Discounted Payback Period (Meaning, Formula)| How to Calculate?

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What is the Discounted Payback Period?

Discounted payback period refers to the time period required to recover its initial cash outlay and it is calculated by discounting the cash flows that are to be generated in future and then totaling the present value of future cash flows where discounting is done by the weighted average cost of capital or internal rate of return.

Discounted Payback Period Formula

From a capital budgeting perspective, this method is a much better method than a simple payback period.

In this formula, there are two parts.

• The first part is “a year before the period occurs.” This is important because by taking the prior year, we can get the integer.
• The next part is the division between cumulative cash flow in the year before recovery and discounted cash flowDiscounted Cash FlowDiscounted cash flow analysis is a method of analyzing the present value of a company, investment, or cash flow by adjusting future cash flows to the time value of money. This analysis assesses the present fair value of assets, projects, or companies by taking into account many factors such as inflation, risk, and cost of capital, as well as analyzing the company’s future sentayho.com.vn more in the year after recovery. The purpose of this part is to find out the proportion of how much is yet to be recovered.

Example

Funny Inc. would like to invest \$150,000 into a project as an initial investment. The firm expects to generate \$70,000 in the first year, \$60,000 in the second year, and \$60,000 in the third year. The weighted average cost of capital is 10%. Find out the discounted payback period of Funny Inc.

We will go step by step.

First, we will find out the present value of the cash flow.

Let’s look at the calculations.

Please note the formula of present value – PV = FV / (1+i) ^n

• Year 0: – \$150,000 / (1+0.10) ^0 = \$150,000
• Year 1: \$70,000 / (1+0.10) ^1 = \$63,636.36
• Year 2: \$60,000 / (1+0.10) ^2 = \$49,586.78
• Year 3: \$60,000 / (1+0.10) ^3 = \$45,078.89

Now, we will calculate the cumulative discounted cash flows –

• Year 0: – \$150,000
• Year 1: – 86,363.64
• Year 2: – 36,776.86
• Year 3: \$8,302.03

Discounted Payback Period = Year before the discounted payback period occurs + (Cumulative cash flow in year before recovery / Discounted cash flow in year after recovery)

= 2 + (\$36.776.86 / \$45,078.89) = 2 + 0.82 = 2.82 years.

Example #2

A project is having a cash outflow of \$ 30,000 with annual cash inflows of \$ 6,000, so let us calculate the discounted payback period, in this case, assuming companies WACC is 15% and the life of the project is 10 years.

In this case, the cumulative cash flows are \$ 30,114 in the 10th year as, so the payback period is approx. 10 years

But, if you calculate the same in simple payback, the payback period is 5 years( \$30,000/\$6,000)

Please note that if the discount rate increases, the distortion between the simple rate of return and discounted payback period increases. Let me explain this further. Let us take the 10% discount rate in the above example and calculate the discounted payback period.

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