7.8 : Discounted Payback Period

The discounted payback period method is used to determine the time it takes for a project to reach financial breakeven, where the present value of the project's cash inflows equals its initial costs.

The traditional payback period calculates the time it takes for initial investments to be recovered from cash inflows without using the present values of those future cash flows.

In comparison, the discounted payback period method discounts each cash flow back to its present value using a specific discount rate, typically the project's cost of capital.

Consider a business owner purchasing new equipment for twenty thousand dollars and expecting to generate cash inflows of five thousand dollars annually for the next six years.

Assuming a discount rate of ten percent annually, the present value of the cash inflow for the first year is approximately four thousand five hundred forty-five dollars.

The cumulative present value of the cash inflows over the six years is approximately twenty-one thousand seven hundred eighty dollars.

The discounted payback period is within the six-year timeframe, indicating the period during which the business owner can expect to recover the initial investment in the new equipment.

This method provides an accurate reflection of a project's profitability and time to recover, considering the value of money over time.