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Discounted Payback Period: What It Is, and How To Calculate It

So, the two parts of the calculation (the cash flow and PV factor) are shown above.We can conclude from this that the DCF is the calculation of the PV factor and the actual cash inflow. If the cash flows are uneven, then the longer method of discounting each cash flow would be used. It also turns the most obvious drawback of the Payback Period technique (excluding the time value of money) into an advantage, as it discounts the cash flows, making it economically sound. Others like to use it as an additional point of reference in a capital budgeting decision framework. Many managers and investors thus prefer to use NPV as a tool for making investment decisions.

The payback period is favored when a company is under liquidity constraints because it can show how long it should take to recover the money laid out for the project. If short-term cash flows are a concern, a short payback period may be more attractive than a longer-term investment that has a higher NPV. The payback period value is a popular metric because it’s easy to calculate and understand.

  1. In this analysis, 3 project alternatives are compared with each other, using the discounted payback period as one of the success measures.
  2. The discounted payback period involves using discounted cash inflows rather than regular cash inflows.
  3. Because of the opportunity cost of receiving cash earlier and the ability to earn a return on those funds, a dollar today is worth more than a dollar received tomorrow.
  4. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.

It does not account for the time value of money, the effects of inflation, or the complexity of investments that may have unequal cash flow over time. Payback period refers to the number of years it will take to pay back the initial investment. In particular, the added step of discounting a project’s cash flows is critical for projects with prolonged payback periods (i.e., 10+ years). It is calculated by taking a project’s future estimated cash flows and discounting them to the present value.

The easiest method to audit and understand is to have all the data in one table and then break out the calculations line by line. But since the payback period metric rarely comes out to be a precise, whole number, the more practical formula is as follows. A longer payback time, on the other hand, suggests that the invested capital is going to be tied up for a long period. The Discounted Payback Period is perceived as an improvement to the Payback Period.

As you can see, the required rate of return is lower for the second project. This means that you would need to earn a return of at least 9.1% on your investment to break even. This means that you would need to earn a return of at least 19.6% on your investment to break even. Get instant access to video lessons taught by experienced investment bankers.

What is the Discounted Payback Period?

Discounted payback period is a variation of payback period which uses discounted cash flows while calculating the time an investment takes to pay back its initial cash outflow. One of the major disadvantages of simple payback period is that it ignores the time value of money. To counter this limitation, discounted payback period was devised, and it accounts for the time value of money by discounting the cash inflows of the project for each period at a suitable discount rate. The discounted payback period is used to evaluate the profitability and timing of cash inflows of a project or investment. In this metric, future cash flows are estimated and adjusted for the time value of money. It is the period of time that a project takes to generate cash flows when the cumulative present value of the cash flows equals the initial investment cost.

How to Calculate Discounted Payback Period (Step-by-Step)

Payback period doesn’t take into account money’s time value or cash flows beyond payback period. Second, we must subtract the discounted cash flows from the initial cost figure to calculate. So, once we calculate the discounted cash flows for each project period, we can subtract those discounted cash flows from the initial cost until we reach zero. The project has an initial investment of $1,000 and will generate annual cash flows of $100 for the next 10 years. The discounted payback period is a measureof how long it takes until the cumulated discounted net cash flows offset theinitial investment in an asset or a project.

Another advantage of this method is that it’s easy to calculate and understand. This makes it a good choice for decision-makers who don’t have a lot of experience with financial analysis. This means that you would only invest in this project if you could get a return of 20% or more. The two calculated values – the Year number and the fractional amount – can be added together to arrive at the estimated payback period.

Sales & Investments Calculators

The discounted payback period is the period of time over which the cash flows from an investment pay back the initial investment, factoring in the time value of money. It is primarily used to calculate the projected return from a proposed capital investment opportunity. This approach adds discounting to the basic payback period calculation, thereby greatly increasing the accuracy of its results. It is significantly more accurate than the basic payback period formula. However, it also suffers from a higher level of complexity, which is what makes the payback period such a commonly-used calculation.

The first column (Cash Flows) tracks the cash flows of each year – for instance, Year 0 reflects the $10mm outlay whereas the others account for the $4mm inflow of cash flows. For example, where a project with higher return has a longer payback period thus higher risk and an alternate project having low risk but also lower return. In such cases the decision mostly rests on management’s judgment and their risk appetite.

Understanding Discounted Payback Period

Depending on the time period passed, your initial expenditure can affect your cash revenue. The screenshot below shows that the time required to recover the initial $20 million cash outlay is estimated to be ~5.4 years under the discounted payback period method. The discounted payback period indicates the profitability of a project while reflecting the timing of cash flows and the time value of money. If the discounted payback period of a project is longer than its useful life, the company should reject the project.

The discounted payback period is often used to better account for some of the shortcomings, such as using the present value of future cash flows. For this reason, the simple payback period may be favorable, while the discounted payback period might indicate an unfavorable investment. When the negative cumulative discounted cash flows become positive, or recover, DPB occurs. The payback period is the time it takes an investment to break even (generate enough cash flows to cover the initial cost).

She has worked in multiple cities covering breaking news, politics, education, and more. Natalya Yashina is a CPA, DASM with over 12 years of experience in accounting including public accounting, financial reporting, and accounting policies. Discounted payback period serves as a way to tell whether an investment is worth undertaking. The lower the payback period, the more quickly an investment will pay for itself. Because of the opportunity cost of receiving cash earlier and the ability to earn a return on those funds, a dollar today is worth more than a dollar received tomorrow. I will briefly explain how the payback period functions to help you better understand the concept.

In other circumstances, we may see projects where the payback occurs during, rather than at the end of, a given year. Since the project’s life is calculated at 5 years, employment contracts for small businesses we can infer that the project returns a positive NPV. From another perspective, the payback period is when an investment breaks even from an accounting standpoint.

Projecting a break-even time in years means little if the after-tax cash flow estimates don’t materialize. The https://www.wave-accounting.net/ determines the payback period using the time value of money. Conceptually, the payback period is the amount of time between the date of the initial investment (i.e., project cost) and the date when the break-even point has been reached. Similar to the Payback Period, the technique omits time intervals beyond the breakeven point.

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