The discounted payback period method calculates the time it takes for a project to reach financial breakeven, where the present value of its cash inflows equals the initial investment. Unlike the traditional payback period, which only considers the time required to recover the initial investment, this method accounts for the time value of money by discounting each cash inflow back to its present value using a specific discount rate, typically the project's cost of capital.
For example, a manufacturing company invests $30,000 in energy-efficient machinery, expecting annual cash inflows of $7,000 for five years. Using a discount rate of 8%, the present value of the first year's cash inflow is approximately $6,481. The cumulative present value of the inflows over the five years is around $27,949. The discounted payback period occurs within the five-year mark, indicating when the company will fully recover its investment, adjusted for the time value of money.
This method offers a more precise assessment of investment recovery and profitability by factoring in the diminishing value of future cash flows over time.
From Chapter 7:
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