Discounted Payback Period: Formula, Calculation, Steps & More

Ct represents the cash flow at time t, r is the discount rate, and  Iams is the initial investment. The time t is supposed to be determined when the sum of discounted cash flows equals or exceeds. 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. Use this calculator to determine the DPP ofa series of cash flows of up to 6 periods.

Step 4: Discount Each Cash Flow

Investors using the discounted payback period are less likely to overlook the impact of time on their investments. This method ensures that projects with extended payback periods are not favoured over those offering quicker returns, leading to wiser capital allocation decisions. In contrast, the discounted payback period takes into account the present value of expected future cash flows, offering a more precise evaluation of an investment’s true profitability. The shorter a discounted payback period, the sooner a project or investment will generate cash flows to cover the initial cost.

• The discounted payback period influences decision-making processes by offering insights into the recovery of initial investment costs.
• 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 cash flows are then added to calculate the cumulative discounted cash flows.
• While comparing two mutually exclusive projects, the one with the shorter discounted payback period should be accepted.

The core rate, which is adjusted to remove food and energy pricing, was 2.8%. Investors should consider the diminishing value of money when planning future investments. 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. The DPP can be used in a cost-benefit analysis as well as for the comparison of different project alternatives. Get instant access to video lessons taught by experienced investment bankers.

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. Once the original investment is decided on, ascertain the total cost of this investment to be recovered over time through future cash inflows. The discounted payback period is used in capital budgeting to evaluate the feasibility and profitability of a given project. 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.

This metric guides organizations in selecting projects that align with their financial objectives and long-term strategies. The two calculated values – the Year number and the fractional amount – can be added together to arrive at the estimated payback period. 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. 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.

What is the Decision Rule for Discounted Payback Period?

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. A project may have a longer discounted payback period but also a higher NPV than another if it creates much more cash inflows after its discounted payback period. 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. For example, let’s say you have an initial investment of $100 and an annual cash flow of $20.

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 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.

Discounted Payback Period Example Calculation

• Cash outlay of 50000, expected cash inflow of per annum over the next four years, and a discount rate of 10%.
• If DPP were the only relevant indicator,option 3 would be the project alternative of choice.
• Investors should consider the diminishing value of money when planning future investments.

The payback period indicates the time required for an investment to recoup its initial expenses through incoming cash without accounting for the time value of money. The above steps ensure that cash flows are treated relatively during discounting time. After the initial purchase period (Year 0), the project generates $5 million in cash flows each year.

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 the payback period (PBP). It does the united states not account for the time value of money, making it less effective in evaluating the true profitability of long-term investments. Accept the project if the discounted payback period is greater than the preferred recovery time.

Example of the Discounted Payback Period Formula

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. Find the year the cumulative discounted cash flow equals the initial investment. If the cumulative discounted cash flow lies between two years, interpolation can give an exact period. One of the disadvantages of discounted payback period analysis is that it ignores the cash flows after the payback period.

The discounted payback period is a widely accepted method in financial analysis to arrive at sound investment decisions. Discounted payback period is the time required to recover the project’s initial investment/costs with the discounted cash flows arising from the project. The discounted payback period is one of the capital budgeting techniques in valuating the investment appraisal. The discounted payback period method takes the time value of money into consideration. Only project relevant costs and revenue streams should be included in the discounted payback period analysis. The discounted payback period method considers the company cost of capital as a discounting factor.

Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. Suppose a company is considering whether to approve or reject a proposed project. You can think of it as the amount of money you would need today to have the same purchasing power as a future payment. Have you been investing and are wondering about some of the different strategies you can use to maximize your return? There can be lots of strategies to use, so it can often be difficult to know where to start.

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. 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.

That makes the investment cost-benefit analysis simpler to compare for the company management. It gives greater weight-age to early cash inflows from the project, which improves the project payback period. The discounted payback period is the time required to recoup an initial investment by applying a discount on future cash inflows to the present value. In contrast to the simple payback period, which does not consider the time value of money, the discounted payback period uses discounted cash flows to ascertain the precise recovery time.

Calculation Steps

The main difference is that the discounted payback period considers the time value of money, making it a more realistic approach. The payback period and discounted payback period are two different methods used to analyze when an investment is to be recovered. 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%.

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