The discounted payback period is an enhanced version of a simple payback period that considers the time value of money. The payback period is a metric typically used along with the Internal Rate of Return and Return on Investment in evaluating the profitability and feasibility of a particular project. However, it fails to consider the time value of money. For this reason, the discounted payback period was devised, and it now considers the time value of money by discounting the cash flows of the projects or investments. This article will try to refine your understanding of this topic and further explain the discounted paybackperiod formula.
Let us dive deeper to understand the rationale of the discounted payback period. This metric is used to evaluate the profitability and timing of cash inflows of a particular project or investment. Future cash flows are discounted using company’s cost of capital. It is the period that a specific project takes to breakeven and recover the initial investment cost. A shorter payback period indicates good performance. If multiple projects are lined up, the shorter discounted payback period should likely be accepted.
To calculate for the discounted payback period, the net cash flows for each year of the project have to be discounted to its present value. Once the discounted cash flows for each period are known, it has to be deducted from the initial investment cost until you reach zero. Here’s the discounted payback period formula which you could work on both Excel or calculator.
Discounted Cash Inflow = Actual Cash Inflow / (1 + i)n
Discounted Payback Period = Initial Cost of Investment – Cumulative Discounted Cash Inflow
The discounted payback period helps assess a project’s profitability while exhibiting the timing of cash flows and the time value of money. It allows companies to evaluate whether a particular project is worth investing in or not. If it turns out that project payback is longer than its useful life, it must be declined. However, it bars to consider cash flows after the payback period. Hence, it fails to uncover whether a project will perform afterward.
The discounted payback period is an upgraded version of a simple payback period method. It helps ascertain the period required for an investment or a project to break even. Though this metric has its limitation, it is a useful metric to determine the viability of a project or investment considering the time value of money. If this method will be incorporated along with other methods, the right decision would sure be made.
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