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Chapter 2

4.3 Introduction to the concept of duration

The problem with payback as an investment appraisal method is that it ignores all the
project’s cash flows after the payback period.

Duration addresses this issue by still considering how quickly the project cash flows
come in, but by looking at all the cash flows over the whole life of the project.

Duration measures the average time to recover the present value of the
project (if cash flows are discounted at the cost of capital).

It is a measure which can be used across projects to indicate when the
bulk of the project value will be captured.

4.4 The Macaulay Duration method and decision rule

 Macaulay Duration can be calculated using the following method:

1 calculate the total present value of the future cash receipts (the
'return phase' cash flows)

2 weight each year’s discounted cash flow according to its time of
receipt, before adding them all together

i.e. (1 x PV of T 1 CF) + (2 x PV of T 2 CF) + (3 x PV of T 3 CF) +
… etc

3 divide the sum of the weighted discounted cash flows (from step
2) by the present value of the 'return phase' cash flows (from
step 1)

 Projects with higher durations carry more risk than projects with
lower durations, so projects with short durations are more
attractive to investors.

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