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Discounted Payback Period: Definition, Formula, Example & Calculator

The lower the payback period, the more quickly an investment will pay for itself. Get instant access to lessons taught by experienced private equity pros and bulge bracket investment bankers including financial statement modeling, DCF, M&A, LBO, Comps and Excel Modeling. I will briefly explain how the payback period functions to help you better understand the concept.

  • In the example, the investment recovers its outlays in a little under three years.
  • It’s similar to determining how much money the investor currently needs to invest at this same rate in order to get the same cash flows at the same time in the future.
  • The project has an initial investment of $1,000 and will generate annual cash flows of $200 for the next 5 years.
  • It is calculated by taking a project’s future estimated cash flows and discounting them to the present value.
  • It enables firms to compare projects based on their payback cutoff to decide which is most worth it.

Discounted payback, in contrast, includes the time value of money, so it is viewed from a financial perspective. The following tables contain the cash flow
forecasts of each of these options. The discount rate was set at 12% and
remains constant for all periods. Read through for the definition and formula
of the DPP, 2 examples as well as a discounted payback period calculator. After the initial purchase period (Year 0), the project generates $5 million in cash flows each year. The formula for the simple payback period and discounted variation are virtually identical.

The discounted payback period is a good
alternative to the payback period if the time value of money or the expected
rate of return needs to be considered. If DPP were the only relevant indicator,
option 3 would be the project alternative of choice. The numbers used in this example are stemming from the case study introduced in our project business case article where you will also find the results of the simple payback period method.

She has worked in multiple cities covering breaking news, politics, education, and more. Her expertise is in personal finance and investing, and real estate. Discounted payback period serves as a way to tell whether an investment is worth undertaking.

The Payback Method

That said, an even better calculation to use in many instances is the net present value calculation. It calculates the time it will take to recover an investment based on observing the present value of the project’s projected cash flows. When deciding on which project to undertake, a company or investor wants to know when their investment will pay off, i.e., when the project’s cash flows cover the project’s costs. The discounted payback period (DPP) is a success measure of investments and projects. 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).

  • The discounted payback period calculation differs only in that it uses discounted cash flows.
  • This means that it doesn’t consider that money today is worth more than money in the future.
  • The period of time that a project or investment takes for the present value of future cash flows to equal the initial cost provides an indication of when the project or investment will break even.
  • First, we must discount (i.e., bring to the present value) the net cash flows that will occur during each year of the project.
  • First, the time value of money is not considered when you calculate the payback period.

The appropriate timeframe for an investment will vary depending on the type of project or investment and the expectations of those undertaking it. Investors may use payback in conjunction with return on investment (ROI) to determine whether or not to invest or enter a trade. 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. One way corporate financial analysts do this is with the payback period. The payback period is favored when a company is under liquidity constraints because it can show how long it should take to recover the money laid out for the project.

Calculate the cumulative discounted cash flows:

It’s a simple way to compare different investment options and to see if an investment is worth pursuing. 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.

Difference between Payback Periods & Discounted Payback Periods

Most capital budgeting formulas, such as net present value (NPV), internal rate of return (IRR), and discounted cash flow, consider the TVM. So if you pay statement of account an investor tomorrow, it must include an opportunity cost. Payback period refers to how many years it will take to pay back the initial investment.

Loan Calculators

Based solely on the payback period method, the second project is a better investment if the company wants to prioritize recapturing its capital investment as quickly as possible. Although calculating the payback period is useful in financial and capital budgeting, this metric has applications in other industries. It can be used by homeowners and businesses to calculate the return on energy-efficient technologies such as solar panels and insulation, including maintenance and upgrades. Since the project’s life is calculated at 5 years, we can infer that the project returns a positive NPV. To make the best decision about whether to pursue a project or not, a company’s management needs to decide which metrics to prioritize.

The point after that is when cash flows will be above the initial cost. Remember, the discounted payback period provides the time in which the initial investment will be recovered in terms of discounted or present value cash flows. Unlike the simple payback period, it provides a more realistic timeframe, factoring in the time value of money. Second, we must subtract the discounted cash flows from the initial cost figure to calculate.

Shape Calculators

So, once we calculate the discounted cash flows for each project period, we can subtract those discounted cash flows from the initial cost until we reach zero. 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. The difference between both indicators is
that the discounted payback period takes the time value of money into account. This means that an earlier cash flow has a higher value than a later cash flow
of the same amount (assuming a positive discount rate). The calculation
therefore requires the discounting of the cash flows using an interest or
discount rate.

Therefore, we are comparing the investment’s initial capital outlay. Projects with higher cash flows toward the end of their life will experience more significant discounting. As a result, the payback period may yield a positive result, whereas the discounted payback period yields a negative outcome. The initial outflow of cash flows is worth more right now, given the opportunity cost of capital, and the cash flows generated in the future are worth less the further out they extend. When deciding on any project to embark on, a company or investor wants to know when their investment will pay off, meaning when the cash flows generated from the project will cover the cost of the project. The payback period value is a popular metric because it’s easy to calculate and understand.

Both the payback period and the discounted payback period can be used to evaluate the profitability and feasibility of a specific project. Second, we must subtract the discounted cash flows from the initial cost figure in order to obtain the discounted payback period. Once we’ve calculated the discounted cash flows for each period of the project, we can subtract them from the initial cost figure until we arrive at zero. In addition to the first two flaws, the business owner also has to guess at the interest rate or cost of capital. 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 rule states that investment can only be considered if its discounted payback covers its initial cost before the cutoff time frame. Use this calculator to determine the DPP of
a series of cash flows of up to 6 periods. Insert the initial investment (as a negative
number since it is an outflow), the discount rate and the positive or negative
cash flows for periods 1 to 6. The present
value of each cash flow, as well as the cumulative discounted cash flows for
each period, are shown for reference.

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