Discounted Payback Period

 

Introduction:

The discounted payback period is calculated by the same way as payback period the only difference is that cash flows are converted into present value. It is the period before which the Present Value of cumulative cash flow becomes zero.

Example: Discounted Payback period with even annual cash flow (constant cashflow)

A company is considering a project with initial investment of Rs.700,000. The constant cash flows to be received from the project is Rs.200,000 for a period of 6 years. Discount Rate is 13%.

 

Answer:

The discounted payback period with even annual cash flow shall be calculated as follows:

Year	Cash Flow (Rs)	Discount Factor (13%)	PV of Cash Flow (Rs)	Cumulative PV (Rs)
0	(700,000)	1	(700,000)	(700,000)
1	200,000	0.884	176,800	(523,200)
2	200,000	0.783	156,600	(366,600)
3	200,000	0.693	138,600	(228,000)
4	200,000	0.613	122,600	(105,400)
5	200,000	0.542	108,400	3,000
6	200,000	0.480	96,000	99,000
NPV			99,000

 

The discounted payback period is 4 years+ (105,400 / 108,400 = 0.97 x 12 = 11.64 months or 11 months and 19 days)

Days calculation = 0.64 months x 30 = 19 days

Or in terms of days it can be (105,400 / 108,400 = 0.97 x 365 = 354 days) = 4 years and 354 days.

Note:

The discounted payback period is always longer than payback period because cash flows are discounted which reduces the inflows and increase the period within which investment shall be recovered.

Example: Payback period with uneven annual cash flow

A company is considering a project with initial investment of Rs.700,000. The cash flows to be received from the project are as follows for a period of 6 years. Discount Rate is 13%.

• • Y1 = Rs.75,000
  • Y2 = Rs.150,000
  • Y3 = Rs.265,000
  • Y4 = Rs.285,000                        
  • Y5 = Rs.291,500
  • Y6 = Rs.75,000

•  

 

Answer:

 

The discounted payback period with uneven cash flow shall be calculated as follows:

Year	Cash Flow (Rs)	Discount Factor (13%)	PV of Cash Flow (Rs)	Cumulative PV (Rs)
0	(700,000)	1	(700,000)	(700,000)
1	75,000	0.884	66,300	(633,700)
2	150,000	0.783	117,450	(516,250)
3	265,000	0.693	183,645	(332,605)
4	285,000	0.613	174,705	(157,900)
5	291,500	0.542	157,993	93
6	75,000	0.480	36,000	36,093
NPV			36,093

The discounted payback period is 5 years.

Advantages of Payback Period

• Easy to understand and easy to calculate.
• Based on cash flows of the project and not accounting profit.

Disadvantages of Payback Period

• It is difficult to set minimum payback period due to its subjectivity.
• It may cause selection of a project with earliest payback period then highest NPV of any other project.

 

Audience:

The article is for students to learn basic concept of payback period and for professionals so that they can revise the topic for usage in practical life. 

Advance topics on payback period:

 

Payback Period

Bailout payback period