Table of Contents
- What Is the Discounted Payback Period?
- Key Takeaways
- Understanding the Discounted Payback Period
- Use by Management
- Calculating the Discounted Payback Period
- Payback Period vs. Discounted Payback Period
- Example of the Discounted Payback Period
- How Do I Calculate the Payback Period?
- How Do I Calculate the Discounted Payback Period?
- What Is the Decision Rule for a Discounted Payback Period?
- The Bottom Line
What Is the Discounted Payback Period?
Let me explain the discounted payback period directly: it's the number of years it takes for you to break even on an initial expenditure in a project. You determine this by discounting future cash flows and accounting for the time value of money.
You use the discounted payback period in capital budgeting to assess the feasibility and profitability of a project. The basic payback period just divides the total cash outlay by average annual cash flows, but that's simpler and less accurate. It assumes one upfront investment and ignores the time value of money, so it doesn't help as much in deciding whether to pursue a project.
Key Takeaways
Here's what you need to know: the discounted payback period is a key metric in capital budgeting for selecting projects. It's more accurate than the standard payback period because it includes the time value of money. The formula reveals how long it takes to recoup your investment based on the present value of projected cash flows. Remember, a shorter discounted payback period means the project generates cash flows faster to cover the initial cost.
Understanding the Discounted Payback Period
When you're deciding on a project, you want to know when your investment will pay off—when the cash flows exceed the costs. This is crucial because you often have to choose between multiple options, and comparing payback times makes that decision straightforward.
The basic method involves taking the future estimated cash flows of a project and discounting them to present value. You compare this to the initial capital outlay. The time it takes for the present value of those cash flows to equal the initial cost shows when the project breaks even. After that point, no further cash flows are offset by the initial cost.
Use by Management
A shorter discounted payback period means the project or investment starts generating cash flows sooner to cover the initial cost. As a rule, you should accept projects with a payback period shorter than your target timeframe. For instance, compare the required break-even date to the discounted payback period—if it's shorter, that's a strong indicator to proceed.
Calculating the Discounted Payback Period
Start by estimating the periodic cash flows and listing them in a table or spreadsheet. Reduce these by their present value factor to account for discounting—you can use the present value function in a spreadsheet for this.
Assuming the project begins with a large cash outflow, net the future discounted inflows against this initial investment. Apply this to each period's inflow until inflows equal outflows. That's when the initial cost is paid off, and the payback period hits zero.
Payback Period vs. Discounted Payback Period
The standard payback period is the time to break even using nominal dollars. In contrast, the discounted version considers not just the cash flows but when they occur and the market's prevailing rate of return.
These calculations might differ because of discounting. Projects with cash flows later in life face more discounting due to compound interest, so the standard period might show positive while the discounted one shows negative.
Example of the Discounted Payback Period
Take Company A with a project needing a $3,000 initial outlay, expected to return $1,000 each of the next five years, at a 4% discount rate. It starts with -$3,000. Year one's $1,000 discounted is $961.54, leaving $2,038.46 needed.
Year two: $924.56, leaving $1,113.90. Year three: $889.00, leaving $224.90. Year four: $854.80, resulting in a positive $629.90. So the discounted payback is between three and four years.
Example of Discounted Payback Period Table
- Initial Investment: -$3,000, Discounted Value: -$3,000, Net Cost: -$3,000
- Year 1 Cash Flow: $1,000, Discounted Value: $961.54, Net Cost: -$2,038.46
- Year 2 Cash Flow: $1,000, Discounted Value: $924.56, Net Cost: -$1,113.90
- Year 3 Cash Flow: $1,000, Discounted Value: $889.00, Net Cost: -$224.90
- Year 4 Cash Flow: $1,000, Discounted Value: $854.80, Net Cost: +$629.90
How Do I Calculate the Payback Period?
For the standard payback period, divide the initial investment cost by the annual net cash flow generated.
How Do I Calculate the Discounted Payback Period?
Determine the initial cost, estimate annual cash flows, and set the discount rate. Calculate the present value of each cash flow and subtract from the cost. The period is the years until discounted cash flows exceed the initial investment.
What Is the Decision Rule for a Discounted Payback Period?
If the discounted payback period is less than the asset's useful life, the investment might be approved. Among options, choose the one with the shortest period for maximum profitability.
The Bottom Line
The discounted payback period determines if an investment is profitable enough within an acceptable time, using predicted returns and accounting for the diminishing value of future money.
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