Companies often use the discounted payback method when making capital budgeting decisions to establish a maximum acceptable period for a project or investment .
Let’s look at an example:
Rabbit Inc. is a large firm who’s assets are tied up in obligations and are considering a new project opportunity. They are concerned about how soon they can recover their initial investment from the Grail Project’s expected future cash flows. The CEO has provided the expected net cash flows and wants you to find the discounted payback period.
|Year||Expected Cash Flow|
Calculate Present Value & Discounted Cumulative Cash Flows
Since the payback periods shows how long it will take until the project covers it’s initial investment, we need to find present value of each cash flow and then determine the discounted cumulative cash flows.
|Expected Cash Flow||Discounted Cash Flow (PV)||Cumulative Discounted Cash Flow|
Calculate Discounted Payback Period
Now we turn our attention to the year when our project breaks even. We do this by dividing the cumulative cash from the year previous to the break even point by the cash flow received during the break even year.
- Discounted payback period: 1 + ($3,462,963 / $4,008,059) = 1.86 Years
The general takeaways are:
- The discounted payback period indicates the time period at which the project breaks even taking into account the time value of money
- When compared to the conventional payback period, it can sometimes be lower or higher
- Both payback methods have a disadvantage of not considering the value of cash flows beyond the point in time equal to the payback period.