In fact, the only difference is that the cash flows are discounted in the latter, as is implied by the name. Because of the opportunity cost of receiving cash earlier and the ability to earn a return on those funds, a dollar today is worth more than a dollar received tomorrow. If you have a cumulative cash flow balance, you made a good investment. Thus, you should compare your year-end cash flow after making an investment.
- You can determine the payback period with a minimum of actual calculation by using one of the many recommended financial calculators available at most office supply stores.
- There is $400,000 of investment yet to be paid back at the end of Year 4, and there is $900,000 of cash flow projected for Year 5.
- Average cash flows represent the money going into and out of the 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 next step is to subtract the number from 1 to obtain the percent of the year at which the project is paid back. 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. Although calculating the payback period is useful in financial and capital budgeting, this metric has applications in other industries.
The time it takes for the present value of future cash flows to equal the initial cost of a project indicates when the project or investment will break even. Alaskan Lumber is considering the purchase of a band saw that costs $50,000 and which will generate $10,000 per year of net cash flow. Alaskan is also considering the purchase of a conveyor system for $36,000, which will reduce sawmill transport costs by $12,000 per year.
The Discounted Payback Period (DPP) Formula and a Sample Calculation
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. As the equation above shows, the payback period calculation is a simple one. It does not account for the time value of money, the effects of inflation, or the complexity of investments that may have unequal cash flow over time.
- The answer is found by dividing $200,000 by $100,000, which is two years.
- Discounted payback period (DPP) occurs when the negative cumulative discounted cash flows turn into positive cash flows which, in this case, is between the second and third year.
- You should also consider factors such as money’s time value and the overall risk of the investment.
- The discounted payback period calculation differs only in that it uses discounted cash flows.
- 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 company would use this calculation to decide if the investment in the new machine is worth the cost based on when they would recover the initial investment considering the time value of money. A technology firm decides to invest $2 million in the development of a new software product. The firm expects cash inflows of $700,000 per year for the next four years from the sale of this software. The firm uses a discount rate of 5% to account for the time value of money.
Therefore, we are comparing the investment’s initial capital outlay. The total cash flows over the five-year period are projected to be $2,000,000, which is an average of $400,000 per year. When divided into the $1,500,000 original investment, this results in a payback period of 3.75 years. However, the briefest perusal of the projected cash flows reveals that the flows are heavily weighted toward the far end of the time period, so the results of this calculation cannot be correct.
Although not entirely satisfactory, the calculation of the discounted payback period is comparatively better than a calculation using an undiscounted payback period as a capital budgeting decision criterion. That said, an even better calculation to use in many instances is the net present value calculation. So, the discounted payback period would take 1.98 years to cover the initial cost of $8,000. The decision criteria can vary depending on the organization’s goals, but it often involves comparing the calculated discounted payback period to a predetermined payback period or target set by the company.
Simple Payback Period vs. Discounted Method
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. Discounted Payback period is the tool that uses present value of cash inflow to measure the time require to recover the initial investment.
What is the Payback Method?
The shorter the payback period, the more likely the project will be accepted – all else being equal. Management then looks at a variety of metrics in order to obtain complete information. Usually, companies are deciding between multiple possible projects. Comparing various profitability metrics for all projects is important when making a well-informed decision. Discounted payback period serves as a way to tell whether an investment is worth undertaking.
Discounted Payback Period: Definition, Formula, Example & Calculator
Depending on the time period passed, your initial expenditure can affect your cash revenue. For example, let’s say you have an initial investment of $100 and an annual cash flow of $20. If you’re discounting at a rate of 10%, your payback period would what is the difference between deferred revenue and unearned revenue be 5 years. The payback period value is a popular metric because it’s easy to calculate and understand. 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.
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. To calculate discounted payback period, you need to discount all of the cash flows back to their present value. The present value is the value of a future payment or series of payments, discounted back to the present.
How to Calculate Discounted Payback Period
Consequently, it is not the best method to use when choosing an investment project. That said, this third flaw of the discounted payback period can be dismissed if the weighted average cost of capital is used as the rate at which to discount the cash flows. The faster a project or investment generates cash flows to cover the initial cost, the shorter the discounted payback period. Generally, projects should only be accepted if the payback period is shorter than the cutoff time frame. Payback period refers to how many years it will take to pay back the initial investment. The simple payback period doesn’t take into account money’s time value.
Average cash flows represent the money going into and out of the investment. Inflows are any items that go into the investment, such as deposits, dividends, or earnings. Cash outflows include any fees or charges that are subtracted from the balance. To begin, the periodic cash flows of a project must be estimated and shown by each period in a table or spreadsheet. 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.