The shorter the payback period, the more likely the project will be accepted – all else being equal. The two calculated values – the Year number and the fractional amount – can be added together to arrive at the estimated payback period. If undertaken, the initial investment in the project will cost the company approximately $20 million. Suppose a company is considering whether to approve or reject a proposed project. In fact, the only difference is that the cash flows are discounted in the latter, as is implied by the name.
In other circumstances, we may see projects where the payback occurs during, rather than at the end of, a given year. The Discounted Payback Period estimates the time needed for a project to generate enough cash flows to break even and become profitable. The answer is no, the project does not meet the board’s criteria of a discounted payback period of 4 years or less. 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.
Discounted Payback Period: Method & Example
The period of time that a project or investment takes for the present value of future cash flows to equal the initial cost provides an indication of when the project or investment will break even. 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 a measure
of how long it takes until the cumulated discounted net cash flows offset the
initial investment in an asset or a project. In other words, DPP is used to
calculate the period in which the initial investment is paid back. When a small business invests in new capital, the owners often want to know when they can expect to recover the costs of that investment. In capital budget accounting, the payback period pertains to the time period needed for the return on an investment to equal the sum of the first investment.
This is not the same as the discounted payback period, where those cash flows are discounted back to their present value before the payback calculation is made. Because no discounting is applied to the basic payback calculation, it always returns a payback period that is shorter than what would be obtained with the discounted payback period calculation. The discounted payback period is a capital budgeting procedure used to determine the profitability of a project. A discounted payback period gives the number of years it takes to break even from undertaking the initial expenditure, by discounting future cash flows and recognizing the time value of money. The metric is used to evaluate the feasibility and profitability of a given project. These two calculations, although similar, may not return the same result due to the discounting of cash flows.
Function of Payback Period
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. Second, we must subtract the discounted cash flows from the initial cost figure in order to obtain the discounted payback period.
In order to find the discounted cash flow amount he must find out the present value factor which considers the diminished value of cash flows in future years. First, we must discount (i.e., bring to the present value) the net cash flows that will occur during each year of the project. The shorter the discounted payback period, the quicker the project generates cash inflows and breaks even.
- The discounted payback period gives Rick the amount of time it takes in years to break even after buying the second car wash.
- Management then looks at a variety of metrics in order to obtain complete information.
- If he could expect to return 10% in the stock market, for example, instead of purchasing the second location he would use a 10% discount rate.
- 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.
- Rick is considering purchasing a second car wash using the money he’s made from the one he already owns and operates.
- The answer is no, the project does not meet the board’s criteria of a discounted payback period of 4 years or less.
While comparing two mutually exclusive projects, the one with the shorter discounted payback period should be accepted. 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. The discounted payback period is a good
alternative to the payback period if the time value of money or the expected
rate of return needs to be considered. If DPP were the only relevant indicator,
option 3 would be the project alternative of choice. A project may have a longer discounted payback period but also a higher NPV than another if it creates much more cash inflows after its discounted payback period.
If Rick took the $45,000 in cash flow each year and applied that against the $140,000 investment he would simply calculate $140,000 / $45,000 and get 3.11 years to break even. 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. Thus, the value of a cash flow equals its notional
value, regardless of whether it occurs in the 1st or in the 6th year. However, it
tends to be imprecise in cases of long cash flow projection horizons or cash
flows that increase significantly over time.
The formula accounts for the time value of money by recognizing that a dollar earned today is more valuable than a dollar earned years in the future. This is accomplished by applying a discount rate, or percentage reduction to the business’s cash flow. The discount rate is the amount of return Rick could get by using that money elsewhere. If he could expect to return 10% in the stock market, for example, instead of purchasing the second location he would use a 10% discount rate. Rick is considering purchasing a second car wash using the money he’s made from the one he already owns and operates. As part of his capital budgeting process he will want to determine how profitable a second location could be before he commits to making the purchase.
Should a Company’s Return on Assets Be Greater Than Its Return on Equity?
In this analysis, 3 project alternatives are compared with each other, using the discounted payback period as one of the success measures. In project management, this measure is often used as a part of a cost-benefit analysis, supplementing other profitability-focused indicators such as internal rate of return or return on investment. It can however also be leveraged to measure the success of an investment or project in hindsight and determine the point at which an initial investment has actually paid back. In particular, the added step of discounting a project’s cash flows is critical for projects with prolonged payback periods (i.e., 10+ years). Let’s say that Rick will spend $140,000 to buy the second location and expects to have cash flows of $45,000 per year. First, prepare a chart showing the cash flow for each year along with an adjustment for the discount rate.
- The discounted payback period calculation begins with the -$3,000 cash outlay in the starting period.
- The project is expected to return $1,000 each period for the next five periods, and the appropriate discount rate is 4%.
- You’re probably wondering why Rick has gone to the trouble of all this math to get what seems like a simple answer.
- While comparing two mutually exclusive projects, the one with the shorter discounted payback period should be accepted.
- The shorter the payback period, the more likely the project will be accepted – all else being equal.
- 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.
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 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. The discounted payback period gives Rick the amount of time it takes in years to break even after buying the second car wash.
Understanding the Discounted Payback Period
The discounted payback period is used to evaluate the profitability and timing of cash inflows of a project or investment. In this metric, future cash flows are estimated and adjusted for the time value of money. It is the period of time that a project takes to generate cash flows when the cumulative present value of the cash flows equals the initial investment cost. The discounted payback period is the period of time over which the cash flows from an investment pay back the initial investment, factoring in the time value of money.
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). Since the project’s life is calculated at 5 years, we can infer that the project returns a positive NPV. Therefore, it would be more practical to consider the time value of money when deciding which projects to approve (or reject) – which is where the discounted payback period variation comes in. You’re probably wondering why Rick has gone to the trouble of all this math to get what seems like a simple answer. The ordinary or simple payback period is indeed a very simplified version of this concept.
In the next step, we’ll create a table with the period numbers (”Year”) listed on the y-axis, whereas the x-axis consists of three columns. The company’s chief financial officer, Johnny Money, asked that you follow him into his office for a meeting. You are an accountant for Boomer Investments Inc., an investment firm that is headquartered in the heart of New York City. Boomer is one of the most successful, diversified investment firms that prides itself on exceptional decision-making and stellar investment opportunities through its global network.
It is primarily used to calculate the projected return from a proposed capital investment opportunity. This approach adds discounting to the basic payback period calculation, thereby greatly increasing the accuracy of its results. However, it also suffers from a higher level of complexity, which is what makes the payback period such a commonly-used calculation. The discounted payback period is calculated
by discounting the net cash flows of each and every period and cumulating the
discounted cash flows until the amount of the initial investment is met.
