The Discounted Payback

We saw that one of the shortcomings of the payback period rule was that it ignored time value. There is a variation of the payback period, the discounted payback period, that fixes this particular problem. The discounted payback period is the length of time until the sum of the discounted cash flows is equal to the initial investment. The discounted payback rule would be:

Based on the discounted payback rule, an investment is acceptable if its discounted payback is less than some prespecified number of years.

To see how we might calculate the discounted payback period, suppose that we require a 12.5 percent return on new investments. We have an investment that costs \$300 and has cash flows of \$100 per year for five years. To get the discounted payback, we have to discount each cash flow at 12.5 percent and then start adding them. We do this in Table 9.3. In Table 9.3, we have both the discounted and the undiscounted cash flows. Looking at the accumulated cash flows, we see that the regular payback is exactly three

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

IV. Capital Budgeting

9. Net Present Value and Other Investment Criteria