Duration Calculation and Capital Budgeting

Duration and Risk Assessments in Capital Budgeting
Author(s): Edward Blocher and Clyde Stickney

Source: The Accounting Review, Vol. 54, No. 1 (Jan., 1979), pp. 180-188
Published by: American Accounting Association
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THE ACCOUNTING REVIEW

Vol. LIV, No. I
January 1979
Duration and Risk Assessments

in Capital Budgeting
Edward Blocher and Clyde Stickney
ABSTRACT: This paper brings to the accounting literature the results of recent research
from other disciplines on a measure called duration and examines its potential usefulness
in capital budgeting decisions. Duration is defined as the number of periods which elapse
before the average present value dollar is received from a stream of cash flows. In this
paper, the authors define duration and describe its major attributes. Its potential for
assessing the risk of changes in required rates of return and the risk of illiquidity are then
explored in a capital budgeting setting.
IN 1938, Frederick R. Macaulay proposed a measure called duration to

represent the average maturity of a
stream of payments. Since that time,
duration has been used often in econom-
value of all future cash flows.

It is calculated as follows:
n CF
Duration= -. t(+ r (1)

n CF
ics, finance, and insurance.' It is surprising, however, to find only a few

references to duration in the accounting
literature. In this paper, we (1) define
duration and summarize its major attributes, and (2) suggest its potential as a
measure for assessing risk in capital
t (1 + r)t
Where:
CFt = a cash flow to be received t units

of time from today, beginning
with t= 1 period from today.
r= an appropriate discount rate for
determining the present value of
the cash flow.
budgeting decisions. In particular, we

show that the duration of a capital
project is precisely the elasticity number
relating percentage changes in net present
value of the project to changes in the
discount rate. This elasticity attribute
provides a simple, direct measure of the
risk of changes in the net present value
of a project, and therefore a firm, from
changes in a firm's cost of capital.
To illustrate the calculation of dura-
tion, assume that $26,143 is invested in a

' For a brief summary, see Weil [1973].
Edward Blocher is Assistant Professor

of Accounting, University of North Carolina at Chapel Hill, and Clyde Stickney is
Coopers and Lybrand Visiting Associate
DEFINITION AND ATTRIBUTES

OF DURATION
Professor of Accounting, Dartmouth ColDuration may be defined as the

lege.
weighted average life of an investment,
where the weights used are the present
Manuscript received November, 1977.
values of the cash flows received each
Revision received February, 1978.
Accepted March, 1978.
period as a percentage of the total present
180
Blocher
and
Stickney
TABLE
181
ILLUSTRATION SHOWING THE CALCULATION OF DURATION
(1) (2) (3) (4)=(2)x(3) (5)=(4) $26,143 (6)=(5)x(1)
Percentage of Calculation of
Present Value Present Value Total Present Weighted
Year Cash Flow Factor at 10% of Cash Flows Value Average Life
1
2
$16,000 .909
8,000
.826
$14,544 .556 .556

6,608
.253
.506
4,000
.751
3,004
.115
.345
2,000
.683
1,366
.052
.208
1,000
Total
.621
$31,000
,621
.024
$26,143
1.00
.120
1.735
Duration= 1.735 years.
new machine which promises cash

savings during the five years of its expected useful life of $16,000, $8,000,
$4,000, $2,000, and $1,000, respectively.

Table 1 shows the calculation of duration
for this project. The project has an internal rate of return of 10 percent, and
this rate is used in the illustration to
compute the project's duration. As we
discuss later, however, discount rates
other than the project's internal rate of
return could be used. Table I indicates
that the average present value dollar is
received 1.735 years after commencing
the project-this is the project's duration
at a discount rate of 10 percent.
Most of the previous research on duration has been in connection with bonds,
Duration has several interesting properties. Many of these properties can be

understood by referring to Figure 1,
which shows the relationship between
duration and the number of years to
maturity for 8 percent coupon bonds. The
relationship is plotted for four discount
rates: one less than, one equal to, and

two greater than the coupon rate.
The properties are as follows:
1. The duration of a stream of cash

