Formula to Find Discounted Payback Period
Discounted payback period formula refers to the time period required to recover its initial cash outlay and it is calculated by discounting the cash flows that are to be generated in future and then totaling the present value of future cash flows where discounting is done by the weighted average cost of capital or internal rate of return.
Here one thing you need to remember – a discounted payback period occurs when the negative cash flow turns into positive cash flow.
From a capital budgeting perspective, a discounted payback period formula is a much better method than a simple payback period.
In this formula, there are two parts.
- The first part is “a year before the discounted payback period occurs”. This is important because by taking the prior year we can get the integer.
- The next part is the division between cumulative cash flow in year before recovery and discounted cash flow in year after recovery. The purpose of this part is to find out the proportion of how much is yet to be recovered.
Funny Inc. would like to invest $150,000 into a project as an initial investment. The firm expects to generate $70,000 in the first year, $60,000 in the second year, and $60,000 in the third year. The weighted average cost of capital is 10%. Find out the discounted payback period of Funny Inc.
We will go step by step in calculating the discounted payback period of Funny Inc.
First, we will find out the present value of the cash flow.
Let’s look at the calculations.
Please note the formula of present value – PV = FV / (1+i) ^n
- Year 0: – $150,000 / (1+0.10) ^0 = $150,000
- Year 1: $70,000 / (1+0.10) ^1 = $63,636.36
- Year 2: $60,000 / (1+0.10) ^2 = $49,586.78
- Year 3: $60,000 / (1+0.10) ^3 = $45,078.89
Now, we will calculate the cumulative discounted cash flows –
- Year 0: – $150,000
- Year 1: – 86,363.64
- Year 2: – 36,776.86
- Year 3: $8,302.03
Discounted Payback Period = Year before the discounted payback period occurs + (Cumulative cash flow in year before recovery / Discounted cash flow in year after recovery)
Or, Discounted Payback Period = 2 + ($36.776.86 / $45,078.89) = 2 + 0.82 = 2.82 years.
Discounted Payback Period Calculation in Excel
Let us now do the same example above in Excel.
This is very simple. You need to provide the two inputs of Cumulative cash flow in a year before recovery and Discounted cash flow in a year after recovery. You can easily calculate the discounted payback period in the template provided.
Use and Relevance
- Discounted payback period Formula is a better option for calculating how much time a project would get back its initial investment; because, in a simple payback period, there’s no consideration for the time value of money.
- It can’t be called the best formula for finding out the payback period.
- But from the perspective of capital budgeting and accuracy, this method is far superior to a simple payback period; because in a simple payback period there is no consideration for the time value of money and cost of capital.
- Many managers have been shifting their focus from a simple payback period to a discounted payback period to find a more accurate estimation of tenure for recouping the initial investments of their firms.
- Even if this method is very complex than a simple payback period; but by using the right steps you can find out the discounted payback period.
Discounted Payback Period Calculator
You can use the following Discounted Payback Period Calculator
|Discounted Payback Period Formula =||Year before the discounted payback period occurs +||
This has been a guide to discounted payback period formula. Here we learn how to calculate a discounted period using its formula along with practical examples. Here we also provide you with a discounted payback period calculator with a downloadable excel template.