Discounted Payback Period Definition, Formula, and Example

The implied payback period should thus be longer under the discounted method. Management then looks at a variety of metrics in order to obtain complete information. Comparing various profitability metrics for all projects is important when making a well-informed decision. The management of Health Supplement Inc. wants to reduce its labor cost by installing a new machine in its production process. For this purpose, two types of machines are available in the market – Machine X and Machine Y. Machine X would cost $18,000 where as Machine Y would cost $15,000. Financial modeling best practices require calculations to be transparent and easily auditable.

Also, the cumulative cash flow is replaced by cumulative discounted cash flow. 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. To calculate the cumulative cash flow balance, add the present value of cash flows to the previous year’s balance.

1. The difference between both indicators is
   that the discounted payback period takes the time value of money into account.
2. This is especially useful because companies and investors frequently have to choose between multiple projects or investments.
3. 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.
4. Have you been investing and are wondering about some of the different strategies you can use to maximize your return?

When deciding on which project to undertake, a company or investor wants to know when their investment will pay off, i.e., when the project’s cash flows cover the project’s costs. The table is structured the same as the previous example, however, the cash flows are discounted to account for 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. 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.

Payback Period Explained, With the Formula and How to Calculate It

The payback period disregards the time value of money and is determined by counting the number of years it takes to recover the funds invested. For example, if it takes five years to recover the cost of an investment, the payback period is five years. The term payback period refers to the amount of time it takes to recover the cost of an investment. https://intuit-payroll.org/ Simply put, it is the length of time an investment reaches a breakeven point. Based on the project’s risk profile and the returns on comparable investments, the discount rate – i.e., the required rate of return – is assumed to be 10%. However, one common criticism of the simple payback period metric is that the time value of money is neglected.

Decision Rule

Projects with higher cash flows toward the end of their life will experience more significant discounting. As a result, the payback period may yield a positive result, whereas the discounted payback period yields a negative outcome. As the equation above shows, the payback period calculation is a simple one. 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. Getting repaid or recovering the initial cost of a project or investment should be achieved as quickly as it allows. 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.

This can be done using the present value function and a table in a spreadsheet program. The following example illustrates the computation of both simple and discounted payback period as well as explains how the two analysis approaches differ from each other. The next step is to subtract the number from 1 to obtain the percent of the year at which the project is paid back.

Payback period refers to how many years it will take to pay back the initial investment. The simple payback period doesn’t take into account money’s time value. The discounted payback period has a similar purpose as the payback period which is to determine how long it takes until variable overhead spending variance an initial investment is amortized through the cash flows generated by this asset. In capital budgeting, the payback period is defined as the amount of time necessary for a company to recoup the cost of an initial investment using the cash flows generated by an investment.

Prepare a table to calculate discounted cash flow of each period by multiplying the actual cash flows by present value factor. The Payback Period measures the amount of time required to recoup the cost of an initial investment via the cash flows generated by the investment. Payback period refers to the number of years it will take to pay back the initial investment.

Depreciation Calculators

Unlike the regular payback period, the discounted payback period metric considers this depreciation of your money. The value obtained using the discounted payback period calculator will be closer to reality, although undoubtedly more pessimistic. The payback period for this project is 3.375 years which is longer than the maximum desired payback period of the management (3 years). The discounted payback period determines the payback period using the time value of money.

Simple Payback Period vs. Discounted Method

Thus, the project is deemed illiquid and the probability of there being comparatively more profitable projects with quicker recoveries of the initial outflow is far greater. 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. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. All of the necessary inputs for our payback period calculation are shown below.

The two calculated values – the Year number and the fractional amount – can be added together to arrive at the estimated payback period. The calculation method is illustrated through the example given below. 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. I will briefly explain how the payback period functions to help you better understand the concept.

The discounted payback period calculation begins with the -$3,000 cash outlay in the starting period. The time it takes for the present value of future cash flows to equal the initial cost of a project indicates when the project or investment will break even. Payback period doesn’t take into account money’s time value or cash flows beyond payback period. 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 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.

Knowing when one project will pay off versus another makes the decision easier. Next, the second column (Cumulative Cash Flows) tracks the net gain/(loss) to date by adding the current year’s cash flow amount to the net cash flow balance from the prior year. As a general rule of thumb, the shorter the payback period, the more attractive the investment, and the better off the company would be. Discounted payback period process is a helpful metric to assess whether or not an investment is worth pursuing. This means that you would only invest in this project if you could get a return of 20% or more. In fact, the only difference is that the cash flows are discounted in the latter, as is implied by the name.

To calculate discounted payback period, you need to discount all of the cash flows back to their present value. The present value is the value of a future payment or series of payments, discounted back to the present. The calculator below helps you calculate the discounted payback period based on the amount you initially invest, the discount rate, and the number of years. So, the discounted payback period would take 1.98 years to cover the initial cost of $8,000. When using this metric, it’s important to keep in mind that a longer payback period doesn’t necessarily mean an investment is bad. You should also consider factors such as money’s time value and the overall risk of the investment.

A project may have a longer discounted payback period but also a higher NPV than another if it creates much more cash inflows after its discounted payback period. Unlike net present value , profitability index and internal rate of return method, payback method does not take into account the time value of money. A modified variant of this method is the discounted payback method which considers the time value of money.