flows is always less than the time of
the last cash flow (unless the stream
is a single cash flow, in which case
duration is equal to the number of
periods which elapse until that last
cash flow).
2. The difference between a project's
for which there is a single cash outflow
immediately, followed by a series of
life and its duration is relatively
future cash inflows. However, if duration small for shorter lived projects but
is to be useful in capital budgeting deincreases as the life of the project is
cisions, it must be adaptable to various
increased.
3. Duration varies inversely with the
patterns of cash inflows and outflows.
discount rate used. The higher the
The principal difficulty in using duration as defined above occurs when a
discount rate, the shorter will be
capital investment project has a net cash
the time until the average present
value dollar is received.
outflow during some future period. In
these cases, duration can be defined as
4. If an investment project has a zero
the difference between the duration of the or positive net present value at the
net cash inflows and the duration of the
discount rate used (analogous to
net cash outflows [Durand, 1974, p. 25].
discount rates of six percent and
182 The Accounting Review, January 1979

FIGURE I
DURATION VALUES FOR 8 PERCENT BONDS

17
-1
16
15
14
131
12
MRKT
INT
RATE
OF
BONDS
11
Interest
Rate
or
Percent
1-
Interest
Rate
of
Percent
I interest Rate of 10 Percent
il
Interest
Rate
of
12
Percent
t)
20
25
30
Years
eight
35
to
40
45
50
Matturity
Thein
applications
of duration in 1),
the
percent
Figure
increases at a decreasing rate as the
finance literature have used a bond's
life of the project is increased but is yield to maturity as the discount rate.
Most of these studies have been conbounded [Fisher and Weil, 1971 ]. If
cerned
with the sensitivity of a bond's
the project has a negative net
market
price to changes in market
present value at the discount rate
interest
rates
[Hicks, 1939; Haugen and
used (analogous to discount rates
Wichern,
1974,
Hopewell and Kaufman,
of 10 percent and 12 percent in
1973].
The
yield
to maturity, or internal
Figure 1), duration increases, levels
rate
of
return,
is
clearly the appropriate
off, and then decreases as the life of
rate
in
these
cases.
However, in a capital
the project is increased. The debugeting
context,
a
case can be made on
crease occurs though only for projtheoretical
grounds
for
using the firm's
ects with a life greater than apcost
of
capital.
The
cost
of capital is
proximately 100 years [Hopewell
usually
chosen
as
a
more
appropriate
and Kaufman, 1973].
5. Duration is relatively insensitive to
the discount rate used for shorter-
reinvestment rate. Also, use of the cost
of capital eliminates the problem of

multiple
internal rates of return which
lived projects, but becomes more
occurs
when
cash flows reverse from
sensitive to the discount rate as the
life is increased.
SELECTING THE DISCOUNT RATE
positive to negative or vice-versa over a

project's life.
How serious a concern is the selection

of a discount rate in typical capital
One question which must be addressed
budgeting situations? To study this quesin calculating duration is: What is the
tion, we created 126 investment projects
appropriate discount rate? Is it the
(data available from the authors upon
project's internal rate of return, the firm's
request) and classified them into one of
cost of capital, or some other rate?
Blocher
and
Stickney
183
groups tion
(42
projects
is calculated
using a five percent eac
discount rate and a 25 percent discount
rate. This measure indicates the change
in the absolute value of duration for this
20 percentage point change in the discount rate. Table 2 presents the results of
this analysis for the three groups of
projects and for various project lives.
Column (2) indicates the difference in
duration (i.e., the range) when discount
rates of five percent and 25 percent are
The first group of projects is typical of
used. The differences are averaged across
sinking fund investments. Group 2 reall projects within a particular group and
flects patterns of cash flows characteristic
sub-group. Column (3) indicates the
of most fixed asset investments. Research
largest difference for a single project
and development projects are a good
within each sub-group. Column (4) indiexample of Group 3 projects. The projcates the average change in the value of
ects selected for each group were chosen
duration for a one percentage point
so that each group had a random assortchange in the discount rate, again averment of project lives (from a minimum of
aged across all projects in the sub-group.
five to a maximum of 15 periods) and
As illustrated in Figure 1 and in Table
three
Group 1: Projects involving an immediate cash outflow followed by a series

