A number of devoted readers to this blog have asked about the concept of duration as an investment appraisal technique.
Duration tells us the average time at which a project will recover the net present value of the project or, alternatively the value of the original investment. It is most commonly encountered in discussion of fixed income securities but it also has a role in the less esoteric areas of capital budgeting. It serves two purposes, it is a measure of the average period to recovery of the value invested which, unlike payback, incorporates time value and does not ignore any of the cash flows in the recovery phase of the project. It also answers a riddle about internal rate of return and the circumstances in which IRR will agree with NPV and when it will not.
The first step in its measurement is to take each year’s cash flow and discount them by the internal rate of return of the project. Alternatively, take each year’s cash flow and discount them by the firm’s cost of capital. In the first case divide each year’s discounted cash flow by the value of the initial investment, in the second case divide by the project’s present value. The sum of the resulting values in either case should equal one. Then, multiply each weighted cash flow by the year to get a weighted average of years. This is the project duration.
How do we interpret the duration? It tells us when the bulk of the cash flows will be received over the life of the project. In this respect it has a similar value to payback in that a firm exposed to significant liquidity risk might prefer the short duration project to one where the bulk of the cash flows arrive at the end of the project’s life.
Duration also helps us solve a problem in finance when using the IRR as a technique for distinguishing between mutually exclusive projects. IRR favours short duration projects and in those cases will contradict NPV. With long duration projects, IRR and NPV will be in agreement. The duration of the project helps reconcile NPV and IRR but more importantly it provides an important timing metric that does not have the faults of payback or discounted payback.
Here is a useful pointer to a reference: