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Discounted Payback Period

Discounted Payback Period

What Is the Discounted Payback Period?

The discounted payback period is a capital budgeting methodology used to decide the profitability of a project. A discounted payback period gives the number of years it takes to break even from undertaking the initial expenditure, by discounting future cash flows and perceiving the time value of money. The measurement is utilized to assess the feasibility and profitability of a given project.

The more simplified payback period formula, which basically separates the total cash outlay for the project by the average annual cash flows, doesn't give as accurate of a response to whether to take on a project since it expects only one, upfront investment, and doesn't factor in the time value of money.

Figuring out the Discounted Payback Period

While settling on any project to set out on, a company or investor needs to know when their investment will pay off, meaning when the cash flows generated from the project will cover the cost of the project.

This is particularly helpful on the grounds that companies and investors typically need to pick either more than one project or investment, so having the option to decide when certain projects will pay back compared to others settles on the choice simpler.

The fundamental method of the discounted payback period is taking what was in store estimated cash flows of a project and discounting them to the present value. This is compared to the initial outlay of capital for the investment.

The period of time that a project or investment takes for the current value of future cash flows to rise to the initial cost gives an indication of when the project or investment will break even. The point after that is when cash flows will be over the initial cost.

The more limited a discounted payback period is means the sooner a project or investment will generate cash flows to cover the initial cost. A basic principle to consider while utilizing the discounted payback period is to acknowledge projects that have a payback period that is more limited than the target time period.

A company can compare its required break-even date for a project to the place where the project will break even as per the discounted cash flows utilized in the discounted payback period analysis, to support or reject the project.

Working out the Discounted Payback Period

To start, the periodic cash flows of a project must be estimated and shown by every period in a table or bookkeeping sheet. These cash flows are then diminished by their present value factor to mirror the discounting system. This should be possible utilizing the current value function and a table in a bookkeeping sheet program.

Next, expecting the project begins with a large cash outflow, or investment to start the project, what was in store discounted cash inflows are netted against the initial investment outflow. The discounted payback period process is applied to each extra period's cash inflow to find the place where the inflows equivalent the outflows. Right now, the project's initial cost has been paid off, with the payback period being decreased to zero.

Payback Period versus Discounted Payback Period

The payback period is the amount of time for a project to break even in cash collections utilizing nominal dollars. On the other hand, the discounted payback period mirrors the amount of time important to break even in a project, put together not just with respect to what cash flows happen however when they happen and the predominant rate of return in the market.

These two calculations, albeit comparable, may not return a similar outcome due to the discounting of cash flows. For instance, projects with higher cash flows close to the furthest limit of a project's life will experience greater discounting due to compound interest. Consequently, the payback period might return a positive figure, while the discounted payback period returns a negative figure.

Illustration of the Discounted Payback Period

Expect that Company A has a project requiring an initial cash outlay of $3,000. The project is expected to return $1,000 every period for the next five periods, and the proper discount rate is 4%. The discounted payback period calculation starts with the - $3,000 cash outlay in the starting period. The main period will experience a +$1,000 cash inflow.

Utilizing the current value discount calculation, this figure is $1,000/1.04 = $961.54. In this way, after the primary period, the project actually requires $3,000 - $961.54 = $2,038.46 to break even. After the discounted cash flows of $1,000/(1.04)2 = $924.56 in period two, and $1,000/(1.04)3 = $889.00 in period three, the net project balance is $3,000 - ($961.54 +$924.56 + $889.00) = $224.90.

Consequently, after receipt of the fourth payment, which is discounted to $854.80, the project will have a positive balance of $629.90. Hence, the discounted payback period is at some point during the fourth period.

Features

  • The more limited a discounted payback period is, means the sooner a project or investment will generate cash flows to cover the initial cost.
  • The discounted payback period is utilized as part of capital budgeting to figure out which projects to take on.
  • The discounted payback period formula shows what amount of time it will require to recover an investment in view of noticing the current value of the project's projected cash flows.
  • More accurate than the standard payback period calculation, the discounted payback period factors in the time value of money.