of equal cash inflows.
Group 2: Projects involving an immediate cash outflow followed by a series of
unequal cash inflows.
Group 3: Projects involving several
years of cash outflows followed by
several years of cash inflows of varied
patterns.
internal rates of return (from five to 25

percent).
For each of the projects we determined
the range of duration values, when dura-
2, the sensitivity of duration to differences
in the discount rate does become greater

as the life of the project increases. However, none of the changes appears very
TABLE 2
SENSITIVITY ANALYSIS OF DURATION VALUES
(1)
(2)
(3)
(4)
Averag
Average (over all projects in each
projects in each group) Change in
group) Difference in Largest Single Dur

Duration Values,for Difference,for Percentage Point
Number of Duration at r=.05 Duration at r=.05 Change in Discount

Projects and r = .25 and r =.25 Rate
Group 1:
5-7 Period Project Life 15 .529 .663 .0265

8-11 Period Project Life 15 1.169 1.548 .0585
Group 2:
5-8 Period Project Life 15 .608 1.016 .0304

Group 3:
large. The maximum average difference

for a one percentage point change in the
discount rate is .1174 periods for group
two projects with a 13-15 period life. In
general, it would seem that for discount
rates up to 25 percent and project lives up
to 15 years, duration is relatively insensitive to the discount rate.
DURATION AND CAPITAL
BUDGETING DECISIONS
Having defined duration and its major

attributes, we are now ready to consider
its potential as a tool for evaluating
capital budgeting proposals. In particular we would like to suggest its role as a
tool for evaluating two dimensions of
risk: changes in required rates of return
and liquidity.
Risk of Changes in Required Rates
of Return
One of the most important uses of
duration with respect to bond investments is in measuring expected changes
in market prices of bonds as a result of
changes in interest rates [Hicks, 1939].
That is, duration serves as a measure of
sensitivity, or elasticity, of market prices
to changes in interest rates. Hopewell and
Kaufman [1973, p. 751] provide a proof
of this relationship. They show that the
percentage change in market price is
equal to the percentage change in interest rates times duration with its sign
reversed. That is:
dP D dr 2
P
(1+
(2)
Consider the example in Table 1. If

interest rates increase from 10 percent to
12 percent, Equation (2) above suggests
that the market price of this bond should
decrease by 3.154 percent [= 1.735(.02
+ 1.10)]. A 3.154 percent reduction will

lead to a decrease in price from $26,143
to $25,318. In comparison, the present
value of the cash flows from this project

discounted at 12 percent is $25,349, the
difference from that predicted due to
rounding.
Thus, other things being equal, the
larger the duration, the more sensitive
will be a bond's market price to changes
in interest rates.
This elasticity attribute of duration can
be interpreted for capital budgeting
decisions. In this context, though, the
risk is of a loss in net present value of a
project and the firm from changes in
required rates of return. For example,
assume the project summarized in Table
1 was accepted because its internal rate
of return of 10 percent exceeded the
firm's cost of capital of eight percent.
Suppose that immediately after acquiring
the asset, investors for some reason increase the rate of return they require for
investing in the firm. As a result, the
firm's cost of capital increases to nine
percent. The investment yielded a net
present value of $856 when the cost of
capital was eight percent. At a required
rate of return of nine percent, the proejct
has a net present value of $419, a decrease
in net present value of $437.
The risk of losses from increases in the
required rate of return can be minimized
by selecting otherwise comparable projects that have the smallest duration. In
this way, the net present value loss per
dollar invested from an increase in required rates of return will be minimized.
This decision rule is illustrated in the top
panel of Table 3. Projects A and B have
internal rates of return of 10 percent and
durations of 2.190 and 1.734, respectively. If the required rate of return
increases from eight to nine percent,
Project B, with the shorter duration,
would have been best. The net present
value loss per dollar invested for Project

