It’s not a calculation of your total expected return, but it only indicates how long it will take to break even on an investment. Compared to the standard payback period calculation, discounted payback period is more complex and first requires a discount rate to be established. Beyond assessing projects against one another, the discounted payback period plays an important role in financial management, especially as it relates to investment evaluation and cash flow management.

What Is the Decision Rule for a Discounted Payback Period?

The payback period is the amount of time it takes to recover the cost of an investment. Simply put, it is the length of time an investment reaches a breakeven point. In any case, the decision for a project option or an investment decision should not be based on a single type of indicator. You can find the full case study here where we have also calculated the other indicators (such as NPV, IRR and ROI) that are part of a holistic cost-benefit analysis.

• The project has an initial investment of $1,000 and will generate annual cash flows of $200 for the next 5 years.
• This is the idea that money is worth more today than the same amount in the future because of the earning potential of the present money.
• Inflows are any items that go into the investment, such as deposits, dividends, or earnings.
• It’s useful for directly measuring how much wealth a project can generate, which you can then compare against the total investment cost.

Comparing discounted payback period with other financial metrics

In other words, it’s the amount of time it would take for your cumulative cash flows to equal your initial investment. The discounted payback period is a capital budgeting procedure that investors and business leaders use to assess the potential profitability of a given project. It’s based on the standard payback period but incorporates a discount rate that integrates the concept of the time value of money. The standard payback period is simply the amount of time an investment takes to recoup the initial cost. It can be calculated by dividing the initial investment cost by the annual net cash flow generated by that investment. Assume that Company A has a project requiring an initial cash outlay of $3,000.

Discount payback period: A 101 for small business owners

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 where’s my refund how to track your tax refund status the payback period and the discounted payback period can be used to evaluate the profitability and feasibility of a specific project. The rest of the procedure is similar to the calculation of simple payback period except that we have to use the discounted cash flows as calculated above instead of nominal cash flows.

There are a number of reasons why money decreases in value, the main one being inflation, but that’s outside the scope of today’s lesson. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. In the next step, we’ll create a table with the period numbers (”Year”) listed on the y-axis, whereas the x-axis consists of three columns.

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. 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.

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. When the negative cumulative discounted cash flows become positive, or recover, DPB occurs. The project has an initial investment of $1,000 and will generate annual cash flows of $100 for the next 10 years. 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 calculationtherefore requires the discounting of the cash flows using an interest ordiscount rate.

Finally, we proceed to convert the percentage in months (e.g., 25% would be 3 months, etc.) and add the figure to the last year in order to arrive at the final discounted payback period number. When using this metric, it’s important to keep in mind that a longer payback period doesn’t necessarily mean an investment is bad. You should also consider factors such as money’s time value and the overall risk of the investment.

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. Prepare a table to calculate discounted cash flow of each period by multiplying the actual cash flows by present value factor. Let’s say you’re considering investing in a project that has an upfront cost of $10 million and it’s expected to generate $2 million of additional revenue each year. You’ve decided to use your required rate of return of 10% as the discount rate.