The time it takes for the present value of future cash flows to equal the initial cost of a project indicates when the project or investment will break even. The calculationtherefore requires the discounting of the cash flows using an interest ordiscount rate. It is a useful way to work out how long it takes to get your capital back from the cash flows.It shows the number of years you will need to get that money back based on present returns. Each present value cash flow is calculated and then added together.The result is the discounted payback period or DPP.

Discounted Payback Period (DPP) Calculator

Knowing when one project will pay off versus another makes the decision easier. The next step is to subtract the number from 1 to obtain the percent of the year at which the project is paid back. Finally, we proceed to convert the percentage in months (e.g., 25% would be 3 months, etc.) and add the figure to the last year in order to arrive at the final discounted payback period number. One observation to make from the example above is that the discounted payback period of the project is reached exactly at the end of a year. In other circumstances, we may see projects where the payback occurs during, rather than at the end of, a given year. If undertaken, the initial investment in the project will cost the company approximately $20 million.

Example 1: Individual Investment

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Cash Flow Projections and DPP Calculation

In other words, the purchasing power of money decreases over time due to factors such as inflation or interest rates. Assume Company A invests $1 million in a project that is expected to save the company $250,000 each year. If we divide $1 million by $250,000, we arrive at a payback period of four years for this investment. Average cash flows represent the money going into and out of the investment.

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Although calculating the payback period is useful in financial and capital budgeting, this metric has applications in other industries. It can be used by homeowners and businesses to calculate the return on energy-efficient technologies such as solar panels and insulation, including maintenance and upgrades. Option 1 has a discounted payback period of5.07 years, option 3 of 4.65 years while with option 2, a recovery of theinvestment is not achieved.

The discounted payback period is a measureof how long it takes until the cumulated discounted net cash flows offset theinitial investment in an asset or a project. In other words, DPP is used tocalculate the period in which the initial investment is paid back. The project has an initial investment of $1,000 and will generate annual cash flows of $200 for the next 5 years.

From another perspective, the payback period is when an investment breaks even from an accounting standpoint. Discounted payback, in contrast, includes the time value of money, so it is viewed from a financial perspective. In any case, the decision for a project option or an investment decision should not be based on a single type of indicator. You can find the full case study here where we have also calculated the other indicators (such as NPV, IRR and ROI) that are part of a holistic cost-benefit analysis.

The discounted payback period of 7.27 years is longer than the 5 years as calculated by the regular payback period because the time value of money is factored in. The discounted payback period (DPP) is a success measure of investments and projects. Although it is not explicitly mentioned in the Project Management Body of Knowledge (PMBOK) it has practical relevance in many projects as an enhanced version of the payback period (PBP). Without considering the time value of money, it is difficult or impossible to determine which project is worth considering. Projecting a break-even time in years means little if the after-tax cash flow estimates don’t materialize.

Many managers and investors thus prefer to use NPV as a tool for making investment decisions. The NPV is the difference between the present value of cash coming in and the current value of cash going out over a period of time. So, the discounted payback period would take 1.98 years to cover the initial cost of $8,000.

However, one common criticism of the simple payback period metric is that the time value of money is neglected. Thus, you should compare your year-end cash flow after making an investment. It’s important to consider other financial metrics and factors specific to the investment before making a decision. The payback period will help the company to use their fund more effective, it recommends to invest in a project which has the shortest payback period.

Payback period refers to the number of years it will take to pay back the initial investment. The main advantage is that the metric takes into account money’s time value. This is important because money today is worth more than money in the future. The discount rate represents the opportunity cost of investing your money. For example, let’s say you have an initial investment of $100 and an annual cash flow of $20.

Discounted payback period refers to time needed to recoup your original investment. In other words, it’s the amount of time it would take for your cumulative cash flows to equal your initial investment. Assume that Company A has a project requiring an initial saving account fees cash outlay of $3,000. The project is expected to return $1,000 each period for the next five periods, and the appropriate discount rate is 4%. The discounted payback period calculation begins with the -$3,000 cash outlay in the starting period.

To calculate discounted payback period, you need to discount all of the cash flows back to their present value. The present value is the value of a future payment or series of payments, discounted back to the present. The decision criteria can vary depending on the organization’s goals, but it often involves comparing the calculated discounted payback period to a predetermined payback period or target set by the company. It helps assess the risk and profitability of an investment by considering the timing and value of cash flows, providing a more accurate picture of its financial feasibility.

Each company will internally have its own set of standards for the timing criteria related to accepting (or declining) a project, but the industry that the company operates within also plays a critical role. Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia. Prior to accepting a position as the Director of Operations Strategy at DJO Global, Manu was a management consultant with McKinsey & Company in Houston.

Management then looks at a variety of metrics in order to obtain complete information. Comparing various profitability metrics for all projects is important when making a well-informed decision. All of the necessary inputs for our payback period calculation are shown below. In fact, the only difference is that the cash flows are discounted in the latter, as is implied by the name. Discounted payback period serves as a way to tell whether an investment is worth undertaking.

1. Unlike the traditional Payback Period, the Discounted Payback Period accounts for the time value of money by discounting future cash flows to their present value.
2. You can use it when analyzing different possibilities to invest your money and combine it with other tools, such as the net present value (NPV calculator) or internal rate of return metrics (IRR calculator).
3. 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.
4. In short, the time value of money is a way of describing the potential return of money.

The discounted payback period involves using discounted cash inflows rather than regular cash inflows. It involves the cash flows when they occurred and the rate of return in the market. The discounted payback period has a similar purpose as the payback period which is to determine how long it takes until an initial investment is amortized through the cash flows generated by this asset. Second, we must subtract the discounted cash https://www.simple-accounting.org/ flows from the initial cost figure in order to obtain the discounted payback period. Once we’ve calculated the discounted cash flows for each period of the project, we can subtract them from the initial cost figure until we arrive at zero. In capital budgeting, the payback period is defined as the amount of time necessary for a company to recoup the cost of an initial investment using the cash flows generated by an investment.

The discounted payback period indicates the profitability of a project while reflecting the timing of cash flows and the time value of money. If the discounted payback period of a project is longer than its useful life, the company should reject the project. The project has an initial investment of $1,000 and will generate annual cash flows of $100 for the next 10 years. The basic method of the discounted payback period is taking the future estimated cash flows of a project and discounting them to the present value. Payback period is the time required to recover the cost of initial investment, it the time which the investment reaches its breakeven points.