The discounted payback period acts as a financial criterion for evaluating investment projects by determining the time required to recoup the initial costs, considering the time value of money. This method is more accurate since it discounts future cash flows and presents a more realistic approach to estimating investment viability. Hence, the discounted payback period is an important practical tool in capital budgeting essential in deciding whether a particular line of investment should be pursued.
Since it recognizes that money depreciates over time, the discounted payback period makes decisions for many investors and corporate houses. In contrast with a simple payback period, which calculates the time taken to recover the initial investment, the discounted payback period makes a present value adjustment to any future cash inflows going into the projion. Thprojectent value adjustment maximizes the decision-making process and accurately depicts the project’s profitability.
What Is Discounted Payback Period?
Discounted payback period is the time required to recover the initial investment in a given project after discounting future cash flows for the time value of money. Unlike simple payback, the discounted payback period considers today’s rupee worth more than the rupee received sometime in the future.
It is instrumental in the capital budgeting arena to help businesses determine how soon they can recover their investment in light of risk and opportunity costs. Fewer recovery periods under discounted payback suggest the investment is less risky; more extended recovery periods are associated with more significant uncertainty and risk.
Discounted Payback Period Formula
The discounted payback period formula calculates the time taken for the sum of discounted cash flows to equal the initial investment. It is represented as follows:
Ct represents the cash flow at time t, r is the discount rate, and Iams is the initial investment. The time t is supposed to be determined when the sum of discounted cash flows equals or exceeds.
This formula ensures that all future cash flows are discounted to their present value before summing them up. This aspect is crucial because it provides a more accurate picture of the timing of investment recovery.
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How to Calculate Discounted Payback Period?
Calculating the discounted payback period involves several steps to maintain either measure of time for any possible error. The steps may include:
Step 1: Identify the Initial Investment
Once the original investment is decided on, ascertain the total cost of this investment to be recovered over time through future cash inflows.
Step 2: Estimate Future Cash Flows
Forecast cash flows that are likely to occur within every year of the project. Cash flows should, however, be based on realistic estimations.
Step 3: Choose the Discount Rate
Choose a discount rate, which may usually be either the cost of capital of the concerned company or the rate of return required.
Step 4: Discount Each Cash Flow
The present value of each of the future cash flows is determined separately by the discount rate. Discounting cash flow is given by: PV = FV/(1+r)^t
where PV is the present value, FV= future value, r is the discount rate, and t is the year.
Step 5: Sum the Discounted Cash Flows
Add all the discounted cash flows cumulatively until the total equals or exceeds the initial investment.
Step 6: Determine the Discounted Payback Period
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.
The above steps ensure that cash flows are treated relatively during discounting time.
What is the Decision Rule for Discounted Payback Period?
The decision rule for the discounted payback period states when to accept or reject an investment. In simple terms,
- Accept the project when the discounted payback period exceeds the desired recovery time.
- Reject the project when the discounted payback period has an exclusive acceptance limit.
- Corporate houses often define their standard payback limits according to risk acceptance level. If the payback period exceeds such limits, the investment may prove not worth the risk it runs. Thus, selection criteria will try to screen only viable investments.
Advantages of Discounted Payback Period
The discounted payback period formula has several advantages that make it appropriate for assessing investment projects. Some of these advantages include:
- Takes into Account Time Value of Money: The method is an improvement over the simple payback period in that it discounts the future cash flows and hence imparts credibility to the evaluation of the respective investments.
- Lowered Investment Risk: Being centered on the rapid recovery of investment funds, this method minimizes risk to investors by selecting those projects that offer a quick payback period.
- Better Decision-Making: The discounted payback offers a means for companies to assess project viability before committing capital.
- Ideally Suited for Capital Budgeting: The widespread use of the method in business finance compares investment opportunities and optimizes resource allocation.
- Financial Stability: This ensures that investors will always favor projects that promise rapid recovery of their initial investment, thereby providing liquidity and economic stability.
Assumptions of Discounted Payback Period Formula
Validity and reliability of the discounted payback formula are dependent on a number of assumptions, a few of which are:-
- Constant Discount Rate – It is a somewhat grand assumption to have one discount rate for the period of the investment.
- Proper Estimation of Cash Flows: The future estimated cash flow amounts must be accurate or else the results will not be reliable.
- Uniform Cash Inflows: The computed value assumes the project experiences stable cash inflows yearly.
- Discounting Commences – Cash flows for the first year are discounted immediately upon the commencement of investment.
- Investment Recovery Assumption – The method assumes that all projects recover the initial investment.
Limitations of Discounted Payback Period
The calculation of the discounting payback period is very important, but it does have some drawbacks:
- Cash Flows After the Payback Period Are Ignored-The Payback Period measures the time taken in recovering the investment while ignoring all extra profits earned thereafter
- Complex Calculations – Discounting of cash flows for each year increases the level of complication in application compared to that of the simple payback period.
- Subjective Nature of the Discount Rate – The discount rate selection is subjective to a large extent, which influences the accuracy of this method.
- Inapplicable for Long-Term Projects – As this formula does not emphasize overall project profitability, it is unfit to be applied in assessing long-term investments.
Discounted Payback Period Example
Cash outlay of 50000, expected cash inflow of 15000 per annum over the next four years, and a discount rate of 10%.
| Year | Cash Flow (INR) | Discount Factor (10%) | Discounted Cash Flow (INR) | Cumulative Discounted Cash Flow (INR) |
| 1 | 15,000 | 0.909 | 13,635 | 13,635 |
| 2 | 15,000 | 0.826 | 12,390 | 26,025 |
| 3 | 15,000 | 0.751 | 11,265 | 37,290 |
| 4 | 15,000 | 0.683 | 10,245 | 47,535 |
Since 50,000 was not fully recovered in 4 years, it can be interpolated that the discounted payback period was just over 4 years.
Payback Period vs Discounted Payback Period
The payback period and discounted payback period are two different methods used to analyze when an investment is to be recovered. The main difference is that the discounted payback period considers the time value of money, making it a more realistic approach.
| Criteria | Payback Period | Discounted Payback Period |
| Time Value of Money | Ignored | Considered |
| Accuracy | Less accurate | More accurate |
| Decision Making | Less reliable | More reliable |
| Calculation Complexity | Simpler | More complex |
| Risk Assessment | Lower risk visibility | Higher risk visibility |
The discounted payback period is preferred because it is a much better representation of the actual worth of an investment.
Discounted Payback Period FAQs
How often do you pay someone to work on your payback?
An amount that an investment completes the recovery of its cost is the payback period. This does not consider any time value of money.
How is the payback period defined?
Discounted payback period is the time required to recover the initial investment in a given project after discounting future cash flows for the time value of money.
What is the discounted payback period?
The period for recovery from an investment after adjusting future cash flows for the time value of money is called the “discounted payback period.”
What is the discounted payback period formula?
The discounted payback period formula sums discounted cash flows until they equal the initial investment.
What are the advantages and disadvantages of the payback period?
Advantages: simplicity, fast decision-making; disadvantages: do not consider profitability, do not consider the time value of money.
