Discounted Payback Period: A More Realistic Investment Measure

When evaluating potential investments, companies need reliable metrics to assess profitability and risk. The payback period, which calculates the time required to recoup the initial investment, is a commonly used tool. However, the simple payback period suffers from a significant flaw: it ignores the time value of money.

Enter the Discounted Payback Period (DPP). This refined version addresses the time value of money by discounting future cash flows to their present value. In essence, it recognizes that a dollar received today is worth more than a dollar received in the future due to factors like inflation and the potential for earning interest.

How it Works

The DPP calculates the number of periods it takes for the sum of the discounted cash inflows to equal the initial investment. Here’s the general process:

1. Discount Future Cash Flows: For each period (usually years), discount the expected cash inflow back to its present value. This is done using the company’s cost of capital or required rate of return as the discount rate. The formula is:
   Present Value (PV) = Future Value (FV) / (1 + Discount Rate)^Number of Periods
2. Calculate Cumulative Discounted Cash Flows: Sum the present values of the cash flows for each period. This gives you a running total of the discounted cash inflows.
3. Determine the Payback Period: Identify the period when the cumulative discounted cash flows equal or exceed the initial investment. This is the discounted payback period.

For example, if an investment costs $10,000 and generates discounted cash flows of $3,000 in year 1, $4,000 in year 2, and $5,000 in year 3, the cumulative discounted cash flows would be $3,000, $7,000, and $12,000 respectively. Therefore, the DPP would be between 2 and 3 years. A more precise calculation would involve interpolating within the third year.

Advantages of the Discounted Payback Period

• Incorporates Time Value of Money: This is the primary advantage over the simple payback period. It provides a more realistic picture of the investment’s true profitability.
• Simple to Understand: While more complex than the simple payback period, it’s still relatively easy to comprehend and calculate compared to other capital budgeting techniques like Net Present Value (NPV) or Internal Rate of Return (IRR).
• Focuses on Liquidity: It highlights how quickly the initial investment will be recovered, which is crucial for companies concerned about liquidity and cash flow.

Disadvantages

• Ignores Cash Flows Beyond the Payback Period: Similar to the simple payback period, the DPP doesn’t consider any cash flows generated after the payback period, potentially overlooking highly profitable long-term investments.
• Arbitrary Cut-off: The acceptance criteria (e.g., “accept projects with a DPP less than 5 years”) is often arbitrary and not necessarily linked to shareholder value.
• Doesn’t Directly Measure Profitability: It only indicates how quickly the investment is recovered, not how profitable it is overall.

Conclusion

The Discounted Payback Period offers a more sophisticated approach to assessing investments than the simple payback period by incorporating the time value of money. While it’s a useful tool, it shouldn’t be the sole factor in making investment decisions. It’s best used in conjunction with other capital budgeting methods like NPV and IRR to gain a comprehensive understanding of an investment’s potential value and risks.