Payback Period: Definition, Formula, and Calculation
In such cases the decision mostly rests on management’s judgment and their risk appetite. This has been a guide to the discounted payback period and its meaning. Here we learn how to calculate a discounted period using its formula along with practical examples. Here we also provide you with a discounted payback period calculator with a downloadable excel template. NPV is a complementary metric to be assessed alongside discounted payback period as opposed to being an alternative.
- Amanda Bellucco-Chatham is an editor, writer, and fact-checker with years of experience researching personal finance topics.
- The project is acceptable according to simple payback period method because the recovery period under this method (2.5 years) is less than the maximum desired payback period of the management (3 years).
- In other circumstances, we may see projects where the payback occurs during, rather than at the end of, a given year.
Discounted Payback Period Example Calculation
For this reason, the simple payback period may be favorable, while the discounted payback period might indicate an unfavorable investment. The discounted payback period indicates the profitability of a project while reflecting the timing of cash flows and the time value of money. It helps a company to determine whether to invest in a project or not. If the discounted payback period of a project is longer than its useful life, the company should reject the project. Payback period doesn’t take into account money’s time value or cash flows beyond payback period.
What Is the Decision Rule for a Discounted Payback Period?
This makes it a more realistic indicator of whether money should be spent today or kept aside for future projects. This is especially important when weighing up multiple opportunities. You may 3 important tax dates you need to know for 2016 have three options in front of you but only have enough capital to invest in one right now. Understanding how long it will take the project to recoup is important to making that decision.
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This is compared to the initial outlay of capital for the investment. An initial investment of $2,324,000 is expected to generate $600,000 per year for 6 years. Calculate the discounted payback period of the investment if the discount rate is 11%. The discounted payback period, on the other hand, does take this into account by incorporating what is known as a discount rate (the rate at which future cash flows are discounted back to a present value). 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. In other words, DPP is used tocalculate the period in which the initial investment is paid back.
This means that you would need to earn a return of at least 19.6% on your investment to break even. This means that you would only invest in this project if you could get a return of 20% or more. UsefulnessThe time value of money is considered when using discounted payback, but otherwise the points made previously regarding the usefulness of payback hold for discounted payback as well.
Cash Flow Projections and DPP Calculation
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. The main advantage is that the metric takes into account money’s time value. This is important because money today is worth more than money in the future. The discount rate represents the opportunity cost of investing your money.
In particular, the added step of discounting a project’s cash flows is critical for projects with prolonged payback periods (i.e., 10+ years). The numbers used in this example are stemming from the case study introduced in our project business case article where you will also find the results of the simple payback period method. In this analysis, 3 project alternatives are compared with each other, using the discounted payback period as one of the success measures. In project management, this measure is often used as a part of a cost-benefit analysis, supplementing other profitability-focused indicators such as internal rate of return or return on investment. It can however also be leveraged to measure the success of an investment or project in hindsight and determine the point at which an initial investment has actually paid back. Payback period refers to the number of years it will take to pay back the initial investment.
It is primarily used to calculate the projected return from a proposed capital investment opportunity. Second, we must subtract the discounted cash flows from the initial cost figure in order to obtain the discounted payback period. Once we’ve calculated the discounted cash flows for each period of the project, we can subtract them from the initial cost figure until we arrive at zero. Discounted payback period refers to time needed to recoup your original investment.
That’s a significantly shorter period of time than 7.28, so you can see how the application of the principle of the time value of money can dramatically affect investment decisions. Both are designed to assess whether a given project should be invested in. However, the standard payback period treats cash flows as if they have the same value, regardless of when the revenue is received.
The point after that is when cash flows will be above the initial cost. We see that in year 3, the investment is not just recovered but the remaining cash inflow is surplus. The initial investment of the company would be recovered in 2.5 years.
The discounted payback period is a simple metric to determine if an investment will be sufficiently profitable to justify the initial cost. It uses the predicted returns from the investment, but also takes into consideration the diminishing value of future returns. The payback period is the amount of time for a project to break even in cash collections using nominal dollars. The basic method of the discounted payback period is taking the future estimated cash flows of a project and discounting them to the present value.
