Payback and discounted payback. The cumulative cash flow table would become:. Two other advantages are that payback is easy to calculate and to understand. There are, however, disadvantages associated with the payback method of investment appraisal: Cash flows after the payback period are ignored, therefore the effect of the whole project on the cash flows of the organisation are not considered.
A target is required, which can be difficult to set and is arbitrary. The time value of money is not considered. From the table above, it is evident that the payback period is three years. Conclusion Candidates need to be able to perform the calculations for payback and discounted payback, as well as understand how useful these measures, as a method of investment appraisal, can be. Written by a member of the Paper FFM examining team. Related Links. Student Accountant hub page.
The calculation therefore requires the discounting of the cash flows using an interest or discount rate. The generic payback period, on the other hand, does not involve discounting.
Thus, the value of a cash flow equals its notional value, regardless of whether it occurs in the 1 st or in the 6 th year. This may fit for the purpose of many high-level analyses. However, it tends to be imprecise in cases of long cash flow projection horizons or cash flows that increase significantly over time. If the expected return rate of an investment is used as the discount rate to calculate the discounted payback period, both indicators can be applied in conjunction to determine different types of payback periods:.
In order to calculate the DPP, create a table with a column for the periods, cash flows, discounted cash flows and cumulative discounted cash flows. Identify y, n and p and insert the numbers in the above-mentioned formula source: Clayman, Fridson, Troughton: Corporate Finance: A Practical Approach.
Alternatively, you can use the calculator embedded in this article. Use this calculator to determine the DPP of a series of cash flows of up to 6 periods. Insert the initial investment as a negative number since it is an outflow , the discount rate and the positive or negative cash flows for periods 1 to 6. The Calculator is determining the DPP. The present value of each cash flow, as well as the cumulative discounted cash flows for each period, are shown for reference.
The numbers used in this example are stemming from the case study introduced in our project business case article where you will also find the results of the simple payback period method. The only difference between solving for n based on the PV of annuity formula and the formula shown at the top of the page is substituting PV for the initial investment since they are both equal. As stated in the prior section, the process of calculating the discounted payback period when all cash flows are equal could be simplified by using a present value of annuity table to calculate n.
If the cash flows are uneven, then the longer method of discounting each cash flow would be used. This site was designed for educational purposes. The user should use information provided by any tools or material at his or her own discretion, as no warranty is provided. When considering this site as a source for academic reasons, please remember that this site is not subject to the same rigor as academic journals, course materials, and similar publications.
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