B is $.018, whereas for Project A it is
$.021.
Blocher
and
Stickney
TABLE
185
ILLUSTRATION SHOWING STRATEGIES TO COPE WITH CHANGES IN REQUIRED RATES OF RETURN
Cash Inflow (Outflowv) in Period:

0
Project A $(12,092) $ 5,000 $4,000 $3,000 $2,000 $1,000

Project B $(26,149) 16,000 8,000 4,000 2,000 1,000
Duration
Project A Project B
.2.190
1.734
Net Present Value at 8% ............ . .. $499 $850

Net Present Value at 9% . ................ ............... 243 413
Decrease in Net Present Value .$256 $437
Decrease in Net Present Value per Dollar
Invested ($256 . $12,092; $437 ? $26,149)................ $.021 $.018
Net Present Value at 8%o+. ..................... $499 $850
Net Present Value at 7%O ................. 762 1,298

Increase in Net Present Value .$263 $448
Increase in Net Present Value per Dollar
Invested ($263 . $12,092; $448 . $26,149). $.022 $.017
Selecting otherwise comparable projects with the shortest duration is a

two-edged sword, however. If the required rate of return decreases, Project
A, with the longer duration, would have
been better. This is shown in the bottom
panel of Table 3. A decrease in the required rate of return from eight to seven
percent results in an increase in net
present value for both projects. The
increase per dollar invested is largest,
however, for Project A.
The decision rules with respect to
changes in required rates of return can,
therefore, be summarized as follows:
1. For the risk-averse manager unwilling to speculate on changes in
required rates of return, otherwise
comparable projects with the smallest duration should be selected.
2. For the manager willing to speculate on the direction of a change in
required rates of return, the rules
are:
a. Select otherwise comparable

projects with the smallest duration if required rates of return
are speculated to increase.
b. Select otherwise comparable
projects with the largest duration
if required rates of return are
speculated to decrease.
It should be noted, however, that once
the direction and amount of the change in

required rate of return become the
market consensus, it will be reflected in
market prices and any gains from speculation will be eliminated.
Illiquidity Risk
Payback is commonly used as a measure

for assessing illiquidity risk. That is, the
quicker the initial investment is recouped

through cash inflows, the less likely the
firm will find itself with insufficient liquid
resources.
In studying duration and its usefulness
in assessing illiquidity risk, we addressed
two questions:

1. Do payback and duration generally
rank competing projects the same?
2. Are there situations where the two
measures give conflicting rankings
of projects?
To address the first question we correlated duration with payback and present
value payback for the 126 projects referred to earlier. The degree of correlation
is measured using Pearson's productmoment correlation. Table 4 presents
the correlation coefficients for the three
groups of projects using discount rates of
five percent, 15 percent, 25 percent, and
each project's internal rate of return. The
number in parentheses is the a level of
significance.
TABLE 4
CORRELATION OF DURATION WITH PAYBACK MEASURES
The correlations between duration and

payback are all large and statistically
significant at .1 percent. The correlation
of duration and payback is highest for all
groups when the discount rate used to
compute duration is the project's internal
rate of return, as shown in the lower portion of Table 4. In fact, it can be shown
that for Group 1 projects, as the project
life becomes large (n-+oo), payback and
duration become functionally related as
follows (where IRR is the internal rate of
of return):
Payback ( +IRR Duration (3)
I+ /R
This follows from the fact that, as n becomes large, the payback period approaches the reciprocal of the internal
rate of return for a project, and as n increases, duration approaches
1 + IRR
Present Value
IRR
Payback Payback
R = .05
Group 1 .5247(.001) .5149(.001)

2 .6297(.001) .5778(.001)
3 .6699(.001) .6515(.001)
R= .15
Group 1 5421(.001) .7759(.001)

2 .6260(.001) .4157(.027)
3 .6810(.001) .8349(.001)
R=.25
Group 1 .5605(.001) not applicable

2 .5989(.001) not applicable
3 .6789(.001) not applicable
R = the internal rate of return for
Group 1 .8162(.001) .9103(.001)

