This payback period calculator is a tool that lets you estimate the number of years required to break even from an initial investment. 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). Using the DCF formula, the calculated discounted cash flows for the project are as follows. 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.
- Positive cash flow that occurs during a period, such as revenue or accounts receivable means an increase in liquid assets.
- Amanda Bellucco-Chatham is an editor, writer, and fact-checker with years of experience researching personal finance topics.
- In addition, comparable company analysis and precedent transactions are two other, common valuation methods that might be used.
- This is especially useful because companies and investors frequently have to choose between multiple projects or investments.
If the investor cannot estimate future cash flows or the project is very complex, DCF will not have much value and alternative models should be employed. It can help those considering whether to acquire a company or buy securities. Discounted cash flow analysis can also assist business owners and managers in making capital budgeting or operating expenditures decisions.
The payback period value is a popular metric because it’s easy to calculate and understand. However, it doesn’t take into account money’s time value, which is the idea that a dollar today is worth more than a dollar in the future. Getting repaid or recovering the initial cost of a project or investment should be achieved as quickly as it allows. 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.
How to Calculate Discounted Payback Period (Step-by-Step)
Comparing various profitability metrics for all projects is important when making a well-informed decision. Next, the second column (Cumulative Cash Flows) tracks the net gain/(loss) to date by adding the current year’s cash flow amount to the net cash flow balance from the prior year. For a bond, the discount rate would be equal to the interest rate on the security. So, the two parts of the calculation (the cash flow and PV factor) are shown above.
Calculating the Discounted Payback Period
Companies and investors should consider other, known factors as well when sizing up an investment opportunity. In addition, comparable company analysis and precedent transactions are two other, common valuation methods that might be used. Discounted cash flow analysis can provide investors and companies with an idea of whether a proposed investment is worthwhile. The positive number of $2,306,727 indicates that the project could generate a return higher than the initial cost—a positive return on the investment. When a company analyzes whether it should invest in a certain project or purchase new equipment, it usually uses its weighted average cost of capital (WACC) as the discount rate to evaluate the DCF.
These two calculations, although similar, may not return the same result due to the discounting of cash flows. For example, projects with higher cash flows toward the end of a project’s life will experience greater discounting due to compound interest. For this reason, the payback period may return a positive figure, while the discounted payback period returns a negative figure. The 15 best practices in setting up and sending nonprofit newsletters payback period is the amount of time for a project to break even in cash collections using nominal dollars. In its simplest form, the formula to calculate the payback period involves dividing the cost of the initial investment by the annual cash flow. This formula assumes that all cash flows received are spread over equal time periods, whether years, quarters, months, or otherwise.
Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. Another advantage of this method is that it’s easy to calculate and understand. This makes it a good choice for decision-makers who don’t have a lot of experience with financial analysis. This means that you would only invest in this project if you could get a return of 20% or more.
Pros and Cons of Discounted Payback Period
Prior to accepting a position as the Director of Operations Strategy at DJO Global, Manu was a management consultant with McKinsey & Company in Houston. He served clients, including presenting directly to C-level executives, in digital, strategy, M&A, and operations projects. The DPP can be used in a cost-benefit analysis as well as for the comparison of different project alternatives.
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. Option 1 has a discounted payback period of
5.07 years, option 3 of 4.65 years while with option 2, a recovery of the
investment is not achieved. The following tables contain the cash flow
forecasts of each of these options. Read through for the definition and formula
of the DPP, 2 examples as well as a discounted payback period calculator. In such situations, we will first take the difference between the year-end cash flow and the initial cost left to reduce.
If Tim has the cash flow to pay the entire invoice in ten days, he can reduce his inventory costs by 2 percent. Tim can either record this inventory purchase using the net method or the gross method to account for the discount. As a general rule of thumb, the shorter the payback period, the more attractive the investment, and the better off the company would be. For example, this initial investment may be on August 15th, the next cash flow on December 31st, and every other cash flow thereafter a year apart. Discounted payback period process is a helpful metric to assess whether or not an investment is worth pursuing.
Specialties include general financial planning, career development, lending, retirement, tax preparation, and credit. For instance, let’s say you own a retail company and are considering a proposed growth strategy that involves opening up new store locations in the hopes of benefiting from the expanded geographic reach. The sooner the break-even point is met, the more likely additional profits are to follow (or at the very least, the risk of losing capital on the project is significantly reduced). Its projections can be tweaked to provide different results for various what-if scenarios.
As you can see, the required rate of return is lower for the second project. Initially an investment of $100,000 can be expected to make an income of $35k per annum for 4 years. Others like to use it as an additional point of reference in a capital budgeting decision framework. To determine the discount period for this stub period, you take the remaining https://simple-accounting.org/ days of the year and divide by the total days in the year. You would not want to use 0.5, 1.5, 2.5, etc., for the discount periods because this company’s sales and FCF are not evenly distributed over the entire year. Due to the discounting of cash flows, these two similar calculations may not yield the same result because of compound interest.
The time value of money assumes that a dollar that you have today is worth more than a dollar that you receive tomorrow because it can be invested. Similarly, if a $1 payment is delayed for a year, its present value is 95 cents because you cannot transfer it to your savings account to earn interest. Once again, you need to “move back” half a year under the Perpetuity Growth Method since it’s based on the company’s cash flows, which arrive halfway through each year under the mid-year convention. The company’s Implied Value increases because the cash flows arrive earlier, and money today is worth more than money tomorrow. It enables firms to compare projects based on their payback cutoff to decide which is most worth it.