The discounted payback period is the number of years it takes for the cumulative discounted cash flows from a project to equal the original investment. The discounted payback period partially addresses the weaknesses of the payback period. Table 4 gives an example of calculating the payback period and discounted payback period. The example assumes a discount rate of 10 percent.

Year

0

1

2

3

4

5

CashFlow (CF)

  (5,000)

          1,500

          1,500

          1,500

         1,500

     1,500

Cumulative (CF)

  (5,000)

        (3,500)

        (2,000)

            (500)

         1,000

     2,500

Discounted (CF)

  (5,000)

    1,363.64

    1,239.67

    1,126.97

   1,024.52

   931.38

Cum Discounted (CF)

  (5,000)

  (3,636.36)

  (2,396.69)

  (1,269.72)

    (245.20)

   686.18

The payback period is three years plus 500/1500 = 1/3 of the fourth year’s cash flow, or 3.33 years. The discounted payback period is between four and five years. The discounted payback period is four years plus 245.20/931.38 = 0.26 of the fifth year’s discounted cash flow, or 4.26 years. The discounted payback period relies on discounted cash flows, much as the NPV criterion does. If a project has a negative NPV, it will usually not have a discounted payback period since it never recovers the initial investment. The discounted payback does account for the time value of money and risk within the discounted payback period, but it ignores cash flows after the discounted pay- back period is reached. This drawback has two consequences. First, the discounted payback period is not a good measure of profitability (like the NPV or IRR) because it ignores these cash flows. Second, another idiosyncrasy of the discounted payback period comes from the possibility of negative cash flows after the discounted payback period is reached. It is possible for a project to have a negative NPV but to have a positive cumulative discounted cash flow in the middle of its life and, thus, a reasonable discounted payback period. The NPV and IRR, which consider all of a project’s cash flows, do not suffer from this problem.

 

Discounted Payback Period

Microsoft Excel 2010
Family Budget Planner Spreadsheet
Discounted Payback Period
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