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## Definition of Discounted Payback Period

Discounted payback period is a capital budgeting method used to calculate the time period a project will take to break even and recover the initial investments. The calculation is done after considering the time value of money and discounting the future cash flows.

## Formula for Calculating Discounted Payback Period

To calculate the discounted payback period, firstly we need to calculate the discounted cash inflow for each period using the following formula:

Discounted Cash Inflow = Actual cash inflow / (1 + i) n

Here, i refers to the discount rate, and

n refers to the period for which the cash inflow relates

In the next step, we calculate the discounted payback period using the following formula:

Discounted Payback Period = A + B / C

Here,

A refers to the last period having negative discounted cash flow

B refers the value of discounted cumulative cash flow at the end of period A

C refers to the discounted cash flow after the period A

## Example of discounted payback period

Initial investment = $ 70000

Years (n) = 5

Rate (i) = 12%

Cash Flow = $ 20000

Calculate what is Discounted Payback Period?

Solution

Year (n) | Cash Flow (CF) | Present Value Factor
PV = 1 / (1+i) n |
Discounted Cash Flow
(CF x PV) |
Cumulative Discounted Cash Flow (CCF) |

0 | 70000 | 1 | 70000 | 70000.00 |

1 | 20000 | 0.89 | 17857.14 | 52142.86 |

2 | 20000 | 0.79 | 15943.87 | 36198.99 |

3 | 20000 | 0.71 | 14235.60 | 21963.39 |

4 | 20000 | 0.64 | 12710.36 | 9253.03 |

5 | 20000 | 0.57 | 11348.54 | -2095.51 |

A i.e. the last period having negative discounted cash flow = 4

B i.e. the value of discounted cumulative cash flow at the end of period A = 9253.03

C i.e. the discounted cash flow after the period A = 11348.54

Formula for calculating,

Discounted Payback Period = A + B / C

Discounted Payback Period = 4 + 9253.03 / 11348.54 = 4.81 years

## Advantages and Disadvantages of Discounted Payback Period

**Advantages**

- Many managers in the organization prefer discounted payback period because it considers the time value of money while calculating the payback period.
- It determines the actual risk involved in a project and whether the investments made are recoverable or not.

**Disadvantages**

- Calculation of payback period using discounted payback period method fails to determine whether the investment made will increase the firm’s value or not.
- It does not consider the project that can last longer than the payback period. It ignores all the calculations beyond the discounted payback period.
- The major problem with using discounted payback period is that it does not give the manager the exact information required to take a decision for investing in a project. The business manager has to assume the interest rate or the cost of capital to determine the payback period.
- The calculation for discounted payback period can get complex if there are multiple negative cash flows during an investment period.

**Conclusion**

Discounted payback period is an upgraded capital budgeting method in comparison to simple payback period method. It helps to determine the time period required by a project to break even. Even though it suffers from some flaws, yet it is a good method to determine the viability of a project as it considers the time value of money. By incorporating this method along with other methods, the managers can arrive at a right decision and know the exact risk involved in a project.

References

- http://www.investopedia.com/terms/d/discounted-payback-period.asp
- http://accountingexplained.com/managerial/capital-budgeting/discounted-payback-period
- http://accounting-simplified.com/management/investment-appraisal/discounted-payback-period.html
- http://educ.jmu.edu/~drakepp/principles/module6/advdistable.pdf