If someone was to ask you to invest in a particular project, your first question would be:
“How long will it take to get the money back?”
It is quite understandable that in financially challenging times and uncertain circumstances that the world sees today, one would be concerned about recovering the costs concerning any investment they make.
Time taken by a project to generate revenue that is enough for meeting the initial incurred expenditure, is known as the discounted payback period. While some may be wondering how to calculate discounted payback period, others might be trying to figure out the difference between the payback period and discounted payback period.
In this article, we will try to answer both of these questions.
Difference between Discounted Payback Period and Payback Period
Even though the purpose of both these measures is the same, i.e., to specify the period required for reaching a project’s break-even point, the main difference between the two is that DPP takes into account the time value for money, which a generic payback period calculation fails to do.
Time value of money is a concept that claims a certain amount of money holds more value in the present day than a similar amount of money would hold in the future.
DPP therefore adjusts the expected future income for the time value of money to reach a more realistic figure. To calculate DPP, one would require a discount rate against which to adjust the values. The interest rate prevalent in the market, or the expected rate of return on the investment-both may be used as a discount rate. Financial experts at certain organizations also use the weighted average cost of capital or an accounting interest rate to discount the projected future earnings.
Quite understandably, a shorter discounted payback period is more favorable for an investor as it means the project would generate cash inflows at a faster pace and hence break even soon. Therefore, when faced with choosing between two investment opportunities, it would be wise to select one that has a shorter DPP.
On the contrary, if the discounted payback period is more than the life of the project, it would make no sense to pursue it.
Since the generic payback period does not take into account the time value of money, cash flows used in that calculation are notional and not discounted values. This makes the calculation less precise than DPP in terms of projecting cash flows. However, it may have used in other high-level analyses
How to calculate Discounted Payback Period?
Calculating the discounted payback period is a two-step process. The first step involves adjusting the net cash flows for every year to the present value. The second step is to subtract an accumulation of the resulting figures every year from the initial cost incurred. When the difference is nil, the payback period is said to have been achieved.
Below is the formula for calculating discounted cash flows:
Cash flow for the period / (1+i)y,
Where “i” is the discount rate being used and “y” is the year for which the cash flow is being discounted.
Once we have derived the values of discounted cash flows for each year, we will subtract them from the initial cost until we reach zero.
The time it takes to cover the complete cost would be the discounted payback period.
However, if DPP is not achieved at the end of a complete year but somewhere in between, this is the formula you would use to derive the exact value:
DPP = Year before DPP occurs + Cumulative Cash Flow in Year before Recovery ÷ Discounted Cash Flow in Year after Recovery
Now that you have understood how to calculate the discounted payback period, let’s have a look at its pros and cons.
Advantages and Disadvantages of a Discounted Payback Period
DPP allows for a cost-benefit analysis of a particular project. It helps decide whether the investment should be made and if yes, then how long would it take to get the return on investment. It also helps choose the better one amongst the two projects.
However, like all measures of financial management, DPP has its limitations too. It does not help foresee the project’s viability after the break-even point has been reached. An analyst would have no idea how profitable the investment would be afterward, and if relying completely on the DPP one would remain unaware of its total worth.
Therefore, one of the disadvantages is that a discounted payback period may misguide an analyst about the viability of long-term projects that may take comparatively longer to break even but have a higher net present value.
Payback periods, either generic or discounted, are not the only measures that a company uses to assess a project’s viability and hence must not be solely relied upon. Net present value, internal rate of return, and profitability index are also used to evaluate a project. To reach the most appropriate decision, a company usually uses a mix of all these financial measures.