##### Discounted Payback Period Definition, Formula, and Example

It is a rate that is applied to future payments in order to compute the present value or subsequent value of said future payments. For example, an investor may determine the net present value (NPV) of investing in something by discounting the cash flows they expect to receive in the future using an appropriate discount rate. It’s similar to determining how much money the investor currently needs to invest at this same rate in order to get the same cash flows at the same time in the future. Discount rate is useful because it can take future expected payments from different periods and discount everything to a single point in time for comparison purposes.

The financial return period goes beyond just getting back what was spent; it leads to making more than what went out. It doesn’t just show when money comes back; it also hints at risk levels. Shorter recovery times usually mean less risk for investors or companies. Interpreting payback period results helps you understand how long it will take to get back the money you put into a project. If the payback period is short, this means you’ll recover your costs quickly. This method helps businesses analyze different projects quickly before making financial decisions about them.

For this reason, the simple payback period may be favorable, while the discounted payback period might indicate an unfavorable investment. 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.

- 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.
- The NPV is the difference between the present value of cash coming in and the current value of cash going out over a period of time.
- First, we’ll calculate the metric under the non-discounted approach using the two assumptions below.
- As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy.

The method is also beneficial if you want to measure the cash liquidity of a project, and need to know how quickly you can get your hands on your cash. One of the biggest advantages of the payback period method is its simplicity. https://www.wave-accounting.net/ The method is extremely simple to understand, as it only requires one straightforward calculation. Hence, it’s an easy way to compare several projects and then to choose the project that has the shortest payback time.

To figure this out, you track when your profits match your initial costs. This blog post will unlock the power of Excel to make calculating your investment’s payback period straightforward and error-free. With our guidance, determining if or when an investment can become profitable becomes a less daunting task. Depreciation five brothers default management solutions is a non-cash expense and therefore has been ignored while calculating the payback period of the project. To begin, the periodic cash flows of a project must be estimated and shown by each period in a table or spreadsheet. These cash flows are then reduced by their present value factor to reflect the discounting process.

## Example 1: Even Cash Flows

Without considering the time value of money, it is difficult or impossible to determine which project is worth considering. Also, the payback period does not assess the riskiness of the project. Projecting a break-even time in years means little if the after-tax cash flow estimates don’t materialize. If opening the new stores amounts to an initial investment of $400,000 and the expected cash flows from the stores would be $200,000 each year, then the period would be 2 years. 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.

## Is the Payback Period the Same Thing As the Break-Even Point?

The easiest method to audit and understand is to have all the data in one table and then break out the calculations line by line. Financial modeling best practices require calculations to be transparent and easily auditable. The trouble with piling all of the calculations into a formula is that you can’t easily see what numbers go where or what numbers are user inputs or hard-coded.

Many managers and investors thus prefer to use NPV as a tool for making investment decisions. The NPV is the difference between the present value of cash coming in and the current value of cash going out over a period of time. 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 term payback period refers to the amount of time it takes to recover the cost of an investment. Simply put, it is the length of time an investment reaches a breakeven point.

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 measures the amount of time required to recoup the cost of an initial investment via the cash flows generated by the investment. As the equation above shows, the payback period calculation is a simple one. It does not account for the time value of money, the effects of inflation, or the complexity of investments that may have unequal cash flow over time. This helps visually track when cumulative earnings offset the investment cost.

Therefore, the cumulative cash flow balance in year 1 equals the negative balance from year 0 plus the present value of cash flows from year 1. The discounted payback period is calculated by adding the year to the absolute value of the period’s cumulative cash flow balance and dividing it by the following year’s present value of cash flows. 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 is a capital budgeting procedure used to determine the profitability of a project.

## Payback Period

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. In addition, the potential returns and estimated payback time of alternative projects the company could pursue instead can also be an influential determinant in the decision (i.e. opportunity costs).

It might not factor in every financial variable but provides a clear metric for recovery time on investments. According to payback method, the equipment should be purchased because the payback period of the equipment is 2.5 years which is shorter than the maximum desired payback period of 4 years. In this article, we will explain the difference between the regular payback period and the discounted payback period. You will also learn the payback period formula and analyze a step-by-step example of calculations. Return on Investment (ROI) is the annual return you receive on investment, and it measures the efficiency of the investment, compared to its cost.

Next, check that your cash flow predictions are ready for each period after the investment. These could be yearly or monthly figures depending on the project’s timeline. The payback period is the expected number of years it will take for a company to recoup the cash it invested in a project. So, if an investment of $200 has an annual return of $100, the ROI will be 50%, whereas the payback period will be 2 years ($200/$100). Since IRR does not take risk into account, it should be looked at in conjunction with the payback period to determine which project is most attractive.

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. Unlike net present value , profitability index and internal rate of return method, payback method does not take into account the time value of money. A modified variant of this method is the discounted payback method which considers the time value of money.