What is the Discounted Payback Period?

What is the Discounted 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.

The more simplified payback period formula, which simply divides the total cash outlay for the project by the average annual cash flows, doesn’t provide as accurate of an answer to the question of whether or not to take on a project because it assumes only one, upfront investment, and does not factor in the time value of money.

introduction of  Discounted Payback Period

The discounted payback period is used to evaluate the profitability and timing of cash inflows of a project or investment. In this metric, future cash flows are estimated and adjusted for the time value of money.

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 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.

Discounted Payback Period Formula

Discounted Payback Period = Year Before the Discounted Payback Period Occurs + (Cumulative Cash Flow in Year Before Recovery / Discounted Cash Flow in Year After Recovery)

From a capital budgeting perspective, this method is a much better method than a simple payback period.

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In this formula, there are two parts.

  • The first part is “a year before the period occurs.” This is important because by taking the prior year, we can get the integer.
  • The next part is the division between cumulative cash flow in the year before recovery and discounted cash flow in the year after recovery. The purpose of this part is to find out the proportion of how much is yet to be recovered.

Pros and Cons of Discounted Payback Period

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.

One of the disadvantages of discounted payback period analysis is that it ignores the cash flows after the payback period. Thus, it cannot tell a corporate manager or investor how the investment will perform afterward and how much value it will add in total. It may lead to decisions that contradict the NPV analysis.

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. Such an analysis is biased against long-term projects.

Example of the Discounted Payback Period

Assume that Company A has a project requiring an initial cash outlay of $3,000. The project is expected to return $1,000 each period for the next five periods, and the appropriate discount rate is 4%. The discounted payback period calculation begins with the -$3,000 cash outlay in the starting period. The first period will experience a +$1,000 cash inflow.

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Using the present value discount calculation, this figure is $1,000/1.04 = $961.54. Thus, after the first period, the project still requires $3,000 – $961.54 = $2,038.46 to break even. After the discounted cash flows of $1,000 / (1.04)2 = $924.56 in period two, and $1,000/(1.04)3 = $889.00 in period three, the net project balance is $3,000 – ($961.54 +$924.56 + $889.00) = $224.90.

Therefore, after receipt of the fourth payment, which is discounted to $854.80, the project will have a positive balance of $629.90. Therefore, the discounted payback period is sometime during the fourth period.

Conclusion

The discounted payback period is a good alternative to the payback period if the time value of money or the expected rate of return needs to be considered.

The DPP can be used in a cost-benefit analysis as well as for the comparison of different project alternatives.