Payback Period & Discounted Payback Period Example

The discounted payback period is calculated

by discounting the net cash flows of each and every period and cumulating the

discounted cash flows until the amount of the initial investment is met. This requires the use of a discount

rate which can be either a market interest rate or an expected return. Some

organizations may also choose to apply an accounting interest rate or their

weighted average cost of capital. The discounted payback period calculates the time it takes to recover a project’s initial investment, considering the time value of money. First, estimate cash inflows for each period, then determine the discount rate. Calculate present value for each cash inflow, add them up, and determine when the cash inflows equal the initial investment.

And it “obviously has to be shorter than the life of the project — otherwise there’s no reason to make the investment.” If there’s a long payback period, you’re probably not looking at a worthwhile investment. The answer is no, the project does not meet the board’s criteria of a discounted payback period of 4 years or less. Simple payback period does not take into account the principles of time value of money. Why this can be a problem when analyzing the payback period can be explained through a simple example. Since IRR does not take risk into account, it should be looked at in conjunction with the payback period to determine which project is most attractive. The payback period will help the company to use their fund more effective, it recommends to invest in a project which has the shortest payback period.

Discounted payback method

Discounted payback method is a capital budgeting technique used to evaluate the profitability of a project based upon the inflows and outflows of cash. Under this technique, we first discount project’s all cash flows to their present value using a https://turbo-tax.org/change-without-notice/ preset discount rate and then determine the time period within which the initial investment would be recovered. Since this method takes into account the time value of money, it can be considered as an upgraded variant of the simple payback method.

From the above formula, we can say that there are two factors which are the determinants of DCF calculation, one is Actual cash inflow and another one is present value factor i.e 1/(1+i)n. Actual cash flow is discounted by the present value factor for getting the present value of cash inflow. The calculation of discounted payback period is very similar to the simple payback period calculation. The Payback Period shows how long it takes for a business to recoup an investment.

How to pronounce discounted payback period?

This type of analysis allows firms to compare alternative investment opportunities and decide on a project that returns its investment in the shortest time if that criteria is important to them. In any case, the decision for a project option or an investment decision should not be based on a single type of indicator. You can find the full case study here where we have also calculated the other indicators (such as NPV, IRR and ROI) that are part of a holistic cost-benefit analysis. Option 1 has a discounted payback period of

5.07 years, option 3 of 4.65 years while with option 2, a recovery of the

investment is not achieved. The following tables contain the cash flow

forecasts of each of these options. It calculates the time it will take to recover an investment based on observing the present value of the project’s projected cash flows.

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Payback Period vs. Discounted Payback Period

Again, the first step would be to ensure that the cash flows are identified, which we have already done – $17,500 per year. Payback also provides more focus on the earlier cash flows arising from a project, as these are both more certain and more important if an organisation has liquidity concerns. As well as ensuring that the cash flows rather than the profits are used within the calculation, candidates also need to ensure that they consider the timing of the cash flows. So if the cash flow arises at the end of the year, payback is three years, and if cash flow arises during the year, the payback is two years and (0.29 x 12) three months (to the nearest month). The implied payback period should thus be longer under the discounted method.

• One of the disadvantages of discounted payback period analysis is that it ignores the cash flows after the payback period.
• It is the method that eliminates the weakness of the traditional payback period.
• The term payback period refers to the amount of time it takes to recover the cost of an investment.
• All else being equal, it’s usually better for a company to have a lower payback period as this typically represents a less risky investment.
• Some

  organizations may also choose to apply an accounting interest rate or their

  weighted average cost of capital.

The initial outflow of cash flows is worth more right now, given the opportunity cost of capital, and the cash flows generated in the future are worth less the further out they extend. People and corporations mainly invest their money to get paid back, which is why the payback period is so important. In essence, the shorter payback an investment has, the more attractive it becomes.

What Is the Role of Depreciation in the Payback Period?

Depreciation will be on a straight line basis over the life of the project. The DPP accounts for the time value of money and is, therefore, more accurate than standard payback periods. So, the discounted payback period would take 1.98 years to cover the initial cost of $8,000. From another perspective, the payback period is when an investment breaks even from an accounting standpoint. Discounted payback, in contrast, includes the time value of money, so it is viewed from a financial perspective.