When using this metric, it’s important to keep in mind that a longer payback period doesn’t necessarily mean an investment is bad. You should also consider factors such as money’s time value and the overall risk of the investment. Discounted payback how to implement demand forecasting to your supply chain period refers to the number of years it takes for the present value of cash inflows to equal the initial investment.

The present value is the value of a future payment or series of payments, discounted back to the present. The corporation advantages and disadvantages discounted payback period is a goodalternative to the payback period if the time value of money or the expectedrate of return needs to be considered. If DPP were the only relevant indicator,option 3 would be the project alternative of choice.

Depending on the time period passed, your initial expenditure can affect your cash revenue. The payback period is the amount of time (usually measured in years) it takes to recover an initial investment outlay, as measured in after-tax cash flows. It is an important calculation used in capital budgeting to help evaluate capital investments. For example, if a payback period is stated as 2.5 years, it means it will take 2½ years to receive your entire initial investment back. In capital budgeting, the payback period is defined as the amount of time necessary for a company to recoup the cost of an initial investment using the cash flows generated by an investment. The calculationtherefore requires the discounting of the cash flows using an interest ordiscount rate.

Discounted Payback Period: Definition, Formula & Calculation

1. You should also consider factors such as money’s time value and the overall risk of the investment.
2. It is an important calculation used in capital budgeting to help evaluate capital investments.
3. However, ittends to be imprecise in cases of long cash flow projection horizons or cashflows that increase significantly over time.
4. At this point, the project’s initial cost has been paid off, with the payback period being reduced to zero.
5. These two calculations, although similar, may not return the same result due to the discounting of cash flows.
6. The rate of return on the investment and the time it will take to recover the project costs.

Please note that if the discount rate increases, the distortion between the simple rate of return and discounted payback period increases. Let us take the 10% discount rate in the above example and calculate the discounted payback period. The decision rule is a simple rule to determine if an investment is worthwhile, and which of several investments is most worthwhile. If the discounted payback period for a certain asset is less than the useful life of that asset, the investment may be approved. If a business is choosing between several potential investments, the one with the shortest discounted payback period will be the most profitable.

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). Investors may use payback in conjunction with return on investment (ROI) to determine whether or not to invest or enter a trade.

Examples of Applying the DPP

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. In this case, the discounting rate is 10% and the discounted payback period is around 8 years, whereas the discounted payback period is 10 years if the discount rate is 15%. So, this means as the discount rate increases, the difference in payback periods of a discounted pay period and simple payback period increases.

How Is the Discounted Payback Period Calculated?

The shorter the payback period, the more likely the project will be accepted – all else being equal. Read through for the definition and formulaof the DPP, 2 examples as well as a discounted payback period calculator. Others like to use it as an additional point of reference in a capital budgeting decision framework.

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.

NPV is a complementary metric to be assessed alongside discounted payback period as opposed to being an alternative. It’s useful for directly measuring how much wealth a project can generate, which you can then compare against the total investment cost. Generally speaking, shorter payback periods are favorable to longer ones. If the cash flows are uneven, then the longer method of discounting each cash flow would be used.

Assume that Company A has a project requiring an initial cash outlay of $3,000. The project is expected to return $1,000 each period for the next five periods, and the appropriate discount rate is 4%. The discounted payback period calculation begins with the -$3,000 cash outlay in the starting period. The discounted payback period is the time when the cash inflows break-even the total initial investment. In other words, the time when the negative cumulative cash flow turn to positive. A simple payback period with an investment or a project is a time of recovery of the initial investment.