Discounted Payback Period

Definition of Discounted Payback Period

Discounted payback period is a capital budgeting method used to calculate the time period a project will take to break even and recover the initial investments. The calculation is done after considering the time value of money and discounting the future cash flows.

Formula for Calculating Discounted Payback Period

To calculate the discounted payback period, firstly we need to calculate the discounted cash inflow for each period using the following formula:

Discounted Cash Inflow = Actual cash inflow / (1 + i) n

Here,  i refers to the discount rate, and
n refers to the period for which the cash inflow relates

In the next step, we calculate the discounted payback period using the following formula:

Discounted Payback Period = A + B / C

Here,

A refers to the last period having negative discounted cash flow

B refers the value of discounted cumulative cash flow at the end of period A

C refers to the discounted cash flow after the period A

Discounted Payback Period

Example of discounted payback period

Initial investment = $ 70000

Years (n) = 5

Rate (i) = 12%

Cash Flow = $ 20000

Calculate what is Discounted Payback Period?

Solution

Year (n) Cash Flow (CF) Present Value Factor

PV = 1 / (1+i) n

Discounted Cash Flow

(CF x PV)

Cumulative Discounted Cash Flow (CCF)
0 70000 1 70000 70000.00
1 20000 0.89 17857.14 52142.86
2 20000 0.79 15943.87 36198.99
3 20000 0.71 14235.60 21963.39
4 20000 0.64 12710.36 9253.03
5 20000 0.57 11348.54 -2095.51

A i.e. the last period having negative discounted cash flow = 4 

B i.e. the value of discounted cumulative cash flow at the end of period A = 9253.03

C i.e. the discounted cash flow after the period A = 11348.54

Formula for calculating,

Discounted Payback Period = A + B / C

Discounted Payback Period = 4 + 9253.03 / 11348.54 = 4.81 years

Advantages and Disadvantages of Discounted Payback Period

Advantages

  • Many managers in the organization prefer discounted payback period because it considers the time value of money while calculating the payback period.
  • It determines the actual risk involved in a project and whether the investments made are recoverable or not.

Disadvantages

  • Calculation of payback period using discounted payback period method fails to determine whether the investment made will increase the firm’s value or not.
  • It does not consider the project that can last longer than the payback period. It ignores all the calculations beyond the discounted payback period.
  • The major problem with using discounted payback period is that it does not give the manager the exact information required to take a decision for investing in a project. The business manager has to assume the interest rate or the cost of capital to determine the payback period.
  • The calculation for discounted payback period can get complex if there are multiple negative cash flows during an investment period.

Conclusion

Discounted payback period is an upgraded capital budgeting method in comparison to simple payback period method. It helps to determine the time period required by a project to break even. Even though it suffers from some flaws, yet it is a good method to determine the viability of a project as it considers the time value of money. By incorporating this method along with other methods, the managers can arrive at a right decision and know the exact risk involved in a project.

References

Last updated on : March 21st, 2017
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