Definition
The Discounted Payback Method is a capital budgeting technique that takes into account the time value of money. This method calculates the number of years it takes for the cumulative discounted cash inflows from a project to equal the initial investment outlay. It is a more refined version of the payback period method because it considers the present value of future cash flows.
Examples
Example 1
Imagine a company invests $100,000 in a project expected to generate $30,000 in annual cash inflows over 5 years. The firm’s discount rate is 10% per annum.
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Calculate present value of each year’s cash inflow:
- Year 1: \( \frac{30,000}{(1+0.1)^1} = $27,273 \)
- Year 2: \( \frac{30,000}{(1+0.1)^2} = $24,793 \)
- Year 3: \( \frac{30,000}{(1+0.1)^3} = $22,539 \)
- Year 4: \( \frac{30,000}{(1+0.1)^4} = $20,490 \)
- Year 5: \( \frac{30,000}{(1+0.1)^5} = $18,627 \)
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Accumulate discounted cash inflows:
- End of Year 1: $27,273
- End of Year 2: $52,066
- End of Year 3: $74,605
- End of Year 4: $95,095
- End of Year 5: $113,722
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The discounted payback period is between Year 4 and Year 5, as the cumulative inflows exceed the initial investment during this period. The exact point can be calculated proportionally if needed.
Example 2
A project requires an initial investment of $50,000 and is anticipated to generate the following cash flows over the next four years: $15,000, $20,000, $15,000, and $10,000 with a discount rate of 5%.
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Calculate present value of each year’s cash inflow:
- Year 1: \( \frac{15,000}{(1+0.05)^1} = $14,286 \)
- Year 2: \( \frac{20,000}{(1+0.05)^2} = $18,140 \)
- Year 3: \( \frac{15,000}{(1+0.05)^3} = $12,951 \)
- Year 4: \( \frac{10,000}{(1+0.05)^4} = $8,230 \)
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Accumulate discounted cash inflows:
- End of Year 1: $14,286
- End of Year 2: $32,426
- End of Year 3: $45,377
- End of Year 4: $53,607
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The discounted payback period is between Year 3 and Year 4, surpassing the initial investment just before Year 4.
Frequently Asked Questions (FAQ)
What is the primary difference between the discounted payback method and the traditional payback period method?
The primary difference is that the discounted payback method accounts for the time value of money by discounting the cash flows, whereas the traditional payback period does not.
Why is the time value of money important in capital budgeting?
The time value of money reflects the principle that a dollar today is worth more than a dollar in the future due to its potential earning capacity. This is critical in capital budgeting for accurately determining the worth of future cash inflows.
What are the limitations of the discounted payback method?
Despite accounting for the time value of money, this method still ignores cash flows that occur after the payback period and does not measure overall project profitability. It also doesn’t account for the project’s risk aspects adequately.
How does the discounted payback method compare to Net Present Value (NPV)?
While both methods account for the time value of money, NPV provides a measure of the total value added by the project, whereas the discounted payback method only focuses on the time required to recoup the initial investment.
In practice, when is the discounted payback method most often used?
The discounted payback method is frequently used in conjunction with other metrics, such as NPV and IRR, to provide a more comprehensive analysis of the project’s viability.
Related Terms
- Capital Budgeting: The process of planning and managing a firm’s long-term investments.
- Time Value of Money: The concept that money available now is worth more than the same amount in the future.
- Payback Period Method: A simpler method of determining how long it will take to recover the initial investment from the cash inflows generated by the project, without considering the discount rate.
- Discounted Cash Flow (DCF): A valuation method used to estimate the value of an investment based on its expected future cash flows, adjusted for the time value of money.
- Net Present Value (NPV): The difference between the present value of cash inflows and outflows over a period, used to assess profitability.
Online References
- Investopedia - Discounted Payback Period
- CFA Institute - Discounted Payback Period
- Corporate Finance Institute - Discounted Payback Method
Suggested Books for Further Studies
- “Principles of Corporate Finance” by Richard A. Brealey, Stewart C. Myers, and Franklin Allen
- “Fundamentals of Corporate Finance” by Stephen A. Ross, Randolph W. Westerfield, and Bradford D. Jordan
- “Financial Management: Theory and Practice” by Eugene F. Brigham and Michael C. Ehrhardt
- “Valuation: Measuring and Managing the Value of Companies” by McKinsey & Company Inc., Tim Koller, Marc Goedhart, and David Wessels
Accounting Basics: “Discounted Payback Method” Fundamentals Quiz
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