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. Then calculate the present value of each instance of cash flow and subtract that from the cost. The discount payback period is the number of years it takes for the discounted cash flows to exceed the initial investment.

How Is the Discounted Payback Period Calculated?

The generic payback period, on the otherhand, does not involve discounting. Thus, the value of a cash flow equals its notionalvalue, regardless of whether it occurs in the 1st or in the 6thyear. However, ittends to be imprecise in cases of long cash flow projection horizons or cashflows that increase significantly over time. The discounted payback period (DPP) is a success measure of investments and projects. Although it is not explicitly mentioned in the Project Management Body of Knowledge (PMBOK) it has practical relevance in many projects as an enhanced version of knowing when you should request a third party evaluation the payback period (PBP). The payback period and discounted payback period are two different methods used to analyze when an investment is to be recovered.

How Do I Calculate the Payback Period?

This is particularly important because companies and investors usually have to choose between more than one project or investment. So being able to determine when certain projects will pay back compared to others makes the decision easier. The discounted payback period refers to the estimated amount of time it will take to make back the invested money.

This figure is compared to the initial outlay of capital for the investment. The payback period indicates how long it takes for an investment to reach a break-even point, where the cumulative cash inflows equal the initial investment. A shorter payback period generally signifies a lower risk and higher return potential.

Time Value of Money

In any case, the decision for a project option or an investment decision should not be based on a single type of indicator. You can find the full case study here where we have also calculated the other indicators (such as NPV, IRR and ROI) that are part of a holistic cost-benefit analysis. The following tables contain the cash flowforecasts of each of these options. In the arsenal of financial analysis tools, the payback period is just one of many metrics. It is often compared and contrasted with other measures such as the Net Present Value (NPV), Internal Rate of Return (IRR), and Discounted Payback Period.

Formula & Steps For Calculation

• The payback period is the time required for an investment to reach a break-even point, where the cumulative cash inflows equal the initial investment outlay.
• The discounted payback period indicates the profitability of a project while reflecting the timing of cash flows and the time value of money.
• It’s determined by discounting future cash flows and recognizing the time value of money.
• Liquidity risk is a major concern for banks, financial institutions, and businesses.

At this point, the project’s initial cost has been paid off, and the payback period is reduced to zero. So, for example, management can compare the required break-even date to the discounted payback period. If the latter’s metric (in years) is less than the required break-even date, that’s a positive sign that can play into the decision of whether or not to give the project the go-ahead. To make the best decision about whether to pursue a project or not, a company’s management needs to decide which metrics to prioritize. 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.

With positive future cash flows, you can increase your cash outflow substantially over a period of time. Depending on the time period passed, your initial expenditure can affect your cash revenue. The discounted payback period is a measureof how long it takes until the cumulated discounted net cash flows offset theinitial investment in an asset or a project.

The discounted payback period influences decision-making processes by offering insights into the recovery of initial investment costs. It aids in identifying investments that not only recoup their costs but also generate profits within a reasonable timeframe. Choosing investments with shorter discounted payback periods is essential for maximizing profitability and minimizing risks. Projects with quicker returns allow businesses to reinvest profits sooner, leading to faster growth and increased financial stability. Compared to the standard payback period, which solely focuses on the time taken to recoup the initial investment, the discounted payback period accounts for the appropriate discount rate. This adjustment reflects the opportunity cost of tying up capital and ensures a more comprehensive assessment.

Once the original investment is decided on, ascertain the total cost of this investment to be recovered over time through future cash inflows. Company A has selected a project which costs $ 350,000 and it expects to generate cash inflow $ 50,000 for ten years. In this figure, we have calculated the payback period for two projects using the same payback period calculation method and formula. The discounted payback period calculation begins with the -$3,000 cash outlay in the starting year (or period). This process is applied to each additional period’s cash inflow to find the point at which the inflows equal the outflows.

Depreciation Calculators

• Amanda Bellucco-Chatham is an editor, writer, and fact-checker with years of experience researching personal finance topics.
• Comparing various profitability metrics for all projects is important when making a well-informed decision.
• The decision rule is a simple rule to determine if an investment is worthwhile, and which of several investments is most worthwhile.
• Compared to the standard payback period, which solely focuses on the time taken to recoup the initial investment, the discounted payback period accounts for the appropriate discount rate.
• It can however also be leveraged to measure the success of an investment or project in hindsight and determine the point at which an initial investment has actually paid back.

In this example, the cumulative discountedcash flow does not turn positive at all. In other words, the investment will not be recoveredwithin the time horizon of this projection. The numbers used in this example are stemming from the case study introduced in our project business case article where you will also find the results of the simple payback period method.

A higher discount rate reduces the present value of future cash flows, potentially increasing the discounted payback period. Conversely, a lower discount rate makes future cash flows more valuable, leading to a shorter discounted payback period. Following the figure you can draw a timeline of a project, put the amount of cashflows year-wise, and cumulative cash flows, and then find out the time using the payback period formula. Drawing a timeline gives you a better representation of the project and helps you calculate more easily.

So, the two parts of the calculation (the cash flow and PV factor) are shown above.We can conclude from this that the DCF is the calculation of the PV factor and the actual cash inflow. 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. Therefore, it would be more practical to consider the time value of money when deciding which projects to approve (or reject) – which is where the discounted payback period variation comes in. For example, projects with higher cash flows toward the end of a project’s life will experience greater discounting due to compound interest. These what is a purchase order and how does it work two calculations, although similar, may not return the same result due to the discounting of cash flows. These cash flows are then reduced by their present value factor to reflect the discounting process.

While it improves upon the traditional payback period, the discounted payback period still does not account for cash flows beyond the recovery period. This means it does not measure overall project profitability, making it less effective for evaluating long-term returns. The discounted payback period is important because it accounts for the time value of money, ensuring that future cash flows are appropriately discounted. This makes it a more reliable metric for evaluating the feasibility of long-term projects. 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.

In this article, we will explore its significance, break down the calculation process, and provide practical examples to illustrate its application in real-world financial analysis. The discounted payback period is a valuable financial metric that refines the traditional payback period by incorporating the time value of money. Unlike the regular payback method, it provides a more accurate estimate of when an investment is truly recovered, making it a more reliable tool how to create a cash flow projection for decision-making.

But always keep in mind if the projects are independent or mutually exclusive. If undertaken, the initial investment in the project will cost the company approximately $20 million. The formula for the simple payback period and discounted variation are virtually identical. However, one common criticism of the simple payback period metric is that the time value of money is neglected. The payback period is the amount of time it takes a project to break even in cash collections using nominal dollars. To begin, the periodic cash flows of a project must be estimated and shown by each period in a table or spreadsheet.