2 8688(.001) .7705(.001)
3 .7916(.001) .8928(.001)
[Boardman, 1975].
Also, it is clear from Table 4 that the
degree of correlation does not change
significantly for changes in the discount
rate. This is consistent with the previous
finding that duration is insensitive to the
discount rate for projects with modest

lives.
The correlations between duration and
present value payback are also large and

statistically significant. The slight deterioration
for Group 2 projects at a discount
each
project
rate of 15 percent is due primarily to the
inclusion of a smaller number of projects
(see note to Table 4).
In most instances, then, duration and

projects the same. Given the relative ease in
present value payback, since present value payback is
calculating payback, it is usually more
not defined for a project when the discount rate is
greater than the project's internal rate of return. Thus, cost-efficient to use payback. We were
for r= .05, n=42; r= .15, n= 15; r= .25 n= 0; r=project
interested, though, in whether duration
internal rate of return, present value payback=project
provides a superior ranking measure in
life.
Note: n = 42 for each correlation
measured
with
payback
measuresabove
rank competing
the exception of the correlations of duration with
Blocher
and
Stickney
187
certain situations. Two such possible
the lower panel of Table 5. The payback
situations were identified.

One situation occurs when the cash
measures rank Project E over Project F,
flows from projects are highly variable

from year to year. Consider Project C and
Project D in the upper panel of Table 5.
Both projects require investments of
$25,000, have five-year lives, and have
internal rates of return of 10 percent.
Payback and present-value payback rank
Project D higher than Project C. Just the
opposite ranking occurs when duration
is used. Payback, of course, fails to
recognize the differences in the timing of
cash flows. Even present-value payback
fails to capture the differences in cash
flows, because it ignores cash inflows
after the present-value payback period is
reached.
A second situation where conflicting

rankings can occur is where there are net
cash outflows in years after the initial
investment. Consider Projects E and F in
while the duration measures do just the

opposite. Here again, payback ignores
the timing of cash flows and presentvalue payback ignores cash flows past the
present-value payback period.
Thus, as a measure of illiquidity risk in
a wide variety of situations, duration
appears to outperform payback. The
benefits of duration in these few situations may not, however, be worth the
extra cost of calculation.
SUMMARY
In this paper we have defined duration

and examined its potential usefulness in
capital budgeting decisions. Recent research in economics and finance has
demonstrated its potential in dealing with
other issues. For example, Grove [1974]
showed that duration can be used in
determining the optimal maturity struc-
TABLE 5
ILLUSTRATION SHOWING INCONSISTENT RANKINGS USING PAYBACK AND DURATION MEASURE
Cash Inflow (Outflow) in Period:
Project C ($25,000) $16,000 $1,000 $4,000 $6,000 $4,071

Project D ($25,000) 1,000 8,000 16,000 4,000 4,404
Project C Project D
Payback
3.67
3.00
Present-Value Payback at 10% 5.00 5.00
Duration at 10% 2.17 2.99

Cash
Inflow
(Outflow)
Project E ($200) ($100) $50 $50 $100 $100 $145

Project F ($50) ($100) ($150) 50 100 100 172
Project E Project F
Payback
5.00
5.29
Present-Value Payback at 10%. 6.00 6.00

in
ture of the balance sheet.

