Discounted payback period refers to the number of years it takes for the present value of cash inflows to equal the initial investment. The decision rule is a simple rule to determine if an investment is worthwhile, and which of several investments is most worthwhile. If the discounted payback period for a certain asset is less than the useful life of that asset, the investment may be approved. If a business is choosing between several potential investments, the one with the shortest discounted payback period will be the most profitable. Please note that if the discount rate increases, the distortion between the simple rate of return and discounted payback period increases. Let us take the 10% discount rate in the above example and calculate the discounted payback period.
Formulation of the Discounted Payback Period
The shorter the discounted payback period, the quicker the project generates cash inflows and breaks even. While comparing two mutually exclusive projects, the one with the shorter discounted payback period should be accepted. Payback period refers to how many years it will take to pay the state of marriage equality worldwide back the initial investment. The simple payback period doesn’t take into account money’s time value. According to discounted payback method, the initial investment would be recovered in 3.15 years which is slightly more than the management’s maximum desired payback period of 3 years.
- If the cash flows are uneven, then the longer method of discounting each cash flow would be used.
- It’s not a calculation of your total expected return, but it only indicates how long it will take to break even on an investment.
- You should also consider factors such as money’s time value and the overall risk of the investment.
- Payback period refers to how many years it will take to pay back the initial investment.
- The metric is used to evaluate the feasibility and profitability of a given project.
Discounted Payback Period: Definition, Formula & Calculation
However, not all projects and investments have the same time horizon, so the shortest possible payback period needs to be nested within the larger context of that time horizon. For example, the payback period on a home improvement project can be decades while the payback period on a construction project may be five years or less. People and corporations mainly invest their money to get paid back, which is why the payback period is so important.
Why should business owners pay attention to discounted payback period?
The DPP can be used in a cost-benefit analysis as well as for the comparison of different project alternatives. You can think of it as the amount of money you would need today to have the same purchasing power as a future payment. Have you been investing and are wondering about some of the different strategies you can use to maximize your return? There can be lots of strategies to use, so it can often be difficult to know where to start.
The key disadvantage of the discounted payback period is that it suffers from a higher level of complexity than the standard payback period. The standard payback period calculation is intended to be quite simple, and can be derived with minimal calculations. This is not the case when discounting is introduced to the formulation. Additionally, any payback period analysis ignores cash flows after the payback period.
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. The discounted payback period is calculatedby discounting the net cash flows of each and every period and cumulating thediscounted cash flows until the amount of the initial investment is met. This requires the use of a discountrate which can be either a market interest rate or an expected return. Someorganizations may also choose to apply an accounting interest rate or theirweighted average cost of capital.
You first need to discount the cash flows for each year you expect to generate revenue from the project. You then add up the discounted cash flows to find the year in which your cash flow meets or exceeds the investment. In this example, the cumulative discountedcash flow does not turn positive at all. In other words, the investment will not be recoveredwithin the time horizon of this projection. One of the disadvantages of discounted payback period analysis is that it ignores the cash flows after the payback period.
An organisation is considering a project which has an initial investment of $40,000 and is expected to generate profit after depreciation but before tax of $12,500 each year for eight years. Depreciation will be on a straight line basis over the life of the project. Year in which the cumulative present value of cash flows from investment exceed the initial cost. NPV calculates the total value that an investment adds to the firm, discounting those future cash flows to a present value. While discounted payback period is an important metric to use in assessing investments, it’s certainly not the only financial metric you should consider. If we didn’t consider the time value of money and instead applied the standard formula, our payback period would be 5 years.