Macaulay Duration vs. Discounted Payback Period

They are similar. However the payback period only looks at the flows within the payback period and ignores all later flows. The duration considers all of the flows and works out an average.

Sir, I appreciate the fact that your answer are similar to model answers from ACCA. I also appreciate the fact that the theory behind Macaulay Duration caused the formula to make an average that reflects different payouts. What I dont appreciate, or dont understand, however, is the statement that "duration, measures the average time required to recover the initial investment if discounted at IRR or the present value of the project if discounted at cost of capital." due to the fact that the payout at the produced average time always ranged between 50% and 100% of the initial investment or present value of the project. We will never receive an exact 100% payback at that time weighted average period. This is because the difference between the discounted payback at irr and duration using irr, is being reflected as the bulk cash flow paid in which period. The duration method sacrificed accuracy to show that a project that pays its bulk cashflow upfront is better. While it accounts for the bulk cashflow upfront and the cashflow after the payback period, it also ignores whether 100% of the initial investment have been paid back. It even ignores how much was invested to initiate the project. My understanding is that we should use both methods hand in hand to not just determine the project with the best liquidity but to also have the extra knowledge when we can EXACTLY get back our initial investment assuming other assumptions are correct. Thus I conclude that the statement produced by ACCA is not entirely correct. And I would advise that we should state the advantages and disadvantages of both methods clearly, otherwise when we are working, we might potentially mislead others who dont really understand the duration method either.

tannyye wrote:Sir, I appreciate the fact that your answer are similar to model answers from ACCA. I also appreciate the fact that the theory behind Macaulay Duration caused the formula to make an average that reflects different payouts. What I dont appreciate, or dont understand, however, is the statement that “duration, measures the average time required to recover the initial investment if discounted at IRR or the present value of the project if discounted at cost of capital.” due to the fact that the payout at the produced average time always ranged between 50% and 100% of the initial investment or present value of the project. We will never receive an exact 100% payback at that time weighted average period. This is because the difference between the discounted payback at irr and duration using irr, is being reflected as the bulk cash flow paid in which period. The duration method sacrificed accuracy to show that a project that pays its bulk cashflow upfront is better. While it accounts for the bulk cashflow upfront and the cashflow after the payback period, it also ignores whether 100% of the initial investment have been paid back. It even ignores how much was invested to initiate the project. My understanding is that we should use both methods hand in hand to not just determine the project with the best liquidity but to also have the extra knowledge when we can EXACTLY get back our initial investment assuming other assumptions are correct.

P.S. I realize the payback methods may only be applicable to projects. We know the payback period of bonds, it is always the last year.

It would seem that maybe you have been reading the lecture notes which would be completely pointless without watching the lectures, given that they are only lecture notes. The Macauley duration itself relates to bonds and is a weighted average time. However (as I make clear in the my lectures) it is not saying that we would receive exactly 100% payback in the weighted average time, and that is not really what is relevant anyway. The real purpose of the calculation is to be able to compare the sensitivity of the market values of bonds to changes in interest rates (as they affect the investors required rates of return). It Is not calculated primarily to assess liquidity, Calculations of the Macauley Duration (and of the duration and the modified duration) are not often asked in the exam (and discussion about them is asked even less) so I really would not spend more time experimenting as you seem to have done a dozen times,