What is Discounted Payback Period?
Discounted Payback period is the updated version of payback period that consider the time value of money. Considering the limitation of traditional Payback period method, the financial analysts taking discounted payback period method as the very useful and complete method of calculating the payback period of the company. To counter the limitation, discounted payback period was initiated which consider the time value of money by discounting the cash inflows of the project for each period at a suitable discount rate.
However, both the payback period and the discounted payback period are using to evaluate the profitability and feasibility of a specific project.
Calculation Procedures of DCF
As time value of money is the main focus, the present of value cash inflow to be discounted with the determine discount rate. For this purpose the management of the company should set a discount rate which would be realistic and which will not produce any unrealistic result. After determining the discount rate, the cash inflow to be discounted.
Discounted Cash Inflow = Actual Cash Inflow/(1+i)n
i is the discount rate
n is the number of period to which the cash inflow relates.
From the above formula, we can say that there are two factors which are the determinants of DCF calculation, one is Actual cash inflow and another one is present value factor i.e 1/(1+i)n. Actual cash flow is discounted by the present value factor for getting the present value of cash inflow.
After getting the cumulative present value of cash inflows, the Payback period to be calculated and at this stage calculation is similar to Traditional Payback period method. In traditional Payback method ” Cumulative cash flow” use and in a Discounted Cash flow method ” Discounted Cumulative Cash Flow” using and this is the difference of the two methods.
Hence, Discounted Payback Period = A + (B/C)
A = Negative Discounted cumulative cash flow of the last period
B = Absolute value of discounted cumulative cash flow at the end of the period A; and
C = Discounted cash flow during the period after A.
Example of Discounted Payback Period
An initial investment of Juno Products Ltd. is $23,24,000 and expecting cash flow generate $600,000 per year for 6 years. Calculate the discounted period of the investment if the discount rate is 11%.
|Year (n)||Cash flow (CF)||DCF @ 11%||Discounted Cash Flow||Cumulative Discounted Cash Flow|
Discounted Payback Period = 5 + (106,462/320,785) = 5.33 years
A shorter payback period indicates lower risk. In case of mutual projects which has a same return, the project which has a shorter payback period should be chosen. Again, management may also set a target payback period which projects could be rejected due to high risk and uncertainty. However, accepts and rejects decision is not so easy as describe.