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The calculation
therefore requires the discounting of the cash flows using an interest or
discount rate. 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%.

  1. For example, if a company wants to recoup the cost of a machine within 5 years of purchase, the maximum desired payback period of the company would be 5 years.
  2. Some
    organizations may also choose to apply an accounting interest rate or their
    weighted average cost of capital.
  3. He served clients, including presenting directly to C-level executives, in digital, strategy, M&A, and operations projects.
  4. Once you have this information, you can use the following formula to calculate discounted payback period.
  5. In essence, the shorter payback an investment has, the more attractive it becomes.
  6. It involves the cash flows when they occurred and the rate of return in the market.

But there are a few important disadvantages that disqualify the payback period from being a primary factor in making investment decisions. First, it ignores the time value of money, which is a critical component of capital budgeting. For example, three projects can have the same payback period; however, they could have varying flows of cash. Payback period is the amount of time it takes to break even on an investment.

Discounted payback period is a variation of payback period which uses discounted cash flows while calculating the time an investment takes to pay back its initial cash outflow. One of the major disadvantages of simple payback period is that it ignores the time value of money. To counter this limitation, discounted payback period was devised, and it accounts for the time value of money by discounting the cash inflows of the project for each period at a suitable discount rate. The discounted payback period is used to evaluate the profitability and timing of cash inflows of a project or investment.

Advantages and Disadvantages of the Payback Period

The appropriate timeframe for an investment will vary depending on the type of project or investment and the expectations of those undertaking it. 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. 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. The numbers used in this example are stemming from the case study introduced in our project business case article where you will also find the results of the simple payback period method.

Logistics Calculators

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. Assume Company A invests $1 million in a project that is expected to save the company $250,000 each year. If we divide $1 million by $250,000, we arrive at a payback period of four years for this investment. 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.

What Is the Formula for Payback Period in Excel?

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. In real-life scenarios, depreciation is considered as it is unlikely an operating machine would remain optimal for an extended period.

Payback Period vs. Discounted Payback Period

One way corporate financial analysts do this is with the payback period. People and corporations mainly invest their money to get paid back, which is why the payback period is so important. In essence, the shorter payback an investment has, the more attractive it becomes. Determining the payback period is useful for anyone and can be done by dividing the initial investment by the average cash flows. In this example, the cumulative discounted
cash flow does not turn positive at all.

It is calculated by taking a project’s future estimated cash flows and discounting them to the present value. 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 payback period value is a popular metric because it’s easy to calculate and understand. However, it doesn’t take into account money’s time value, which is the idea that a dollar today is worth more than a dollar in the future. 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.

Depreciation is a non-cash expense and therefore has been ignored while calculating the payback period of the project. Where,
i is the discount rate; and
n is the period to which the cash inflow relates. This is especially useful because companies and investors frequently have to choose between multiple projects or investments.

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. 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. So, the two parts of the calculation (the cash flow and PV factor) are shown above.

For example, the payback period on a home improvement project can be decades while the payback period on a construction project may be five years or less. In project management, this measure is often used as a part of a cost-benefit analysis, supplementing other profitability-focused quickbooks accountant support 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.

One of the disadvantages of discounted payback period analysis is that it ignores the cash flows after the payback period. Thus, it cannot tell a corporate manager or investor how the investment will perform afterward and how much value it will add in total. Given a choice between two investments having similar returns, the one with shorter payback period should be chosen. Management might also set a target payback period beyond which projects are generally rejected due to high risk and uncertainty.

Discounted payback period calculation is a simple way to analyze an investment. One limitation is that it doesn’t take into account money’s time value. This means that it doesn’t consider that money today is worth more than money in the future. For example, let’s say you have an initial investment of $100 and an annual cash flow of $20. If you’re discounting at a rate of 10%, your payback period would be 5 years. Discounted payback period refers to the number of years it takes for the present value of cash inflows to equal the initial investment.

We will also cover the formula to calculate it and some of the biggest advantages and disadvantages. 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. An initial investment of $2,324,000 is expected to generate $600,000 per year for 6 years. Calculate the discounted payback period of the investment if the discount rate is 11%. The payback period is calculated by dividing the initial capital outlay of an investment by the annual cash flow. In its simplest form, the formula to calculate the payback period involves dividing the cost of the initial investment by the annual cash flow.