Payback method formula, example, explanation, advantages, disadvantages

Although it is not explicitly mentioned in the Project Management Body of Knowledge (PMBOK) it has practical relevance in many projects as an enhanced version of the payback period (PBP). After the initial purchase period (Year 0), the project generates $5 million in cash flows each year. The formula for the simple payback period and discounted variation are virtually identical. 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 Discounted Payback Period estimates the time needed for a project to generate enough cash flows to break even and become profitable.

When deciding on any project to embark on, a company or investor wants to know when their investment will pay off, meaning when the cash flows generated from the project will cover the cost of the project. 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. The Payback Period Calculator can calculate payback periods, discounted payback periods, average returns, and schedules of 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. Without considering the time value of money, it is difficult or impossible to determine which project is worth considering.

Projecting a break-even time in years means little if the after-tax cash flow estimates don’t materialize. 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). 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. It is calculated by taking a project’s future estimated cash flows and discounting them to the present value. The calculator below helps you calculate the discounted payback period based on the amount you initially invest, the discount rate, and the number of years. 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.

  1. From above example, we can observe that the outcome with discounted payback method is less favorable than with simple payback method.
  2. This is important because money today is worth more than money in the future.
  3. In the next step, we’ll create a table with the period numbers (”Year”) listed on the y-axis, whereas the x-axis consists of three columns.
  4. When deciding on any project to embark on, a company or investor wants to know when their investment will pay off, meaning when the cash flows generated from the project will cover the cost of the project.

Under payback method, an investment project is accepted or rejected on the basis of payback period. Payback period means the period of time that a project requires to recover the money invested in it. 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. 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.

According to payback method, the project that promises a quick recovery of initial investment is considered desirable. If the payback period of a project is shorter than or equal to the management’s maximum desired payback period, the project is accepted, otherwise rejected. 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. The purchase of machine would be desirable if it promises a payback period of 5 years or less. According to discounted payback method, the initial investment would be recovered in 3.15 years which is slightly more than the management’s maximum desired payback period of 3 years. When the negative cumulative discounted cash flows become positive, or recover, DPB occurs.

This makes it a good choice for decision-makers who don’t have a lot of experience with financial analysis. The two calculated values – the Year number and the fractional amount – can be added together to arrive at the estimated payback period. 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.

Understanding the Discounted Payback Period

Payback period refers to the number of years it will take to pay back the initial 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. 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. Getting repaid or recovering the initial cost of a project or investment should be achieved as quickly as it allows.

Discounted payback method

Since discounting decreases the value of cash flows, the discounted payback period will always be longer than the simple payback period as long as the cash flows and discount rate are positive. To calculate the cumulative cash flow balance, add the present value of cash flows to the previous year’s balance. The cash flow balance in year zero is negative as it marks the initial outlay of capital. 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.

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. Prior to accepting a position as the Director of Operations Strategy at DJO Global, Manu was a management consultant with McKinsey & Company in Houston. He served clients, including presenting directly to C-level executives, in digital, strategy, M&A, and operations projects. Another advantage of this method is that it’s easy to calculate and understand.

Use Excel’s present value formula to calculate the present value of cash flows. The rest of the procedure is similar to the calculation of simple payback period except that we have to use the discounted cash flows as calculated above instead of nominal cash flows. Also, the cumulative cash flow is replaced by cumulative discounted cash flow. Use this calculator to determine the DPP of
a series of cash flows of up to 6 periods.

For more detailed cash flow analysis, WACC is usually used in place of discount rate because it is a more accurate measurement of the financial opportunity cost of investments. WACC can be used in place of discount rate for either of the calculations. A discounted payback period determines how long it will take for an investment’s discounted cash flows to equal its initial cost.

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 how to compute vertical analysis 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.

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However, not all projects and investments have the same time horizon, so the shortest possible payback period needs to be nested within the larger context of that time horizon. 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 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.

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. The discounted payback period (DPP) is a success measure of investments and projects.

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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. 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.

February 10, 2024

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