As a business owner or finance leader, you’re likely often met with the task of assessing whether a given business investment is worthwhile.
And one of the first calculations you’re likely to run to make that assessment is the payback period, a metric that describes how long it will take for the revenues from a given investment to “pay back” the cost of that investment.
You might decide, for example, that an acceptable payback period is three years, and if the investment you’re considering won’t have broken even after that time, it’s not worth pursuing.
But here’s the thing:
The value of money today differs from the value of that money in the future. This is known as the “time value of money” and is something that a standard payback period calculation fails to take into account.
That’s why many business leaders and investors opt to use the discounted payback period instead, a modified version of the payback period calculation that seeks to incorporate the fact that the value of money decreases over time.
In this article, we’re going to explore discounted payback period, explaining how it differs from the standard payback period, how to calculate it, and the various pros and cons associated with using it for business decision-making.
What is a discounted payback period?
The discounted payback period is a capital budgeting procedure that investors and business leaders use to assess the potential profitability of a given project. It’s based on the standard payback period but incorporates a discount rate that integrates the concept of the time value of money.
Let’s take a step back and discuss that idea. What is the time value of money?
The time value of money is the financial concept that a given unit of money (a dollar, say) is not worth the same across different periods of time.
As a general rule, the value of money decreases over time. That is, a dollar today is worth more than a dollar tomorrow, which is worth more than a dollar next month, and so on.
There are a number of reasons why money decreases in value, the main one being inflation, but that’s outside the scope of today’s lesson.
Let’s return to the discounted payback period.
A discounted payback period tells you the amount of time (typically expressed in years but sometimes in months for fast-returning projects) it would take to break even from a given investment expenditure.
Importantly, it takes into account the fact that the revenue generated by that investment is a future cash flow and that, owing to the time value of money, that future cash flow is worth less when expressed in terms of its current value.
Difference between discounted payback and payback period
The big difference between the regular payback period and the discounted payback period is that the latter considers the time value of money.
Both are designed to assess whether a given project should be invested in. However, the standard payback period treats cash flows as if they have the same value, regardless of when the revenue is received.
The discounted payback period, on the other hand, does take this into account by incorporating what is known as a discount rate (the rate at which future cash flows are discounted back to a present value).
Calculating discounted payback period
To calculate your discounted payback period, you need four figures:
- The initial investment required
- The predicted cash inflows the investment is expected to generate (for each period)
- The discount rate you’re going to use
- The time periods (e.g. the number of years) of which the investment is expected to generate cash inflows
For the discount rate, investors most commonly used a company’s WACC or their required rate of return for that investment.
Discounted payback period formula
The discounted payback period formula is not a simple formula. Instead, there are a few steps required.
You first need to discount the cash flows for each year you expect to generate revenue from the project. You then add up the discounted cash flows to find the year in which your cash flow meets or exceeds the investment.
Then, you can interpolate to find the exact payback period figure.
This is best demonstrated with an example.
Discounted payback period example
Let’s say you’re considering investing in a project that has an upfront cost of $10 million and it’s expected to generate $2 million of additional revenue each year. You’ve decided to use your required rate of return of 10% as the discount rate.
First, we calculate the DCF (discounted cash flow) for each year using this formula.
DCFt = CashFlowt / ((1 + r)t)
Where:
- r = 10% (0.10)
- t = Year
For the first year, the DCF is $1,818,182. In year 2, its $1,652,893. We also add these up as we go to give a cumulative DCF count. Here’s what the cumulative DCFs look like:
- Year 1: $1,818,182
- Year 2: $3,471,075
- Year 3: $4,973,704
- Year 4: $6,339,731
- Year 5: $7,581,574
- Year 6: $8,711,432
- Year 7: $9,738,576
- Year 8: $10,672,343
So, the point where we break even is somewhere between years 7 and 8. To determine the exact figure, we need to then apply the following formula:
DPP = 7 + ((Initial Investment - Y7 Cumulative DCF) / Y8 DCF)
Where:
- Initial investment = $10,000,000
- Y7 Cumulative DCF = $9,738,576
- Y8 DCF = $933,767
The result is that our discounted payback period is 7.28, which means it will take 7.28 years to repay our original investment when considering the time value of money.
If we didn’t consider the time value of money and instead applied the standard formula, our payback period would be 5 years. That’s a significantly shorter period of time than 7.28, so you can see how the application of the principle of the time value of money can dramatically affect investment decisions.
Why should business owners pay attention to discounted payback period?
When considering allocating funds toward a given project, a company or investor naturally wants to know how long it will take for the cash flows generated from the project to cover the initial costs.
This is especially important when weighing up multiple opportunities. You may have three options in front of you but only have enough capital to invest in one right now. Understanding how long it will take the project to recoup is important to making that decision.
Generally speaking, shorter payback periods are favorable to longer ones.
Beyond assessing projects against one another, the discounted payback period plays an important role in financial management, especially as it relates to investment evaluation and cash flow management.
In particular, discounted payback period is important to:
- Risk assessment. Projects with shorter discounted payback periods are seen as less risky than those with longer payback periods.
- Cash flow management. Understanding how long it will take to fill a cash reserve back up after a large investment is crucial to the effective management of company cash flow.
- Project viability. In capital budgeting, discounted payback period helps assess the viability of a project or compare two potential projects against each other.
- Budgeting and resource allocation. An accurate calculation of the expected discounted payback period for a project helps business leaders better allocate financial resources, focusing on projects that improve cash flow in the short term.
Comparing discounted payback period with other financial metrics
While discounted payback period is an important metric to use in assessing investments, it's certainly not the only financial metric you should consider.
Here are some other metrics investors and business leaders use to weigh up projects.
Net Present Value (NPV)
NPV calculates the total value that an investment adds to the firm, discounting those future cash flows to a present value.
It's useful for directly measuring how much wealth a project can generate, which you can then compare against the total investment cost.
NPV is a complementary metric to be assessed alongside discounted payback period as opposed to being an alternative.
Internal Rate of Return (IRR)
IRR tells you the discount rate at which the NPV of a project or investment is zero. This makes it easy to compare against the company’s cost of capital.
Like NPV, IRR doesn’t focus on the timing of cash flows, so it’s best assessed alongside the discounted payback period for a fuller picture.
Advantages and disadvantages of discounted payback period
The main point in favor of using a discounted payback period to assess different investment options is that it takes the time value of money into account.
This makes it a more realistic indicator of whether money should be spent today or kept aside for future projects.
It does have some disadvantages, however.
Compared to the standard payback period calculation, discounted payback period is more complex and first requires a discount rate to be established.
Additionally, any payback period analysis ignores cash flows after the payback period. It’s not a calculation of your total expected return, but it only indicates how long it will take to break even on an investment.
Make smarter more informed finance decisions
Discounted payback period is an important tool for assessing potential business investments, helping you understand how long it will take for a given investment to break even while also taking into account the time value of money across the period during which you expect to generate revenues from said investment.
However, it's not the only financial figure you’ll want to dig into when making investment decisions.
You may also wish to consider your debt-to-equity ratio, your current ratio, and your gross margin, among other measurements.
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