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What is the 'Discounted Payback Period'

The discounted payback period is a capital budgeting procedure used to determine the profitability of a project. A discounted payback period gives the number of years it takes to break even from undertaking the initial expenditure, by discounting future cash flows and recognizing the time value of money. The net present value (NPV) aspect of the discounted payback period does not exist in a payback period in which the gross inflow of future cash flows are not discounted.

BREAKING DOWN 'Discounted Payback Period'

The general rule for the calculation of the discounted payback period is to accept projects that result in a payback period that is less than the targeted period. A company is able to compare its required break-even date to when the project will break even in terms of discounted cash flows, to approve or reject the project.

Discounted Payback Period Calculation

To begin, the cash flow of a project must be estimated and broken down into periods. These cash flows are then reduced by their present value factor to reflect the discounting process. With the assumption of a large cash outflow to begin the project, future discounted cash flows are net against the initial outflow. The discounted payback period is calculated when the inflows equal the outflows.

Example of Discounted Payback Period

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%. The discounted payback period calculation begins with the -$3,000 cash outlay in the starting period. The first period will experience a +$1,000 cash inflow.

Using the present value discount calculation, this figure is $1,000/1.04 = $961.54. Thus, after the first period, the project still requires $3,000 - $961.54 = $2,038.46 to break even. After the discounted cash flows of $1,000/(1.04)2 = $924.56 in period two, and $1,000/(1.04)3 = $889.00 in period three, the net project balance is $3,000 - ($961.54 +$924.56 + $889.00) = $224.90.

Therefore, after receipt of the fourth payment, which is discounted to $854.80, the project will have a positive balance of $629.90. Therefore, the discounted payback period is sometime during the fourth period.

Payback Period vs. Discounted Payback Period

The payback period is the amount of time for a project to break even in cash collections using nominal dollars. Alternatively, the discounted payback period reflects the amount of time necessary to break even in a project based not only on what cash flows occur, but when they occur and the prevailing rate of return in the market. These two calculations, although similar, may not return the same result due to discounting of cash flows. For example, projects with higher cash flows toward the end of the project life will experience greater discounting due to compound interest. For this reason, the payback period may return a positive figure, while the discounted payback period returns a negative figure.

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