Discounted Payback Period takes into account the time value of money for a project to pay back the initial amount of investment.
The discounted payback period is less than a perfect method as the cash flows after the period is no considered, which excludes this measure from deciding profitability of a project. The discounted payback period is the time period the investment takes to break even with its future cash inflows.
How discounted payback period is calculated?
Discounted payback for a project can be calculated by, Initial investment of $5000 with a discount rate of 4%.
Even or equal cash flows of $2000 every year for 4 years.
CF0: -$5000, CF1: $2000, CF2: $2000, CF3:$2000
-5000 + 2000/(1.04) + 2000/(1.04)^2 + 2000/(1.04)^3
-5000 + 1923.07 + 1849.11 + 1778 which exceeds 5000.
2 + (5000 – 3772.18 (for 2 years)) / 1778 = 2.7
2 years 8 months and 15 days is the discounted payback period for the project of $5000 investment and $2000 even cash flows. Apart from the result, the method is same as calculating net present value,
Notice that the discounted period is more than the normal payback period, which is 2.5 years with the same cash flow. The investment committee values every day holding cash that is unused, or voluntarily restrains from delaying payments to the suppliers, a year of cash flow from a project without getting is opportunity cost accounted in unbearable.
Capital budgeting is the play area of payback periods. Whenever two projects clash in the basis of investments a project with lesser payback period is chosen in order to add value to the firm in short period eliminating the danger of opportunity cost.
Discounted Payback period Vs Payback period:
Discounted payback period not only accounts for cash inflows, when the cash flow has occurred and how much value is added accordingly. Payback period can be perfectly suitable if the project is set up and revenues are made in the same year.
In the case of discounting, some projects may have huge cash flows at a later stage, which is affected by years of discounting increasing the discounted payback period. Payback method just accounts for the time at which the cash flows are made and not the value that has been diminished all those years.