Discounted Payback Periods
The discounted payback period is a capital budgeting procedure used to determine the profitability of a project. A discounted payback period gives the number of years it takes to break even from undertaking the initial expenditure, by discounting future cash flows and recognizing the time value of money. The metric is used to evaluate the feasibility and profitability of a given project.The more simplified payback period formula, which simply divides the total cash outlay for the project by the average annual cash flows, doesn't provide as accurate of an answer to the question of whether or not to take on a project because it assumes only one, upfront investment, and does not factor in the time value of money.
Definition: The discounted payback period is a capital budgeting procedure used to determine the profitability of a project. It calculates the number of years needed to recover the initial investment by discounting future cash flows, recognizing the time value of money. This metric is used to assess the feasibility and profitability of a given project.
Origin: The concept of the discounted payback period originated in the mid-20th century as capital budgeting techniques evolved. It was introduced to address the shortcomings of the traditional payback period method, particularly the importance of considering the time value of money.
Categories and Characteristics: The discounted payback period has the following characteristics: 1. Considers the time value of money: By discounting future cash flows, the calculation results are more accurate. 2. Suitable for long-term projects: Especially useful for evaluating projects that take a longer time to break even. 3. Higher complexity: Compared to the simple payback period, the calculation process is more complex and requires the use of a discount rate.
The main difference between the discounted payback period and the simple payback period is whether the time value of money is considered. The simple payback period only divides the total cash outflow by the average annual cash flow, which does not provide an accurate answer for whether to undertake the project.
Specific Cases: Case 1: Suppose a company plans to invest $1 million in a new project, with expected cash flows of $200,000, $300,000, $400,000, $500,000, and $600,000 over the next five years. Assuming a discount rate of 10%, the discounted cash flows can be calculated, resulting in a discounted payback period of approximately 3.5 years.
Case 2: Another company plans to invest $2 million in a new project, with expected cash flows of $500,000, $600,000, $700,000, $800,000, and $900,000 over the next five years. Assuming a discount rate of 8%, the discounted cash flows can be calculated, resulting in a discounted payback period of approximately 4 years.
Common Questions: 1. How to choose the discount rate? The discount rate is usually determined based on the company's cost of capital or market interest rates. 2. Is the discounted payback period applicable to all projects? Not necessarily, especially for projects with unstable cash flows or shorter cycles, the discounted payback period may not be suitable.
