Comparing various profitability metrics for all projects is important when making a well-informed decision. Financial modeling best practices require calculations to be transparent and easily auditable. The trouble with piling all of the calculations into a formula is that you can't easily see what numbers go where or what numbers are user inputs or hard-coded. First, we’ll calculate the metric under the non-discounted approach using the two assumptions below. The Discounted Payback Period is perceived as an improvement to the Payback Period. One should understand the payback time well, before diving into the DPBP.

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The point after that is when cash flows will be above the initial cost. The project has an initial investment of $1,000 and will generate annual cash flows of $200 for the next 5 years. 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.

Statistics and Analysis Calculators

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. All of the necessary inputs for our payback period calculation are shown below. The implied payback period should thus be longer under the discounted method.

Payback Period and Capital Budgeting

It helps assess the risk and profitability of an investment by considering the timing and value of cash flows, providing a more accurate picture of its financial feasibility. Option 1 has a discounted payback period of5.07 years, option 3 of 4.65 years while with option 2, a recovery of theinvestment is not achieved. The generic payback period, on the otherhand, does not involve discounting.

How to Calculate Discounted Payback Period

It involves the cash flows when they occurred and the rate of return in the market. 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. In capital budgeting, the payback period is defined as the amount of time necessary for a company to recoup the cost of an initial investment using the cash flows generated by an investment. 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 is the amount of time for a project to break even in cash collections using nominal dollars. The payback period is the number of years necessary to recover funds invested https://www.business-accounting.net/ in a project. Because we cover the negative cash flows related to the project sooner. The payback period shouldn’t be used as a measure of investment project profitability.

Factor Effect Cash Inflow

An initial investment of $2,324,000 is expected to generate $600,000 per year for 6 years. Calculate the discounted payback period of the investment if the discount rate is 11%. The discounted payback period indicates the profitability of a project while reflecting the timing of cash flows and the time value of money. If the discounted payback period of a project is longer than its useful life, the company should reject the project.

  1. The discounted payback period indicates the profitability of a project while reflecting the timing of cash flows and the time value of money.
  2. The time value of money is a fundamental concept in finance that suggests that a dollar in hand today is worth more than a dollar promised in the future.
  3. If short-term cash flows are a concern, a short payback period may be more attractive than a longer-term investment that has a higher NPV.

The discounted payback period is a modified version of the payback period that accounts for the time value of money. Both metrics are used to calculate the amount of time that it will take for a project to “break even,” or to get the point where the net cash flows generated cover the initial cost of the project. Both the payback period and the discounted payback period can be used to evaluate the profitability and feasibility of a specific project. From above example, we can observe that the outcome with discounted payback method is less favorable than with simple payback method.

The shorter the payback period, the more attractive the investment is considered. 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 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 is calculatedby discounting the net cash flows of each and every period and cumulating thediscounted cash flows until the amount of the initial investment is met. This requires the use of a discountrate which can be either a market interest rate or an expected return. Someorganizations may also choose to apply an accounting interest rate or theirweighted average cost of capital. Discounted payback method is a capital budgeting technique used to evaluate the profitability of a project based upon the inflows and outflows of cash. Under this technique, we first discount project’s all cash flows to their present value using a preset discount rate and then determine the time period within which the initial investment would be recovered. Since this method takes into account the time value of money, it can be considered as an upgraded variant of the simple payback method.

If DPP were the only relevant indicator,option 3 would be the project alternative of choice. In project management, this measure is often used as a part of a cost-benefit analysis, supplementing other profitability-focused indicators payroll tax such as internal rate of return or return on investment. 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.

Next, assuming the project starts with a large cash outflow, or investment to begin the project, the future discounted cash inflows are netted against the initial investment outflow. The discounted payback period process is applied to each additional period's cash inflow to find the point at which the inflows equal the outflows. At this point, the project's initial cost has been paid off, with the payback period being reduced to zero. We see that in year 3, the investment is not just recovered but the remaining cash inflow is surplus. The project is acceptable according to simple payback period method because the recovery period under this method (2.5 years) is less than the maximum desired payback period of the management (3 years).