Discounted Payback Period Formula + Calculator Leave a comment

This means that you would only invest in this project if you could get a return of 20% or more. However, it’s not the only financial figure you’ll want to dig into when making investment decisions. Here are some other metrics investors and business leaders use to weigh up projects. That is, a dollar today is worth more than a dollar tomorrow, which is worth more than a dollar next month, and so on. The time value of money is the financial concept that a given unit of money (a dollar, say) is not worth the same across different periods of time. The implied payback period should thus be longer under the discounted method.

Example of the Discounted Payback Period Formula

You should also consider factors such as money’s time value and the overall risk of the investment. Despite these limitations, discounted payback period methods can help with decision-making. It’s a simple way to compare different investment options and to see if an investment is worth pursuing. Like NPV, IRR doesn’t focus on the timing of cash flows, so it’s best assessed alongside the discounted payback period for a fuller picture. IRR tells you the discount rate at outstanding check list which the NPV of a project or investment is zero.

Cash Flow Projections and DPP Calculation

After the initial purchase period (Year 0), the project generates $5 million in cash flows each year. 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. 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. The following tables contain the cash flowforecasts of each of these options.

For example, three projects can have the same payback period with varying break-even points due to the varying flows of cash each project generates. Additionally, any payback period analysis ignores cash flows after the payback period. It’s not a calculation of your total expected return, but it only indicates how long it will take to break even on an investment.

1. Use Excel’s present value formula to calculate the present value of cash flows.
2. This makes it a more realistic indicator of whether money should be spent today or kept aside for future projects.
3. It’s a simple way to compare different investment options and to see if an investment is worth pursuing.
4. Amanda Bellucco-Chatham is an editor, writer, and fact-checker with years of experience researching personal finance topics.
5. The lower the payback period, the more quickly an investment will pay for itself.
6. To begin, the periodic cash flows of a project must be estimated and shown by each period in a table or spreadsheet.

When considering allocating funds toward a given project, a company or investor naturally wants to know how long it will take for the cash flows generated from the project to cover the initial costs. Let’s say you’re considering investing in a project that has an upfront cost of $10 million and it’s expected to generate $2 million of additional revenue each year. You’ve decided to use your required rate of return of 10% as the discount rate.

Internal Rate of Return (IRR)

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. In this example, the cumulative discountedcash flow does not turn positive at all. In other words, the investment will not be recoveredwithin the time horizon of this projection. Compared to the standard payback period calculation, discounted payback period is more complex and first requires a discount rate to be established. In particular, the added step of discounting a project’s cash flows is critical for projects with prolonged payback periods (i.e., 10+ years).

Discount payback period: A 101 for small business owners

I hope you guys got a reasonable understanding of what is payback period and discounted payback period. 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.

Read through for the definition and formulaof the DPP, 2 examples as well as a discounted payback period calculator. Once you have this real estate financial analysis information, you can use the following formula to calculate discounted payback period. The discounted payback period determines the payback period using the time value of money.