decision. The project would be accepted if its pay back period is less than the maximum or standard payback period set by management. As a ranking method, it gives highest ranking to the project, which has the shortest payback period and lowest ranking to the project with highest payback period.

However, the payback method answers only one question: How long before the cash invested is returned? The payback method does not address which investment is more profitable. Note from our examples that the payback method not only ignores the time value of money, it ignores all of the cash received after the payback period.

To overcome the above shortcomings, capital budgeting should include calculations that recognize the time value of money. These include (1) the net present value, and (2) the internal rate of return. These calculations involve discounting the future cash flows since a dollar in the distant future will be less valuable than a dollar in the near future, and both of those dollars have less value than a dollar today.

The problem of non consideration of time value of money of the payback period method can be solved  if we discount the cash flows and then calculate the PBP. Thus, discounted payback  period is the number of years taken in recovering the investment outlay on the present value basis. But it still fails to consider the cash flows beyond the payback.

Another example of a non-discount method in capital budgeting is the accounting rate of return method, which is similar to the return on investment (ROI).

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