As you can see in the example below, a DCF model is used to graph the payback period (middle graph below). A longer payback time, on the other hand, suggests that the invested capital is going to be tied up for a long period. I will briefly explain how the payback period functions to help you better understand the concept. Prior to accepting a position as the Director of Operations Strategy at DJO Global, Manu was a management consultant with McKinsey & Company in Houston.

- All of the necessary inputs for our payback period calculation are shown below.
- It is an important calculation used in capital budgeting to help evaluate capital investments.
- Projecting a break-even time in years means little if the after-tax cash flow estimates don’t materialize.
- The other project would have a payback period of 4.25 years but would generate higher returns on investment than the first project.

However, not all projects and investments have the same time horizon, so the shortest possible payback period needs to be nested within the larger context of that time horizon. For example, the payback period on a home improvement project can be decades while the payback period on a construction project may be five years or less. People and corporations mainly invest their money to get paid back, which is why the payback period is so important. In essence, the shorter payback an investment has, the more attractive it becomes. Determining the payback period is useful for anyone and can be done by dividing the initial investment by the average cash flows. The shorter the discounted payback period, the quicker the project generates cash inflows and breaks even.

To begin, we must discount (that is, bring to present value) the cash flows that will occur throughout the project’s years. Where,i is the discount rate; andn is the period to which the cash inflow relates. Assume Company A invests $1 million in a project that is expected to save the company $250,000 each year.

## Illustrative Payback Period Example

The decision rule using the payback period is to minimize the time taken for the return on investment. The table is structured the same as the previous example, however, the cash flows are discounted to account for the time value of money. 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.

## How to Calculate Discounted Payback Period (Step-by-Step)

When the negative cumulative discounted cash flows become positive, or recover, DPB occurs. 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 calculationtherefore requires the discounting of the cash flows using an interest ordiscount rate. 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. The period of time that a project or investment takes for the present value of future cash flows to equal the initial cost provides an indication of when the project or investment will break even.

## Discounted Payback Period Calculation Analysis

At this point, the project’s initial cost has been paid off, with the payback period being reduced to zero. 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.

While the payback period shows us how long it takes for the return on investment, it does not show what the return on investment is. Referring to our example, cash flows continue beyond period 3, but they are not relevant in accordance with the decision rule in the payback method. Cash flow is the inflow and outflow of cash or cash-equivalents of a project, an individual, an organization, or other entities. Positive cash flow that occurs during a period, such as revenue or accounts receivable means an increase in liquid assets. On the other hand, negative cash flow such as the payment for expenses, rent, and taxes indicate a decrease in liquid assets. Oftentimes, cash flow is conveyed as a net of the sum total of both positive and negative cash flows during a period, as is done for the calculator.

Use this calculator to determine the DPP ofa series of cash flows of up to 6 periods. Insert the initial investment (as a negativenumber since it is an outflow), the discount rate and the positive or negativecash flows for periods 1 to 6. The presentvalue of each cash flow, as well as the cumulative discounted cash flows foreach period, are shown for reference. Forecasted future cash flows are discounted backward in time to determine a present value estimate, which is evaluated to conclude whether an investment is worthwhile. In DCF analysis, the weighted average cost of capital (WACC) is the discount rate used to compute the present value of future cash flows. WACC is the calculation of a firm’s cost of capital, where each category of capital, such as equity or bonds, is proportionately weighted.

The term payback period refers to the amount of time it takes to recover the cost of an investment. Simply put, it is the length of time an investment reaches a breakeven https://www.wave-accounting.net/ point. Based on the project’s risk profile and the returns on comparable investments, the discount rate – i.e., the required rate of return – is assumed to be 10%.

Next, we divide the number by the year-end cash flow in order to get the percentage of the time period left over after the project has been paid back. Other metrics, such as the internal rate of return (IRR), profitability index (PI), net present value (NPV), and effective annual annuity (EAA) can also be used to quantify the profitability of a given project. To make the best decision about whether to pursue a project or not, a company’s management needs to decide which metrics to prioritize. Thus, the value of a cash flow equals its notionalvalue, regardless of whether it occurs in the 1st or in the 6thyear.

For example, if a payback period is stated as 2.5 years, it means it will take 2½ years to receive your entire initial investment back. The payback period is the time it takes an investment to break even (generate enough cash flows to cover the initial cost). Certain businesses have a payback cutoff which is essential to consider when proceeding with investment projects. Assume that Company A has a project requiring an initial cash outlay of $3,000.

The value obtained using the discounted payback period calculator will be closer to reality, although undoubtedly more pessimistic. If opening the new stores amounts to an initial investment of $400,000 and the expected cash flows from the stores would be $200,000 each year, then the period would be 2 years. Although electrical invoice template 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.

## Loan Calculators

However, ittends to be imprecise in cases of long cash flow projection horizons or cashflows that increase significantly over time. The discounted payback period determines the payback period using the time value of money. In essence, the payback period is used very similarly to a Breakeven Analysis, but instead of the number of units to cover fixed costs, it considers the amount of time required to return an investment.

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. Inflows are any items that go into the investment, such as deposits, dividends, or earnings.

Investors may use payback in conjunction with return on investment (ROI) to determine whether or not to invest or enter a trade. Corporations and business managers also use the payback period to evaluate the relative favorability of potential projects in conjunction with tools like IRR or NPV. As the equation above shows, the payback period calculation is a simple one. It does not account for the time value of money, the effects of inflation, or the complexity of investments that may have unequal cash flow over time. The screenshot below shows that the time required to recover the initial $20 million cash outlay is estimated to be ~5.4 years under the discounted payback period method. One of the disadvantages of discounted payback period analysis is that it ignores the cash flows after the payback period.