Based on the project’s risk profile and the returns on comparable investments, the discount rate – i.e., the required rate of return debtors control account – is assumed to be 10%. The discounted payback period, in theory, is the more accurate measure, since fundamentally, a dollar today is worth more than a dollar received in the future. Therefore, it would be more practical to consider the time value of money when deciding which projects to approve (or reject) – which is where the discounted payback period variation comes in. To begin, the periodic cash flows of a project must be estimated and shown by each period in a table or spreadsheet. These cash flows are then reduced by their present value factor to reflect the discounting process.

The present value is the value of a future payment or series of payments, discounted back to the present. In particular, the added step of discounting a project’s cash flows is critical for projects with prolonged payback periods (i.e., 10+ years). The initial outflow of cash flows is worth more right now, given the opportunity cost of capital, and the cash flows generated in the future are worth less the further out they extend. The cumulative discounted cash flow at the end of the 3rd year is $7.4m, and the discounted cash flow in the next year is projected to be $18m. Thus, we divide 7.4 by 18 to approximate the 3 years and “something” result.

## Discounted Payback Period Formula

The discounted payback period indicates the profitability of a project while reflecting the timing of cash flows and the time value of money. It helps a company to determine whether to invest in a project or not. 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 $200 for the next 5 years.

## Examples of Applying the DPP

The two calculated values – the Year number and the fractional amount – can be added together to arrive at the estimated payback period. The inflation rate for consumer prices in the United States, according to the Bureau of Labor Statistics in June 2024. Investors should consider the diminishing value of money when planning future investments. Where CF is the Cash Flow for the respective nth year, and r is the opportunity cost of capital.

Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more. Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia. The DPP can be used in a cost-benefit analysis as well as for the comparison of different project alternatives. You can think of it as the amount of money you would need today to have the same purchasing power as a future payment.

## Discounted Payback Period 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. 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.

- If a business is choosing between several potential investments, the one with the shortest discounted payback period will be the most profitable.
- Others like to use it as an additional point of reference in a capital budgeting decision framework.
- In this example, the cumulative discountedcash flow does not turn positive at all.
- 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.

For example, if it takes five years to recover the cost of an investment, the payback period is five years. 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. The following tables contain the cash flowforecasts of each of these options.

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. The numbers used in this example are stemming from the case study introduced in our project business case article where you will also find the results of the simple payback period method. In this analysis, 3 project alternatives are compared with each other, using the discounted payback period as one of the success measures.

The discounted payback period is often used to better account for some of the shortcomings, such as using the present value of future cash flows. For this reason, the simple payback period may be favorable, while the discounted payback period might indicate an unfavorable investment. 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. Payback period refers to the number of years it will take to pay back the initial investment. The discounted payback period is a simple metric to determine if an investment will be sufficiently profitable to justify the initial cost.

If the discounted payback period for a certain asset is less than move from excel to accounting software the useful life of that asset, the investment may be approved. If a business is choosing between several potential investments, the one with the shortest discounted payback period will be the most profitable. The discounted payback period is a goodalternative to the payback period if the time value of money or the expectedrate of return needs to be considered. There are two steps involved in calculating the discounted payback period. First, we must discount (i.e., bring to the present value) the net cash flows that will occur during each year of the project. The shorter the discounted payback period, the quicker the project generates cash inflows and breaks even.

With positive future cash flows, you can increase your cash outflow substantially over a period of time. Depending on the time period passed, your initial expenditure can affect your cash revenue. Essentially, you can determine how long you’re going to need until your original investment amount is equal to other cash flows. We will also cover the formula to calculate it and some of the biggest advantages and disadvantages.

At the end of the day, the Discount Payback Period relies on the opportunity cost of capital, so picking an appropriate discount rate will make a significant difference in your analysis. The payback period is favored when a company is under liquidity constraints because it can show how long it should take to recover the money laid out for the project. If short-term cash flows are a concern, a short payback period may be more attractive than a longer-term investment that has a higher NPV.