market beta.Boquist,
Perhaps the time Racette
has come
to explore more fully its applicability to
and Schlarbaum [1975] demonstrated
that duration is functionally related to
other accounting problems.
REFERENCES
Boardman, Cal, "The Payback Period-A Direct Measure of Risk," unpublished paper, The Graduate
School of Business, University of North Carolina at Chapel Hill (1975).
Boquist, John A., George A. Racette and Gary G. Schlarbaum, "Duration and Risk Assessment for
Bonds and Common Stocks," The Journal of Finance (December 1975), pp. 1360-1365.
Durand, David, "Payout Period, Time Spread, and Duration: Aids to Judgment in Capital Budgeting,"
Journal of Bank Research (Spring 1974), pp. 20-34.
Fisher, Lawrence and Roman L. Weil, "Coping with the Risk of Interest Rate Fluctuations: Returns to
Bondholders from Naive and Optimal Strategies," Journal of Business (October 1971), pp. 408-431.
Grove, Myron A., "On Duration and the Optimal Maturity Structure of the Balance Sheet," The Bell
Journal of Economics and Management Science (Autumn 1974), pp. 696-709.
Haugen, Robert A. and Dean W. Wichern, "The Elasticity of Financial Assets," Journal of Finance
(September 1974), pp. 1229-1240.
Hicks, J. R., Value and Capital (Clarendon Press, 1939).
Hopewell, Michael and George Kaufman, "Bond Price Volatility and Term to Maturity: A Generalized
Respecification," The American Economic Review (September 1973), pp. 749-753.
Macaulay, Frederick R., Some Theoretical Problems Suggested by the Movements of Interest Rates, Bond
Yields, and Stock Prices in the United States Since 1856 (Columbia University Press, 1938).
Weil, Roman L., "Macaulay's Duration: An Appreciation," Journal of Business (October 1973), pp. 589592.

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Duration and Risk Assessments in Capital Budgeting

Author(s): Edward Blocher and Clyde Stickney

THE ACCOUNTING REVIEW

Duration and Risk Assessments

IN 1938, Frederick R. Macaulay proposed a measure called duration to

value of all future cash flows.

Duration= -. t(+ r (1)

ics, finance, and insurance.' It is surprising, however, to find only a few

CFt = a cash flow to be received t units

budgeting decisions. In particular, we

To illustrate the calculation of dura-

tion, assume that $26,143 is invested in a

Edward Blocher is Assistant Professor

DEFINITION AND ATTRIBUTES

Professor of Accounting, Dartmouth ColDuration may be defined as the

ILLUSTRATION SHOWING THE CALCULATION OF DURATION

(1) (2) (3) (4)=(2)x(3) (5)=(4) $26,143 (6)=(5)x(1)

$14,544 .556 .556

Duration= 1.735 years.

new machine which promises cash

$4,000, $2,000, and $1,000, respectively.

Duration has several interesting properties. Many of these properties can be

rates: one less than, one equal to, and

1. The duration of a stream of cash

182 The Accounting Review, January 1979

DURATION VALUES FOR 8 PERCENT BONDS

I interest Rate of 10 Percent

increases at a decreasing rate as the

finance literature have used a bond's

reinvestment rate. Also, use of the cost

of capital eliminates the problem of

SELECTING THE DISCOUNT RATE

positive to negative or vice-versa over a

How serious a concern is the selection

Group 1: Projects involving an immediate cash outflow followed by a series

internal rates of return (from five to 25

2, the sensitivity of duration to differences

in the discount rate does become greater

SENSITIVITY ANALYSIS OF DURATION VALUES

group) Difference in Largest Single Dur

Number of Duration at r=.05 Duration at r=.05 Change in Discount

5-7 Period Project Life 15 .529 .663 .0265

5-8 Period Project Life 15 .608 1.016 .0304

5-9 Period Project Life 15 .130 .344 .0065

10-12 Period Project Life 16 .319 .828 .0160

13-15 Period Project Life 11 1.010 1.830 .0505

184 The Accounting Review, January 1979

large. The maximum average difference

Having defined duration and its major

Consider the example in Table 1. If

+ 1.10)]. A 3.154 percent reduction will

value of the cash flows from this project

value loss per dollar invested for Project

ILLUSTRATION SHOWING STRATEGIES TO COPE WITH CHANGES IN REQUIRED RATES OF RETURN

Cash Inflow (Outflowv) in Period:

Project A $(12,092) $ 5,000 $4,000 $3,000 $2,000 $1,000

Net Present Value at 8% ............ . .. $499 $850

Invested ($256 . $12,092; $437 ? $26,149)................ $.021 $.018

Net Present Value at 8%o+. ..................... $499 $850

Net Present Value at 7%O ................. 762 1,298

Invested ($263 . $12,092; $448 . $26,149). $.022 $.017

Selecting otherwise comparable projects with the shortest duration is a

a. Select otherwise comparable

the direction and amount of the change in