The Discounted Payback Period estimates the time needed for a project to generate enough cash flows to break even and become profitable. In types of errors in accounting 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 of5.07 years, option 3 of 4.65 years while with option 2, a recovery of theinvestment is not achieved.

How to Calculate Discounted Payback Period (Step-by-Step)

One observation to make from the example above is that the discounted payback period of the project is reached exactly at the end of a year. In other circumstances, we may see projects where the payback occurs during, rather than at the end of, a given year. Investors may use payback in conjunction with return on investment (ROI) to determine whether or not to invest or enter a trade. Corporations and business managers also use the payback period to evaluate the relative favorability of potential projects in conjunction with tools like IRR or NPV. Assume Company A invests $1 million in a project that is expected to save the company $250,000 each year.

Based on the project’s risk profile and the returns on comparable investments, the discount rate – i.e., the required rate of return – is assumed to be 10%. 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. From a capital budgeting perspective, this method is a much better method than a simple payback period. The next step is to subtract the number from 1 to obtain the percent of the year at which the project is paid back.

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 simple metric to determine if an investment will be sufficiently profitable to justify the initial cost. It uses the predicted returns from the investment, but also takes into consideration the diminishing value of future returns. 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 Do I Calculate the Payback Period?

The DPP can be used in a cost-benefit analysis as well as for the comparison of different project alternatives. Amanda Bellucco-Chatham is an editor, writer, and fact-checker with years of experience researching personal finance topics. Specialties include general financial planning, career development, lending, retirement, tax preparation, and credit. Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs.

Calculation

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. The breakeven point is the price or value that an investment or project must rise to cover the initial costs or outlay. The payback period refers to how long it takes to reach that breakeven.

1. Calculate the discounted payback period of the investment if the discount rate is 11%.
2. Thus, it cannot tell a corporate manager or investor how the investment will perform afterward and how much value it will add in total.
3. 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.
4. The formula for the simple payback period and discounted variation are virtually identical.

The answer is found by dividing $200,000 by $100,000, which is two years. The second project will take less time to pay back, and the company’s earnings potential is greater. Based solely on the payback period method, the second project is a better investment if the company wants to prioritize recapturing its capital investment as quickly as possible. Many managers and investors thus prefer to use NPV as a tool for making investment decisions.

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 calculatedby discounting the net cash flows of each and every period and cumulating thediscounted cash flows until the amount of the initial investment is met.

The calculator below helps you calculate the discounted payback period based on the amount you initially invest, the discount rate, and the number of years. The 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. When deciding on any project to embark on, a company or investor wants to know when their investment will pay off, meaning when the cash flows generated from the project will cover the cost of the project. There are two steps involved in calculating the discounted payback period.

Contractor Calculators

Unlike other methods of capital budgeting, the payback period ignores the time value of money (TVM). This is the idea that money is worth more today than the same amount in the future because of the earning potential of the present money. If DPP were the only relevant indicator,option 3 would be the project alternative of choice.

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. 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.

Initially an investment of $100,000 can be expected to make an income of $35k per annum for 4 years.If the discount rate is 10% then we can calculate the DPP. In most cases, this is a pretty good payback period as experts say it can take as much as 7 to 10 years for residential homeowners in the United States to break even on their investment. The inflation rate for consumer prices in the United States, according to the Bureau of Labor Statistics in June 2024. Investors should consider the diminishing value of money when planning future investments. Management then looks at a variety of metrics in order to obtain complete information.

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 crossword clue: single entry in a list crossword solver performing. 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 compound interest. For this reason, the payback period may return a positive figure, while the discounted payback period returns a negative figure. When the negative cumulative discounted cash flows become positive, or recover, DPB occurs.

Cash Flow Projections and DPP Calculation

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 payback period is favored when a company is under liquidity constraints because it can show how long it should take to recover the money laid out for the project. If short-term cash flows are a concern, a short payback period may be more attractive than a longer-term investment that has a higher NPV.

Finally, we proceed to convert the percentage in months (e.g., 25% would be 3 months, etc.) and add the figure to the last year in order to arrive at the final discounted payback period number. Since the project’s life is calculated at 5 years, we can infer that the project returns a positive NPV. The payback period disregards the time value of money and is determined by counting the number of years it takes to recover the funds invested. For example, if it takes five years to recover the cost of an investment, the payback period is five years. The discounted payback period, in theory, is the more accurate measure, since fundamentally, a dollar today is worth more than a dollar received in the future. However, one common criticism of the simple payback period metric is that the time value of money is neglected.