Discounted Payback Period
One of the limitations in using payback period is that it does not take into account the time value of money. Thus, future cash inflows are not discounted or adjusted for debt/equity used to undertake the project, inflation, etc. However, the discounted payback period solves this problem. It considers the time value of money, it shows the breakeven after covering such costs. This technique is somewhat similar to payback period except that the expected future cash flows are discounted for computing payback period.
Discounted payback period is how long an investment’s cash flows, discounted at project’s cost of capital, will take to cover the initial cost of the project. In this approach, the PV of future cash inflows are cumulated up to time they cover the initial cost of the project. Discounted payback period is generally higher than payback period because it is money you will get in the future and will be less valuable than money today.
For example, assume a company purchased a machine for $10000 which yields cash inflows of $8000, $2000, and $1000 in year 1, 2 and 3 respectively. The cost of capital is 15%. The regular payback period for this project is exactly 2 year. But the discounted payback period will be more than 2 years because the first 2 years cumulative discounted cash flow of $8695.66 is not sufficient to cover the initial investment of $10000. The discounted payback period is 3 years.
Decision Rule of Discounted Payback:
If discounted payback period is smaller than some pre-determined number of years then an investment is worth undertaking.