Payback Period Explained, With the Formula and How to Calculate It

Insert the initial investment (as a negative
number since it is an outflow), the discount rate and the positive or negative
cash flows for periods 1 to 6. The present
value of each cash flow, as well as the cumulative discounted cash flows for
each period, are shown for reference. The discounted payback period is a capital budgeting procedure used to determine the profitability of a project. key steps of the application process 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. The discounted payback period is a modified version of the payback period that accounts for the time value of money.

To learn more about the various types of cash flow, please read CFI’s cash flow guide. That would indicate that the project cost would be more than the projected return. Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more.

The discounted payback method tells companies about the time period in which the initial investment in a project is expected to be recovered by the discounted value of total cash inflow. Additionally, it indicates the potential profitability of a certain business venture. For example, if a project indicates that the funds or initial investment will never be recovered by the discounted value of related cash inflows, the project would not be profitable at all.

  1. The quicker a company can recoup its initial investment, the less exposure the company has to a potential loss on the endeavor.
  2. Discounted cash flow analysis can also assist business owners and managers in making capital budgeting or operating expenditures decisions.
  3. This requires the use of a discount
    rate which can be either a market interest rate or an expected return.
  4. The payback period is a fundamental capital budgeting tool in corporate finance, and perhaps the simplest method for evaluating the feasibility of undertaking a potential investment or project.

The study of cash flow provides a general indication of solvency; generally, having adequate cash reserves is a positive sign of financial health for an individual or organization. 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. 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. The breakeven point is the price or value that an investment or project must rise to cover the initial costs or outlay.

For example, if solar panels cost $5,000 to install and the savings are $100 each month, it would take 4.2 years to reach the payback period. In most cases, this is a pretty good payback period as experts say it can take as much as years for residential homeowners in the United States to break even on their investment. This stub period affects the PV of Terminal Value calculation because it reduces the time between today’s date and the end of the projection period. When you value a company, much of its cash flow for the first projected year has already been generated (unless you’re valuing it on January 1). In reality, though, the company generates cash flow every day, and on average, that cash flow is distributed throughout the year (with exceptions for highly seasonal companies). If undertaken, the initial investment in the project will cost the company approximately $20 million.

Discounted payback method

To conduct a DCF analysis, an investor must make estimates about future cash flows and the ending value of the investment, equipment, or other assets. 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. 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. The generic payback period, on the other
hand, does not involve discounting. 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.

DCF Formula in Excel

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. Dividend discount models, such as the Gordon Growth Model (GGM) for valuing stocks, are other analysis examples that use discounted cash flows. If DPP were the only relevant indicator,
option 3 would be the project alternative of choice.

Assume that Company A has a project requiring an initial cash outlay of $3,000. 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.

Discounted Cash Flow Formula

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. Discounted cash flow is a valuation method that estimates the value of an investment based on its expected future cash flows. By using a DFC calculation, investors can estimate the profit they could make with an investment (adjusted for the time value of money). The value of expected future cash flows is first calculated by using a projected discount rate.

Certain businesses have a payback cutoff which is essential to consider when proceeding with investment projects. Discounted cash flow analysis finds the present value of expected future cash flows using a discount rate. Investors can use the concept of the present value of money to determine whether the future cash flows of an investment or project are greater than the value of the initial investment. The discounted payback period involves using discounted cash inflows rather than regular cash inflows. It involves the cash flows when they occurred and the rate of return in the market.

What is the payback period?

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.

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. Discounted payback period refers to time needed to recoup your original investment. In other words, it’s the amount of time it would take for your cumulative cash flows to equal your initial investment. Second, we must subtract the discounted cash flows from the initial cost figure in order to obtain the discounted payback period.

We can conclude from this that the DCF is the calculation of the PV factor and the actual cash inflow. The WACC incorporates the average rate of return that shareholders in the firm are expecting for the given year. But that’s not accurate because a period of “3.000” implies that all the company’s FCF in Year 3 is generated at the end of Year 3.

The discount rate represents the opportunity cost of investing your money. The project has an initial investment of $1,000 and will generate annual cash flows of $200 for the next 5 years. With positive future cash flows, you can increase your cash outflow substantially over a period of time. Depending on the time period passed, your initial expenditure can affect your cash revenue.

The company should therefore refrain from investing its funds in such 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. 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. At this point, the project’s initial cost has been paid off, with the payback period being reduced to zero. The payback period is the time it takes an investment to break even (generate enough cash flows to cover the initial cost).


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