Duration is an important issue when analyzing an investment. Regardless of how much risk an investment involves, or how much it is expected to pay out, just when it will pay out or how sensitive it is to risk are key factors for investors to consider. Both businesses and individual investors perform calculations involving investment durations, including capital budgeting duration and modified duration.
Capital Budgeting Duration
Capital budgeting duration refers to the duration of a capital business investment. Capital investments are those that take many years to pay off, such as building a new factory or expanding into another region. Business leaders consider capital budgeting duration and perform calculations based on projected costs and revenue to determine when a capital investment will pay off, or whether it will be likely to pay for itself.
The concept of modified duration is very different from capital budgeting duration. Instead of referring to a length of time, it indicates how much exposure an investment has to interest rate risk. This is the risk that an investment will produce a poor return if interest rates rise but the investor is tied to the old investment at a lower rate. Modified duration measures how sensitive an investment, such as a bond, is to investment rate risk.
Calculating capital budget duration is a complex process. It includes accounting for the future value of a capital investment and projecting its return for each year that the investment remains in place. Comparing estimated costs to these results shows how long it will take for the capital investment to pay for itself. Measuring modified duration is a relatively straightforward process. The equation is percentage of the change in price divided by percentage of change in the yield. A higher modified duration indicates a greater sensitivity to interest rate risk.
Investment duration metrics are important because of the significance of opportunity cost in investment decisions. Opportunity cost refers to lost opportunities that are part of an investment's natural outcome. The modified duration of a bond doesn't affect how much the bond pays in interest, but it does indicate the likelihood of interest rate risk, which is an opportunity cost. Likewise, capital budgeting duration reveals how long a business will be paying for an investment, which leaves it with less money to invest elsewhere or provide financial stability.
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