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What is Discounted Payback Period?
The "discounted payback period" is a modification of the simple payback version where the time value of money is considered in the calculation. In discounted payback period calculation, different metrics are used to measure the amount of time the project will take to "break-even."
In some cases, the discounted payback is measured to the point of time where the net cash flows generated from the project cover the initial cost of the project.
Simple and discounted payback periods are both used to measure the profitability and feasibility of an investment project.
Underlying Meaning of Discounted Payback Period
The discounted payback period is used to measure the time period an investment project takes to cover the initial cost of the project.
It considers both profitability and time value of money to calculate the discounted payback period.
In this metric, future cash flows are anticipated and adjusted to get the time value of money.
It represents the total period a project takes to generate cash flows so that the cumulative total cash flows equal the initial cost of the project.
Shorter discounted payback periods generate earlier returns on investment. Hence, shorter discounted payback periods are preferable when two mutually exclusive investment projects are dealt with.
Calculating Discounted Payback Period
The discounted payback period is calculated in two steps.
First, the net cash flows that will occur each year should be brought to net present value by discounting.
Second, the discounted cash flows should be subtracted from the initial cost to arrive at the discounted payback period.
Once the discounted cash flows for each period of the project are calculated, subtraction should be continued until the value of zero is reached. The time period it takes to reach zero is the discounted payback period.
One simple observation that is notable in specific cases of discounted payback periods is that in some circumstances, the period may lie in the midst of a year instead of at the end of the year.
In such circumstances, the year-end cash flows are subtracted from the initial cash flow.
Next, the number is divided by the year-end cash flow to get the percentage value of the time period left over after the investment in the project has been totally paid back.
The third step is to subtract the number obtained after the second step from 1 to obtain the percentage of the year at which the project is totally paid back.
Finally, the percentage is converted in months (e.g., 25% will be 3 months, etc.) and add the figure to the last year to get the final discounted payback period value.
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