Discounted payback period is a variation of payback period which uses discounted cash flows while calculating the time an investment takes to pay back its initial cash outflow. One of the major disadvantages of simple payback period is that it ignores the time value of money. To counter this limitation, discounted payback period was devised, and it accounts for the time value of money by discounting the cash inflows of the project for each period at a suitable discount rate.

- Cash flow is the inflow and outflow of cash or cash-equivalents of a project, an individual, an organization, or other entities.
- The payback period is the time it takes an investment to break even (generate enough cash flows to cover the initial cost).
- The shorter the payback period, the more likely the project will be accepted – all else being equal.
- The second project will take less time to pay back, and the company’s earnings potential is greater.
- In DCF analysis, the weighted average cost of capital (WACC) is the discount rate used to compute the present value of future cash flows.

The shorter a discounted payback period is means the sooner a project or investment will generate cash flows to cover the initial cost. A general rule to consider when using the discounted payback period is to accept projects that have a payback period that is shorter than the target timeframe. 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. To calculate the cumulative cash flow balance, add the present value of cash flows to the previous year’s balance.

The following tables contain the cash flowforecasts of each of these options. Read through for the definition and formulaof the DPP, 2 examples as well as a discounted payback period calculator. Since IRR does not take risk into account, it should be looked at in conjunction with the payback period to determine which project is most attractive. It enables firms to compare projects based on their payback cutoff to decide which is most worth it. For example, where a project with higher return has a longer payback period thus higher risk and an alternate project having low risk but also lower return. In such cases the decision mostly rests on management’s judgment and their risk appetite.

## Irregular Cash Flow Each Year

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. It is a useful way to work out how long it takes to get your capital back from the cash flows.It shows the number of years you will need to get that money back based on present returns. Each present value cash flow is calculated and then added together.The result is the discounted payback period or DPP. Our calculator uses the time value of money so you can see how well an investment is performing.

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Comparing various profitability metrics for all projects is important when making a well-informed decision. CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation. CFI is on a mission to enable anyone to be a great financial analyst and have a great career path. In order to help you advance your career, CFI has compiled many resources to assist you along the path.

## Cash Flow Projections and DPP Calculation

This requires the use of a discountrate which can be either a market interest rate or an expected return. Someorganizations may also choose to apply an accounting interest rate or theirweighted average cost of capital. Discounted payback period will usually be greater than regular payback period.

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. In this analysis, 3 project alternatives are compared with each other, using the discounted payback period as one of the success measures. Without considering the time value of money, it is difficult or impossible to determine which project is worth considering. Projecting a break-even time in years means little if the after-tax cash flow estimates don’t materialize. The discounted payback period of 7.27 years is longer than the 5 years as calculated by the regular payback period because the time value of money is factored in.

Also, it is a simple measure of risk, as it shows how quickly money can be returned from an investment. However, there are additional considerations that should be taken into account when performing the capital budgeting process. It is a rate that is applied to future payments in order to compute the present value or subsequent value of said future payments. For example, an investor may determine the net present value (NPV) of investing in something by discounting the cash flows they expect to receive in the future using an appropriate discount rate. 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.

## Calculation

After all, your $100,000 will not be worth the same after ten years; in fact, it will be worth a lot less. Every year, your money will depreciate by a certain percentage, called the discount rate. The first column (Cash Flows) tracks the cash flows of each year – for instance, Year 0 reflects the $10mm outlay whereas the others account for the $4mm inflow of cash flows. As a general rule of thumb, the shorter the payback period, the more attractive the investment, and the better off the company would be.

The rest of the procedure is similar to the calculation of simple payback period except that we have to use the discounted cash flows as calculated above instead of nominal cash flows. Also, the cumulative cash flow is replaced by cumulative discounted cash flow. Next, assuming the project starts with a large cash outflow, or investment to begin the project, the future discounted cash inflows are netted against the initial investment outflow. The discounted payback period process is applied to each additional period’s cash inflow to find the point at which the inflows equal the outflows.

The metric is used to evaluate the feasibility and profitability of a given project. The discounted payback period is a modified version of the payback period that accounts for the time value of money. Both metrics are used to calculate the amount of time that it will take for a project to “break even,” or to get the point where the net cash flows generated cover the initial cost of the project. Both the payback period and the discounted payback period can be used to evaluate the profitability and feasibility of a specific project. The faster a project or investment generates cash flows to cover the initial cost, the shorter the discounted payback period. Generally, projects should only be accepted if the payback period is shorter than the cutoff time frame.

One of the most important concepts every corporate financial analyst must learn is how to value different investments or operational projects to determine the most profitable project or investment to undertake. These two calculations, although similar, may not return the same result due to the discounting of cash flows. For example, projects with higher cash flows toward the end of a project’s life will experience greater discounting due to net sales vs gross sales compound interest. For this reason, the payback period may return a positive figure, while the discounted payback period returns a negative figure. The basic method of the discounted payback period is taking the future estimated cash flows of a project and discounting them to the present value. The discounted payback period is often used to better account for some of the shortcomings, such as using the present value of future cash flows.

## Payback Periods Vs. discounted Payback Periods

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 estimates the time needed for a project to generate enough cash flows to break even and become profitable. So, the two parts of the calculation (the cash flow and PV factor) are shown above.We can conclude from this that the DCF is the calculation of the PV factor and the actual cash inflow.

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