The discounted payback period method is part of the large family of capital budgeting techniques.
Here’s what you need to know about discounted payback:
1) The discounted payback method is not as simple as the “regular” payback method.
2) Discounted payback is close to, but not as “complete” as Net Present Value.
3) Very often the discounted payback period method leads to the same project selection as the payback method.
4) The discounted payback calculation outcome (in number of years) is always longer than the outcome of the “regular” payback method calculation.
⏱️TIMESTAMPS⏱️
00:00 Introduction to discounted payback
00:43 Payback method explained
02:22 Accept or reject a project based on payback period
03:03 Discounted payback method calculation
06:37 Accept or reject a project based on discounted payback
09:09 Payback period shortcomings
09:54 Discounted payback shortcomings
The payback method is often used as a first screening method for an investment. The payback method asks a very simple central question: How many years does it take to recover the initial investment? An alternative way to phrase the central question is: When do the cumulative cash flows reach zero?
The discounted payback method is very closely related to the payback method, but it poses a slightly different central question: When do the cumulative cash flows reach zero, if time value of money is applied? The “regular” payback method ignores the time value of money, while the discounted payback method incorporates it!
However, both the regular #payback method, which is nice and simple, as well as the #discountedpayback period method, which is slightly more complicated, have a crucial blind spot. The regular payback method answers the question “How many years does it take to recover the initial investment?” Nothing more, nothing less. So if project A has an investment of $1000 and 4 years of $400 benefits per year, and project D has an investment of $1000 with 5 years of $400 benefits per year, the payback method tells you that both projects are equally attractive at a payback period of 2.5 years. It simply ignores what happens after those 2.5 years!
The discounted payback period method answers the question “When do the cumulative cash flows reach zero, if time value of money is applied?” So if project A and project D have the exact same nominal cash flows as well as the exact same discounted cash flows in year 1 through 4 (as we apply the same discount rate), but project D provides one more year of benefits in year 5, then the discounted payback period method tells you bluntly that both projects are equally attractive at a discounted payback period of 3.8 years. It simply ignores what happens after those 3.8 years! This is where more sophisticated methods like Net Present Value or Internal Rate of Return have to come in to provide a very different answer.
Philip de Vroe (The Finance Storyteller) aims to make accounting, finance and investing enjoyable and easier to understand. Learn the business and accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better investing decisions. Philip delivers #financetraining in various formats: YouTube videos, livestreams, classroom sessions, and webinars. Connect with me through Linked In!
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