The discounted payback period is a projection of the time it will take to receive a full recovery on an investment that has an accompanying discount rate. Payback period is the amount of time it takes to break even on an investment. The appropriate timeframe for an investment will vary depending on the type of project or investment and the expectations of those undertaking it.

## Time Value of Money and Discounting

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. Discounted payback period will usually be greater than regular payback period. Investments with higher cash flows toward the end of their lives will have greater discounting.

## An Example Of A Discounted Payback Periods

The simple payback period doesn’t take into account money’s time value. 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 $200 for the next 5 years. The main advantage is that the metric takes into account money’s time value. This is important because money today is worth more than money in the future.

- Payback period refers to how many years it will take to pay back the initial investment.
- The company would use this calculation to decide if the investment in the new machine is worth the cost based on when they would recover the initial investment considering the time value of money.
- Cash outflows include any fees or charges that are subtracted from the balance.
- With positive future cash flows, you can increase your cash outflow substantially over a period of time.

## Understanding the Discounted Payback Period

At the end of Year 4, the cumulative discounted cash flows exceed the initial investment. Discounted payback period refers to time needed to recoup your original investment. In other words, it’s the amount of time it would take for your cumulative cash flows to equal your initial investment. The faster a project or investment generates cash flows to cover the initial cost, the shorter the discounted payback period.

## What is the difference between the regular and discounted payback periods?

A discounted payback period is a type of payback period that uses discounted cash flows to calculate the time it takes an investment to pay back its initial cash flow. The discounted payback period is a financial metric that measures the time it takes for an investment to recover its initial cost, taking into account the time value of money. Most capital budgeting formulas, such as net present value (NPV), internal rate of return (IRR), and discounted cash flow, consider the TVM. So if you pay an investor tomorrow, it must include an opportunity cost.

## Calculating the Discounted Payback Period

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 a beginner’s guide to operating expenses for small businesses horizon. For example, the payback period on a home improvement project can be decades while the payback period on a construction project may be five years or less. Payback period refers to the number of years it will take to pay back the initial investment. The screenshot below shows that the time required to recover the initial $20 million cash outlay is estimated to be ~5.4 years under the discounted payback period method.

Learn from instructors who have worked at Morgan Stanley, HSBC, PwC, and Coca-Cola and master accounting, financial analysis, investment banking, financial modeling, and more. 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.

This is because future cash flows are worth less than present cash flows. When the negative cumulative discounted cash flows become positive, or recover, DPB occurs. The discounted payback period involves using discounted cash inflows rather than regular cash inflows. It involves the cash flows when they occurred and the rate of return in the market. The period of time that a project or investment takes for the present value of future cash flows to equal the initial cost provides an indication of when the project or investment will break even.

The payback period value is a popular metric because it’s easy to calculate and understand. However, it doesn’t take into account money’s time value, which is the idea that a dollar today is worth more than a dollar in the future. The discounted payback period is a goodalternative to the payback period if the time value of money or the expectedrate of return needs to be considered. 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%. Projects with higher cash flows toward the end of their life will experience more significant discounting.

Where CF is the Cash Flow for the respective nth year, and r is the opportunity cost of capital. Another advantage of this method is that it’s easy to calculate and understand. This makes it a good choice for decision-makers who don’t have a lot of experience with financial analysis. 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. All of the necessary inputs for our payback period calculation are shown below.

All else being equal, it’s usually better for a company to have a lower payback period as this typically represents a less risky investment. The quicker a company can recoup its initial investment, the less exposure the company has to a potential loss on the endeavor. The answer is found by dividing $200,000 by $100,000, which is two years. The second project will take less time to pay back, and the company’s earnings potential is greater. 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.

At this point, the project’s initial cost has been paid off, with the payback period being reduced to zero. The discounted payback period considers the present value of future cash flows by applying a discount rate, while the regular payback period does not account for the time value of money. Remember, the discounted payback period provides the time in which the initial investment will be recovered in terms of discounted or present value cash flows. Unlike the simple payback period, it provides a more realistic timeframe, factoring in the time value of money. 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.

Read through for the definition and formulaof the DPP, 2 examples as well as a discounted payback period calculator. In fact, the only difference is that the cash flows are discounted in the latter, as is implied by the name. From another perspective, the payback period is when an investment breaks even from an accounting standpoint. Discounted payback, in contrast, includes the time value of money, so it is viewed from a financial perspective. This is especially useful because companies and investors frequently have to choose between multiple projects or investments.

The investor can purchase the bond today for a discount and receive the full face value of the bond at maturity. The coupon payments found in a regular bond are discounted by a certain interest rate. They’re then added together with the discounted par value to determine the bond’s current value. When trying to estimate whether or not a new investment is financially viable, you should have a discount rate in mind. Note that period 0 doesn’t need to be discounted because that is the initial investment.

If you’re discounting at a rate of 10%, your payback period would be 5 years. Essentially, you can determine how long you’re going to need until your original investment amount is equal to other cash flows. https://www.business-accounting.net/ We will also cover the formula to calculate it and some of the biggest advantages and disadvantages. Calculate the discounted payback period of this project if Mr Smith is using a discount rate of 10%.