Key Difference – Payback Period vs Discounted Payback Period
Payback period and discounted payback period are investment appraisal techniques that are used to evaluate investment projects. The key difference between payback period and discounted payback period is that payback period refers to the length of time required to recover the cost of an investment whereas discounted payback period calculates the length of time required to recover the cost of an investment taking the time value of money into account. Recovering the initial investment is one of the major objectives of any investment project.
CONTENTS
1. Overview and Key Difference
2. What is Payback Period
3. What is Discounted Payback Period
4. Side by Side Comparison – Payback Period vs Discounted Payback Period
5. Summary
What is Payback Period?
The payback period is the length of time required to recover the cost of an investment. Knowing the amount of time that a project would take to recover the initial investment is essential to decide whether the project should be invested in or not. Shorter payback periods are preferred compared to longer ones. The payback period can be calculated using the following formula.
Payback Period = Initial Investment/ Capital Inflow per Period
E.g. DFE Company is planning to undertake an investment project that has a cost of $15m, which is expected to generate a cash flow of $3m per year for the next 7 years. Thus, the payback period will be 5 years ($15m/$3m).
The payback period can be calculated using the above formula if the project is expected to generate equal cash flows for the life of the project. If the project is to generate uneven cash flows then the payback period will be calculated as follows.
E.g. A project that has an initial investment of $20m with a life span of 5 years. It generates the cash flows as follows. Year1= $4m, Year2= $5m, Year3= $8m, Year4= $8m and Year5= $ 10m. The payback period will be,
Payback Period = 3+ ($3m/$8m)
= 3+0.38
= 3.38 years
Figure 1: Payback period
Payback period is a very simple investment appraisal technique that is easy to calculate. For companies with liquidity issues, payback period serves as a good technique to select projects that payback within a limited number of years. However, payback period does not consider the time value of money, thus is less useful in making an informed decision. Further, this method ignores the cash flows made after the payback period.
What is Discounted Payback Period?
Discounted payback period is the length of time required to recover the cost of an investment after considering the time value of money. Here, the cash flows will be discounted at a discounting rate which represents the required rate of return on the investment. Discounting factors can be easily acquired through the present value table that shows the discounting factor with correspondence to the number of years. Discounted payback period can be calculated using the below formula.
Discounted Payback Period = Actual Cash Flow / (1+i) n
i = discount rate
n = number of years
E.g. For the above example, assume the cash flows are discounted at a rate of 12%. The discounted payback period will be,
Discounted Payback Period = 4+ ($1.65m/$5.67m)
= 3+0.29
= 3.29 years
Discounted payback period evades the main drawback of payback period by using discounted cash flows. However, this method also ignores the cash flows made after the payback period.
What is the difference between Payback Period and Discounted Payback Period?
Payback Period vs Discounted Payback Period |
|
| Payback period refers to the length of time required to recover the cost of an investment. | Discounted payback period calculates the length of time required to recover the cost of an investment taking the time value of money into the account. |
| Time Value of Money | |
| Payback period does not account for the effect of time value of money. | Discounted payback period accounts for the effect of time value of money. |
| Cash Flows | |
| Payback period does not use discounted cash flows, thus is less accurate | Discounted payback period uses discounted cash flows, thus is more accurate compared to payback period. |
Summary – Payback Period vs Discounted Payback Period
The difference between payback period and discounted payback period mainly depends on the type of cash flows used for the calculation. Normal cash flows are used in payback period whereas discounted payback period uses discounted cash flows. These two investment appraisal techniques are less complex and less useful compared to others such as Net Present Value (NPV) and Internal Rate of Return (IRR), thus should not be used as the sole decision-making criteria.
References
1.Irfanullah. “Payback Period.” Payback Period Formula | Examples | Advantages and Disadvantages. N.p., n.d. Web. 06 Apr. 2017.
2.”Advantages & Disadvantages of Payback Capital Budgeting Method.” Chron.com. