Payback period (PBP) calculates the time required to recover initial investment made in a project in nominal sense. It is the time period when the cumulative cash inflows from a project equals the amount of initial cash outlay of the project (Moyer, McGuigan, Rao, & Kretlow, 2012). Discounted Payback Period (DPBP) also measures the time needed to recover the original costs of investment but it takes into consideration the time value of money unlike PBP. In DPBP, the cash flows are discounted at required rate of return (cost of capital) before calculating the period of payback.
Let us consider the following examples.
Project A:
Initial Investment = Rs. 120,000
Discount Rate = 10 %
Year
Cash flow (CF) in Rs.
Cumulative CF
PV Factor @ 10%
Discounted CF
Cumulative Discounted CF
0
-120,000
-120,000
1
-120,000.00
-120,000.00
1
48,000
-72,000
0.9091
43,636.80
-76,363.20
2
50,000
-22,000
0.8264
41,320.00
-35,043.20
3
40,000
18,000
0.7513
30,052.00
-4,991.20
4
39,000
57,000
0.6830
26,637.00
21,645.80
Here,
PBP = Number of years before full recovery + ( Unrecovered Amount at the Start of Year/Cashflow During the Year)
= 2 + (22,000/40,000)
= 2.55 years
DPBP = Number of years before full recovery + ( Unrecovered Discounted Amount at the Start of Year/Discounted Cashflow During the Year)
= 3 + (4,991.20/26,637)
= 3.19 years
Project B:
Initial Investment = Rs. 50,000
Cost of Capital = 10 %
Here,
PBP = Net Investment/Annual Cashflow
= 50,000/13,500
= 3.7 years
DPBP = Number of years before full recovery + ( Unrecovered Discounted Amount at the Start of Year/Discounted Cash flow During the Year)
= 4 + (7207.70/8382.15)
= 4. 85 years
Results:
Project
Payback Period
Discounted Payback Period
A
2.55 years
3.19 years
B
3.7 years
4.85 years
From the above result, we can see that the discounted payback period is higher than the payback period because it considers the discounted cash flow for determining the duration for recovering the initial investment of a project.
Decision Criteria
Although payback period is not an effective criteria to decide about the acceptance of a project, it is used at times because it is easy to calculate and understand. In case of independent projects, the management has a pre-determined standard payback period which is usually three or four years and the projects that have less payback period than the standard period are accepted. In case of mutually exclusive projects, the project with lower payback period is selected.
Let us assume the standard payback period for the organization is 4 years. If projects A and B are independent projects, both are selected on the criteria of payback period. Analyzing from the discounted payback period concept, project A is selected and B is rejected as the payback period of project B exceeds the standard set by management.
If these projects are mutually exclusive, project A is selected as its payback period is less than that of the project B.
References
Moyer, R. C., McGuigan, J. R., Rao, R., & Kretlow, W. J. (2012). Contemporary Financial Management (12th ed.). Oklahoma: Cengage Learning.
For further actions, you may consider blocking this person and/or reporting abuse
We're a place where students share, stay up-to-date, learn and grow.
Payback period (PBP) calculates the time required to recover initial investment made in a project in nominal sense. It is the time period when the cumulative cash inflows from a project equals the amount of initial cash outlay of the project (Moyer, McGuigan, Rao, & Kretlow, 2012). Discounted Payback Period (DPBP) also measures the time needed to recover the original costs of investment but it takes into consideration the time value of money unlike PBP. In DPBP, the cash flows are discounted at required rate of return (cost of capital) before calculating the period of payback.
Let us consider the following examples.
Project A:
Initial Investment = Rs. 120,000
Discount Rate = 10 %
Here,
PBP = Number of years before full recovery + ( Unrecovered Amount at the Start of Year/Cashflow During the Year)
DPBP = Number of years before full recovery + ( Unrecovered Discounted Amount at the Start of Year/Discounted Cashflow During the Year)
Project B:
Initial Investment = Rs. 50,000
Cost of Capital = 10 %
Here,
PBP = Net Investment/Annual Cashflow
DPBP = Number of years before full recovery + ( Unrecovered Discounted Amount at the Start of Year/Discounted Cash flow During the Year)
Results:
From the above result, we can see that the discounted payback period is higher than the payback period because it considers the discounted cash flow for determining the duration for recovering the initial investment of a project.
Decision Criteria
Although payback period is not an effective criteria to decide about the acceptance of a project, it is used at times because it is easy to calculate and understand. In case of independent projects, the management has a pre-determined standard payback period which is usually three or four years and the projects that have less payback period than the standard period are accepted. In case of mutually exclusive projects, the project with lower payback period is selected.
Let us assume the standard payback period for the organization is 4 years. If projects A and B are independent projects, both are selected on the criteria of payback period. Analyzing from the discounted payback period concept, project A is selected and B is rejected as the payback period of project B exceeds the standard set by management.
If these projects are mutually exclusive, project A is selected as its payback period is less than that of the project B.
References
Moyer, R. C., McGuigan, J. R., Rao, R., & Kretlow, W. J. (2012). Contemporary Financial Management (12th ed.). Oklahoma: Cengage Learning.