Discounted Payback Period

Definition
Discounted Payback Period is the duration that an investment requires to recover its cost taking
into consideration the time value of money.

Topic Contents:

1. Definition
2. Formula
3. Explanation
4. Example
5. Advantages
6. Limitations

Formula
Discounted Payback Period:

Cost - Cumulative Present Value of Cash Flow( A - 1)

= (A - 1) +
Present Value of Cash FlowA

Where:

Year in which the cumulative present value of cash

A =
flows from investment exceed the initial cost.
A-1 = The year prior to A.
Present Value of Cash FlowA = Present value of Net cash flow in Year A.
Cumulative Present Value of Cumulative Present Value of the Cash Flows from
=
Cash Flow( A - 1) investment at the end of the Year (A - 1).
Cost = The initial cost of investment.

Explanation
Discounted Payback Period is the time required to recover the present value of cash flows equal
to the cost of investment.

Simple payback period does not take into account the principles of time value of money. Why
this can be a problem when analyzing the payback period can be explained through a simple
example.

Consider the cash flow pattern of the following investments that have an initial cost of $100,000
each:

Investment A Investment B
Year
$ $
1 10,000 40,000
2 20,000 30,000
3 30,000 20,000
4 40,000 10,000
5 5,000 5,000
Total 105,000 105,000

Both investments have a payback period of exactly 4 years. However, 70% of the recovery of
investment A occurs in 3rd and 4th years whereas 70% of the amount in investment B is
recovered in the first 2 years.

By investing in Investment A, the investor will have to sacrifice the additional gain he could
have earned by simply re-investing a higher proportion of cash inflows earlier in other
investment opportunities had he opted for Investment B.

Clearly, investment B has a better payback but the simple payback period fails to account for the
timing of cash flows within the payback period.

As with simple payback period, the investments with shorter discounted payback period should
be preferred as it reduces the risk and uncertainty associated with investments.

The calculation of discounted payback period is very similar to the simple payback period
calculation.

Example
Mr. A is considering to invest in a business.
The business will cost $100,000 to set up and is expected to generate the following yearly net
cash flows:

Year $
1 (20,000)
2 30,000
3 35,000
4 40,000
5 150,000

The cost of capital is 10%.

Calculate the discounted payback period and comment on your answer.

Solution
Cummulative
Discount Factor @ Present Value
Year Cash Flows Present Value of
16% of Cash Flows
Cash Flows
$ $ $
1 (20,000) 0.909 -18,180 -18,180
2 30,000 0.825 24,780 6,600
3 35,000 0.751 26,285 32,885
4 40,000 0.683 27,320 60,205
5 150,000 0.621 93,150 153,365

Discounted Payback Period:

Cost - Cumulative Present Value of Cash Flow( A - 1)

= (A - 1) +
Present Value of Cash FlowA
100,000 - 60,205
= 4 +
93,150
= 4.43 years or 4 years and 157* days

* 0.43 x 365 = 157

Advantages
  Discounted Payback Period incorporates the principle of time value of money into the
payback period calculation which provides a more relevant measure of the risk of non-
recoverability of investments.

Limitations
Discounted Payback Period suffers most of the drawbacks of simple payback period summarized
below:

 Does not take into account the post-payback period cash flows of investments.
 Its calculation can be problematic where multiple negative cash flows are incurred during
the investment period. This problem can be solved however by applying the modified
payback period approach.
 Involves the use of judgment in its interpretation as it does not present a definitive
decision rule unlike other investment appraisal methods such as NPV (e.g. all positive
NPV investment should be accepted).