Discounted Payback Period: Definition, Formula, Example & Calculator

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. Many managers and investors thus prefer to use NPV as a tool for making investment decisions. The NPV is the difference between the present value of cash coming in and the current value of cash going out over a period of time. Although calculating the payback period is useful in financial and capital budgeting, this metric has applications in other industries. It can be used by homeowners and businesses to calculate the return on energy-efficient technologies such as solar panels and insulation, including maintenance and upgrades.

Simple Payback Period vs. Discounted Method

Also, the cumulative cash flow is replaced by cumulative discounted cash flow. The shorter a discounted payback period is means the sooner a project or investment will generate cash flows to cover the initial cost. A general rule to consider when using the discounted payback period is to accept projects that have a payback period that is shorter than the target timeframe. From above example, we can observe that the outcome with discounted payback method is less favorable than with simple payback method. Since discounting decreases the value of cash flows, the discounted payback period will always be longer than the simple payback period as long as the cash flows and discount rate are positive. The discounted payback period is the period of time over which the cash flows from an investment pay back the initial investment, factoring in the time value of money.

Examples of Applying the DPP

These cash flows are then reduced by their present value factor to reflect the discounting process. This can be done using the present value function and a table in a spreadsheet program. We can see that the payback period is either five years if cash flows arise at the end of the year or four years and (5,000/17,500 x 12) three months (to the nearest month) if cash flows arise during the year.

Discounted Payback Period Example Calculation

Since the project’s life is calculated at 5 years, we can infer that the project returns a positive NPV. Other metrics, such as the internal rate of return (IRR), profitability index (PI), net present value (NPV), and effective annual annuity (EAA) can also be used to quantify the profitability of a given project. To make the best decision about whether to pursue a project or not, a company’s management needs to decide which metrics to prioritize. To begin, the periodic cash flows of a project must be estimated and shown by each period in a table or spreadsheet.

• You need to provide the two inputs of Cumulative cash flow in a year before recovery and Discounted cash flow in a year after recovery.
• Suppose a company is considering whether to approve or reject a proposed project.
• 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.
• The initial outflow of cash flows is worth more right now, given the opportunity cost of capital, and the cash flows generated in the future are worth less the further out they extend.

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 following tables contain the cash flowforecasts of each of these options. The discount rate was set at 12% andremains constant for all how to obtain a copy of your tax return 2020 periods. In such situations, we will first take the difference between the year-end cash flow and the initial cost left to reduce. Next, we divide the number by the year-end cash flow in order to get the percentage of the time period left over after the project has been paid back.

Formulation of the Discounted Payback Period

However, it doesn’t take into account money’s time value, which is the idea that a dollar today is worth more than a dollar in the future. In this case, we are given the profit figure so need to adjust for depreciation of ($40,000/8 years) $5,000 per year, to give an annual cash flow of ($12,500 + $5,000) $17,500. DefinitionPayback is defined as the length of time it takes the net cash revenue / cash cost savings of a project to payback the initial investment.

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. The payback period is the amount of time it takes to break even on an investment. The appropriate timeframe for an investment will vary depending on the type of project or investment and the expectations of those undertaking it. A higher payback period means it will take longer for a company to cover its initial investment.

She has worked in multiple cities covering breaking news, politics, education, and more. 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.