Discounted payback method definition, explanation, example, advantages, disadvantages

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. 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.

It offers a more accurate measure of how long it takes to recover an investment, considering the discounted value of future cash flows.
While it provides useful insights, it should be used alongside other metrics to evaluate the overall profitability and attractiveness of an investment.
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).
This method is more accurate since it discounts future cash flows and presents a more realistic approach to estimating investment viability.
However, ittends to be imprecise in cases of long cash flow projection horizons or cashflows that increase significantly over time.

This makes it a good choice for decision-makers who don’t have a lot of experience with financial analysis. This means that you would only invest in this project if you could get a return of 20% or more. 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. This metric guides organizations in selecting projects that align with their financial objectives and long-term strategies.

Calculation

The lower the payback period, the more quickly an investment will pay for itself. The DPP can be used in a cost-benefit analysis as well as for the comparison of different project alternatives. In large project appraisals, it may not present a true picture or the forecast that may affect the resource allocation and project appraisal decisions. In this article, we will demonstrate 3 methods to calculate Discounted Payback Period in Excel.

Simple Payback Period vs. Discounted Method

It offers a more accurate measure of how long it takes to recover an investment, considering the discounted value of future cash flows. While it provides useful insights, it should be used alongside other metrics to evaluate the overall profitability and attractiveness of an investment. When evaluating investments, the discounted payback period plays a significant role in providing a more accurate picture of the project’s profitability. By considering the time value of money, this metric accounts for the opportunity cost of capital and adjusts for risk. As a result, it offers a more realistic perspective on the investment’s potential returns. The discount rate, often the weighted average cost of capital (WACC) or a required rate of return, is used to calculate the present value of future cash flows.

Method 1 – Using PV Function

The project has an initial investment of $1,000 and will generate annual cash flows of $200 for the next 5 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 invoice templates gallery success of an investment or project in hindsight and determine the point at which an initial investment has actually paid back. Based on the payback period alone, Project A seems more attractive, with a shorter payback period.

Logistics Calculators

Get instant access to video lessons taught by experienced investment bankers. 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. 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. Have you been investing and are wondering about some of the different strategies you can use to maximize your return?

Risk-Adjusted Return on Capital – RAROC Model Full Guide Calculation process

Thprojectent value adjustment maximizes the decision-making process and accurately depicts the project’s profitability. A shorter discounted payback period signifies that a project generates quicker cash flows to cover the initial investment costs. This rapid recovery indicates higher liquidity and reduced risk exposure for the investor, making it an attractive metric for decision-making in capital budgeting.

The discounted payback period is the time when the cash inflows break-even the total initial investment. In other words, the time when the negative cumulative cash flow turn to positive. In summary, the discounted payback period is a valuable financial metric that improves upon the traditional payback period by incorporating the time value of money.

What is the discounted payback period formula?

If the discounted payback period for a certain asset is less than the useful life of that asset, the investment might be approved. If a business is choosing between several potential investments, the one with the shortest discounted payback period will be the most profitable. 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. In this case, the discounting rate is 10% and the discounted payback period is around 8 years, whereas the discounted payback period is 10 years if the discount rate is 15%. So, this means as the discount rate increases, the difference in payback periods of a discounted pay period and simple payback period increases.

Next, identify when the total of these discounted cash flows matches the original investment amount.
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 discounted payback method takes into account the present value of cash flows.
There is no universal “good” discounted payback period—it depends on the industry, project type, and investment risk.

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. Essentially, you can determine how long you’re going to need until your original investment amount is equal to other cash flows.

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. Prepare a table to calculate discounted cash flow of each period by multiplying the actual cash flows by present value factor. According to discounted payback method, the initial investment would be recovered in 3.15 years which is slightly more than the management’s maximum desired payback period of 3 years.

By discounting future cash flows using the firm’s cost of capital, businesses can assess project viability with greater precision, especially for long-term, high-cost investments. The discounted payback period is calculatedby discounting the net cash flows of each and every period and cumulating thediscounted cash flows until the amount of the initial investment is met. This requires the use of a discountrate which can be either a market interest rate or an expected return. Someorganizations may also choose to apply an accounting interest rate or theirweighted average cost of capital.

Discounted payback is accumulated depreciation a current asset period calculation is a simple way to analyze an investment. This means that it doesn’t consider that money today is worth more than money in the future. For example, let’s say you have an initial investment of $100 and an annual cash flow of $20.

The presentvalue of each cash flow, as well as the cumulative discounted cash flows foreach period, are shown cash disbursement journal for reference. The discounted payback period method provides a useful investment appraisal method. It can be best utilized in conjunction with other investment appraisal methods. However, a project with a shorter payback period with discounted cash flows should be taken on a priority basis. The discounted payback period can be calculated by first discounting the cash flows with the cost of capital of 7%.