What Is the Discounted Payback Period?

A discounted payback period is the number of years it takes to break even from undertaking an initial expenditure in a project. It's determined by discounting future cash flows and recognizing the 澳洲幸运5官方开奖结果体彩网:time value of money.

The discounted payback period is used in 澳洲幸运5官方开奖结果体彩网:capital budgeting to evalua🗹te the feasibility and profitability of a given project.

The simpler 澳洲幸运5官方开奖结果体彩网:payback period formula divides the total cash outlay for the project by the average annual 澳洲幸运5官方开奖结果体彩网:cash flows.

However, it's not as accurate as the discounted cash flow version because it assumes only one, upfront investment, and does not factor in the time value of money. So it's not as good at helping management to decide whether or not to take on a project.

Understanding the Discounted Payback Period

When deciding on any project to embark on,🌱 a company or investor wants to know when their investmen𒊎t will pay off, meaning when the cash flows generated from the project will more than cover the cost of the project or the investment.

This is pa🌊rticularly 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.

Basic DPBP Method

The basic method of the discounted payback period is to take the future estimated cash flows of a project and discount them to their 澳洲幸运5官方开奖结果体彩网:present value (using 澳洲幸运5官方开奖结果体彩网:discounted cash flows). This figure is compared to the initial outlay of capital for the 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 in๊vestment will break even. No cash flows after that will be diminished by the initial cost.

Use by Management

The shorter a discounted payback per🌠iod, the sooner a project or investment will generate𝔍 cash flows to cover the initial cost.

A general rule to consider is to accept projects that have a 澳洲幸运5官方开奖结果体彩网:payback period that is shorter than the project's targe🍃t timeframe.

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.

Calculating the Discounted Payback Period

To begin, the periodic cash flows of a project must be estimated and shown by each period in a table or 澳洲幸运5官方开奖结果体彩网:spreadsheet.

These cash flows are then reduced by their 澳洲幸运5官方开奖结果体彩网:present value factor to reflect the discounting process. This can be done using the present value function and a table ♍in 🍒a spreadsheet program.

Next, assuming the project starts with a large cash outflow (or investment), the future discount💝ed cash inflows are netted against the initial investment outflow.

This 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, and the payback period is reduced to zero.

Payback Period vs. Discounted Payback Period

The payback period is the amount of time it takes a project to break even in cash collections using nominal dollℱars🌠.

Alternatively, the discounted payback period reflects the amount of time necessary to break even based not only on what cash flows occur but when they occur and the prevailing 澳洲幸运5官方开奖结果体彩网:rate of return in the market.

These two calculatioꦺns, although similar, may not return the same resu🍎lt due to the discounting of cash flows.

For example, projects with higher cash flows toward the end of a project's life will experience greater discounting due to 澳洲幸运5官方开奖结果体彩网:compound interest.

For this reason, the pay♍back period may return a positive figure, while the discounted payback period returns a negative figure.

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 for each of the next five years, and the appropriate 澳洲幸运5官方开奖结果体彩网:discount rate is 4%.

The discounted payback period calculation begins with the -$3,000 cash outlay in the starting year (or period). The first year cash inflow is +$1,000.

Using the present value discount calculation, the discounted payback period 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.

💜 After receipt of the fourth year payment, which is discounted to $854.80, the project will have a positive balance of $629.90. Therefore, the discounted payback period is between thꩵree and four years.

The Bottom Line

The discounted payback period is a metric used to determine if an investment will be sufficiently profitable (in an acceptable time period) to justify its initial cost. It uses the predicted returns from the investment, and takes into consideration the diminishing value of future returns.