Discounted Payback Period Definition, Formula, and Example

Tim’s Golf store purchases clubs from Nike every few months to sell to its customers. Nike usually offers Tim a 2% discount if he pays the entire invoice in ten days. The full invoice will be due in 30 days if Tim choices not to take advantage of the discount. This is one of the most common discount arrangements and is traditionally referred to as a 2/10 n/30 or 2/10 net/30 trade discount. Amanda Bellucco-Chatham is an editor, writer, and fact-checker with years of experience researching personal finance topics.

Because of the opportunity cost of receiving cash earlier and the ability to earn a return on those funds, a dollar today is worth more than a dollar received tomorrow. 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. Bonds are typically discounted because they carry a higher degree of risk to the purchaser or investor. The discount is based on the value of an asset’s income at the present moment. A callable bond is a municipal bond that’s subject to redemption by a state or local government before its maturity date.

  1. 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.
  2. Payback period is the amount of time it takes to break even on an investment.
  3. If undertaken, the initial investment in the project will cost the company approximately $20 million.
  4. To begin, the periodic cash flows of a project must be estimated and shown by each period in a table or spreadsheet.

The discounted payback method takes into account the present value of cash flows. The Payback Period Calculator can calculate payback periods, discounted payback periods, average returns, and schedules of investments. In case we decide to differentiate between risky projects by applying project-specific discount rates, we should be careful in choosing the discount rate for each venture. At the end of the day, the Discount Payback Period relies on the opportunity cost of capital, so picking an appropriate discount rate will make a significant difference in your analysis.

In any case, the decision for a project option or an investment decision should not be based on a single type of indicator. You can find the full case study here where we have also calculated the other indicators (such as NPV, IRR and ROI) that are part of a holistic cost-benefit analysis. Option 1 has a discounted payback period of
5.07 years, option 3 of 4.65 years while with option 2, a recovery of the
investment is not achieved. 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.

For this reason, the simple payback period may be favorable, while the discounted payback period might indicate an unfavorable investment. The main advantage is that the metric takes into account money’s time value. This is important because money today is worth more than money in the future. The discount rate represents the opportunity cost of investing your money. The payback period is the time it takes an investment to break even (generate enough cash flows to cover the initial cost).

For example, projects with higher cash flows toward the end of a project’s life will experience greater discounting due to compound interest. For this reason, the payback period may return a positive figure, while the discounted payback period returns a negative figure. 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. Discount rate is useful because it can take future expected payments from different periods and discount everything to a single point in time for comparison purposes.

The cash flow balance in year zero is negative as it marks the initial outlay of capital. Therefore, the cumulative cash flow balance in year 1 equals the negative balance from year 0 plus the present value of cash flows from year 1. The discounted payback period is calculated by adding the year to the absolute value of the period’s cumulative cash flow balance and dividing it by the following year’s present value of cash flows.

Payback period doesn’t take into account money’s time value or cash flows beyond payback period. When the negative cumulative discounted cash flows become positive, or recover, DPB occurs. 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. We see that in year 3, the investment is not just recovered but the remaining cash inflow is surplus.

What Is the Difference between Payback Period and

Another advantage of this method is that it’s easy to calculate and understand. This makes it a good choice for decision-makers who don’t have a lot of experience with financial analysis. The two calculated values – the Year number and the fractional amount – can be added together to arrive at the estimated payback period. All of the necessary inputs for our payback period calculation are shown below. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.

Payback Period Calculator

Investments with higher cash flows toward the end of their lives will have greater discounting. Forecasted future cash flows are discounted backward in time to determine a present value estimate, which is evaluated to conclude whether an investment is worthwhile. In DCF analysis, the weighted average cost of capital (WACC) is the discount rate used to compute the present value of future cash flows. WACC is the calculation of a firm’s cost of capital, where each category of capital, such as equity or bonds, is proportionately weighted. For more detailed cash flow analysis, WACC is usually used in place of discount rate because it is a more accurate measurement of the financial opportunity cost of investments. WACC can be used in place of discount rate for either of the calculations.

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A government might do this because the bond is paying an interest rate that’s higher than the market rate at the time. You can determine whether a bond is callable before you commit by looking it up on the Electronic Municipal Market Access website provided by the Municipal Securities Rulemaking Board. Discounted payback period serves as a way to tell whether an investment is worth undertaking. The lower the payback period, the more quickly an investment will pay for itself. The implied payback period should thus be longer under the discounted method. The shorter the payback period, the more likely the project will be accepted – all else being equal.

Understanding the Payback Period

Others like to use it as an additional point of reference in a capital budgeting decision framework. As you can see, the required rate of return is lower for the second project. This means that you would need to earn a return of at least 9.1% on your investment to break even. This means that you would need to earn a return of at least 19.6% on your investment to break even. Due to the discounting of cash flows, these two similar calculations may not yield the same result because of compound interest.

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). It considers the opportunity cost of tying up capital in a project and allows investors to compare different investment options more effectively. A higher payback period means it will take longer for a company to cover its initial investment. All else being equal, it’s usually better for a company to have a lower payback period as this typically represents a less risky investment. The quicker a company can recoup its initial investment, the less exposure the company has to a potential loss on the endeavor.

As presented below, in our calculation of the Discounted Payback Period, we discount the initial cash flows (originally found in column C) in column H. Average cash flows represent the money going into qbo instant deposit 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.

I will briefly explain how the payback period functions to help you better understand the concept. Prior to accepting a position as the Director of Operations Strategy at DJO Global, Manu was a management consultant with McKinsey & Company in Houston. He served clients, including presenting directly to C-level executives, in digital, strategy, M&A, and operations projects. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. Investors must qualify for them through purchasing these mutual fund shares and meeting a few other requirements.

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