Others like to use it as an additional point of reference in a capital budgeting decision framework. Average cash flows represent the money going into and out of the investment. Inflows are any items that go into the investment, such as deposits, dividends, or earnings. Cash outflows include any fees or charges that are subtracted from the balance. For example, if solar panels cost $5,000 to install and the savings are $100 each month, it would take 4.2 years to reach the payback period. In most cases, this is a pretty good payback period as experts say it can take as much as years for residential homeowners in the United States to break even on their investment.

This approach might look a bit similar to net present value method but is, in fact, just a poor compromise between NPV and simple payback technique. The discounted payback method takes into account the present how to create a small business budget value of cash flows. The Discounted Payback Period calculation takes these cash flows and discount rate into account, providing a more nuanced understanding of the return period of an investment.

Initially an investment of $100,000 can be expected to make an income of $35k per annum for 4 years. Once you have this information, you can use the following formula to calculate discounted payback period. The Discounted Payback Period estimates the time needed for a project to generate enough cash flows to break even and become profitable. To begin, the periodic cash flows of a project must be estimated and shown by each period in a table or spreadsheet. These cash flows are then reduced by their present value factor to reflect the discounting process.

Discounted Payback Period Example Calculation

Option 1 has a discounted payback period of
5.07 years, option 3 of 4.65 years while with option 2, a recovery of the
investment is not achieved. The generic payback period, on the other
hand, does not involve discounting. Thus, the value of a cash flow equals its notional
value, regardless of whether it occurs in the 1st or in the 6th
year. However, it
tends to be imprecise in cases of long cash flow projection horizons or cash
flows that increase significantly over time. The payback period for this project is 3.375 years which is longer than the maximum desired payback period of the management (3 years).

  • Most capital budgeting formulas, such as net present value (NPV), internal rate of return (IRR), and discounted cash flow, consider the TVM.
  • The formula for computing the discounted payback period is as follows.
  • Once you have this information, you can use the following formula to calculate discounted 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. The discount rate represents the opportunity cost of investing your money. These two calculations, although similar, may not return the same result 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 compound interest.

In this analysis, 3 project alternatives are compared with each other, using the discounted payback period as one of the success measures. Unlike net present value , profitability index and internal rate of return method, payback method does not take into account the time value of money. A modified variant of this method is the discounted payback method which considers the time value of money.

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 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. Essentially, you can determine how long you’re going to need until your original investment amount is equal to other cash flows. We will also cover the formula to calculate it and some of the biggest advantages and disadvantages.

What Is the Difference between Payback Period and

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. When the negative cumulative discounted cash flows become positive, or recover, DPB occurs. 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 point after that is when cash flows will be above the initial cost. The difference between both indicators is
that the discounted payback period takes the time value of money into account.

Is a Higher Payback Period Better Than a Lower Payback Period?

Alternatively, go to one of several financial online financial calculator sites. Management then looks at a variety of metrics in order to obtain complete information. Comparing various profitability metrics for all projects is important when making a well-informed decision. 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. Depreciation is a non-cash expense and therefore has been ignored while calculating the payback period of the project.

Calculation

This means that you would need to earn a return of at least 19.6% on your investment to break even. This means that you would only invest in this project if you could get a return of 20% or more. In fact, the only difference is that the cash flows are discounted in the latter, as is implied by the name. Because of the opportunity cost of receiving cash earlier and the ability to earn a return on those funds, a dollar today is worth more than a dollar received tomorrow. So, the two parts of the calculation (the cash flow and PV factor) are shown above.

In this example, the cumulative discounted
cash flow does not turn positive at all. In other words, the investment will not be recovered
within the time horizon of this projection. One of the disadvantages of discounted payback period analysis is that it ignores the cash flows after the payback period. Thus, it cannot tell a corporate manager or investor how the investment will perform afterward and how much value it will add in total. The discounted payback period is a capital budgeting procedure which is frequently used to determine the profitability of a project. It is an extension of the payback period method of capital budgeting, which does not account for the time value of money.

Advantages of 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 each period for the next five periods, and the appropriate discount rate is 4%. The discounted payback period calculation begins with the -$3,000 cash outlay in the starting period.

Create a free account to unlock this Template

Corporations and business managers also use the payback period to evaluate the relative favorability of potential projects in conjunction with tools like IRR or NPV. In particular, the added step of discounting a project’s cash flows is critical for projects with prolonged payback periods (i.e., 10+ years). In project management, this measure is often used as a part of a cost-benefit analysis, supplementing other profitability-focused indicators 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.

Amanda Bellucco-Chatham is an editor, writer, and fact-checker with years of experience researching personal finance topics. Specialties include general financial planning, career development, lending, retirement, tax preparation, and credit.