Discounted payback method definition, explanation, example, advantages, disadvantages

The rest of the procedure is similar to the calculation of simple payback period except that we have to use the discounted cash flows as calculated above instead of nominal cash flows. Also, the cumulative cash flow is replaced by cumulative discounted cash flow. The payback period is the amount of time it takes for the cash flows from a project to pay back the initial investment. This is not the same as the discounted payback period, where those cash flows are discounted back to their present value before the payback calculation is made. Because no discounting is applied to the basic payback calculation, it always returns a payback period that is shorter than what would be obtained with the discounted payback period calculation.

If Rick took the $45,000 in cash flow each year and applied that against the $140,000 investment he would simply calculate $140,000 / $45,000 and get 3.11 years to break even. An initial investment of Juno Products Ltd. is $23,24,000 and expecting cash flow generate $600,000 per year for 6 years. Calculate the discounted period of the investment if the discount rate is 11%. After getting the cumulative present value of cash inflows, the Payback period to be calculated and at this stage calculation is similar to Traditional Payback period method. In traditional Payback method ” Cumulative cash flow” use and in a Discounted Cash flow method ” Discounted Cumulative Cash Flow” using and this is the difference of the two methods. As time value of money is the main focus, the present of value cash inflow to be discounted with the determine discount rate.

Understanding the Payback Period

The discounted payback period is a capital budgeting procedure used to determine the profitability of a project. A discounted payback period gives the number of years it takes to break even from undertaking the initial expenditure, by discounting future cash flows and recognizing the time value of money. The metric is used to evaluate the feasibility and profitability of a given project. https://turbo-tax.org/tax-dates-and-deadlines-in-2021/ 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. The discounted payback period involves using discounted cash inflows rather than regular cash inflows.

• In the Averaging method, the payback period formula is the annual cash a product or project is estimated to generate divided by the initial expenditure.
• Although it is not explicitly mentioned in the Project Management Body of Knowledge (PMBOK) it has practical relevance in many projects as an enhanced version of the payback period (PBP).
• A project or investment with a shorter discounted payback period will generate cash flows sooner, so the initial investment will be recovered sooner.
• In order to find the discounted cash flow amount he must find out the present value factor which considers the diminished value of cash flows in future years.
• One observation to make from the example above is that the discounted payback period of the project is reached exactly at the end of a year.

The discounted payback method may seem like an attractive approach at first glance. On closer inspection, however, we find that it shares some of the same significant flaws as the simple payback method. For example, it first arbitrarily chooses a cutoff period and then ignores all cash flows that occur after that period. This approach might look a bit similar to net present value method but is, in fact, just a poor compromise between NPV and simple payback technique. Discounted Payback Period incorporates the principle of time value of money into the payback period calculation which provides a more relevant measure of the risk of non-recoverability of investments.

How To Calculate the Payback Period in Excel?

The other project would have a payback period of 4.25 years but would generate higher returns on investment than the first project. However, based solely on the payback period, the firm would select the first project over this alternative. The implications of this are that firms may choose investments with shorter payback periods at the expense of profitability. While the payback period shows us how long it takes for the return on investment, it does not show what the return on investment is.

The discounted payback period is a modified version of the payback period that accounts for the time value of money. Both metrics are used to calculate the amount of time that it will take for a project to “break even,” or to get the point where the net cash flows generated cover the initial cost of the project. Both the payback period and the discounted payback period can be used to evaluate the profitability and feasibility of a specific project. Use this calculator to determine the DPP of

a series of cash flows of up to 6 periods. Insert the initial investment (as a negative

number since it is an outflow), the discount rate and the positive or negative

cash flows for periods 1 to 6. The present

value of each cash flow, as well as the cumulative discounted cash flows for

each period, are shown for reference.

How to calculate the Payback Period?

Referring to our example, cash flows continue beyond period 3, but they are not relevant in accordance with the decision rule in the payback method. For example, a firm may decide to invest in an asset with an initial cost of $1 million. Over the next five years, the firm receives positive cash flows that diminish over time. As seen from the graph below, the initial investment is fully offset by positive cash flows somewhere between periods 2 and 3. Payback period is the time required to recover the cost of initial investment, it the time which the investment reaches its breakeven points. It calculates the number of years we need to generated the initial cost of investment.

• For this reason, the simple payback period may be favorable, while the discounted payback period might indicate an unfavorable investment.
• The following tables contain the cash flow

  forecasts of each of these options.

• The calculation

  therefore requires the discounting of the cash flows using an interest or

  discount rate.

• Let’s say that Rick will spend $140,000 to buy the second location and expects to have cash flows of $45,000 per year.
• These cash flows are then reduced by their present value factor to reflect the discounting process.

Boomer is one of the most successful, diversified investment firms that prides itself on exceptional decision-making and stellar investment opportunities through its global network. Discounted Payback Period is the duration that an investment requires to recover its cost taking into consideration the time value of money. As you can see in the example below, a DCF model is used to graph the payback period (middle graph below). I will briefly explain how the payback period functions to help you better understand the concept.

AccountingTools

This is accomplished by using a discount rate to calculate a present value factor for the cash flows in each year after the investment is made. The present value factor is multiplied by the annual cash flow to determine a discounted cash flow. 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.

Based solely on the payback period method, the second project is a better investment if the company wants to prioritize recapturing its capital investment as quickly as possible. Although calculating the payback period is useful in financial and capital budgeting, this metric has applications in other industries. It can be used by homeowners and businesses to calculate the return on energy-efficient technologies such as solar panels and insulation, including maintenance and upgrades. To begin, the periodic cash flows of a project must be estimated and shown by each period in a table or spreadsheet. These cash flows are then reduced by their present value factor to reflect the discounting process. This can be done using the present value function and a table in a spreadsheet program.