Discounted Payback Period

Some firms use a variant of the regular payback, the discounted payback period, which is similar to the regular payback period except that the expected cash flows are discounted by the project's cost of capital. Thus, the discounted payback period is defined as the number of years required to recover the investment from discounted net cash flows. Figure 7-3 contains the discounted net cash flows for Projects S and L,

FIGURE 7-2 Payback Period for Projects S and L

Project S: Net cash flow

0

1

2

3

4

-1,000

500

400

300

100

Cumulative NCF

-1,000

-500

-100

200

300

PaybackS = 2.33 years.

Project L: Net cash flow

0

1

2

3

4

-1,000

100

300

400

600

Cumulative NCF

-1,000

-900

-600

-200

400

PaybackL = 3.33 years.

FIGURE 7-3 Projects S and L: Discounted Payback Period

Project S: Net cash flow Discounted NCF (at 10%) Cumulative discounted NCF Paybacks = 2.95 years.

Project L: Net cash flow Discounted NCF (at 10%) Cumulative discounted NCF PaybackL = 3.88 years.

0

1

2

3

4

1,000

500

400

300

100

1,000

455

331

225

68

1,000

-545

-214

11

79

0

1

2

3

4

1,000

100

300

400

600

1,000

91

248

301

410

1,000

-909

-661

-360

50

assuming both projects have a cost of capital of 10 percent. To construct Figure 7-3, each cash inflow is divided by (1 + r)t = (1.10)t, where t is the year in which the cash flow occurs and r is the project's cost of capital. After three years, Project S will have generated $1,011 in discounted cash inflows. Because the cost is $1,000, the discounted payback is just under three years, or, to be precise, 2 + ($214/$225) = 2.95 years. Project L's discounted payback is 3.88 years:

Discounted paybacks = 2.0 + $214/$225 = 2.95 years.

Discounted paybackL = 3.0 + $360/$410 = 3.88 years.

For Projects S and L, the rankings are the same regardless of which payback method is used; that is, Project S is preferred to Project L, and Project S would still be selected if the firm were to require a discounted payback of three years or less. Often, however, the regular and the discounted paybacks produce conflicting rankings.

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Responses

  • jayden
    What are the project’s payback and discounted payback periods?
    8 years ago

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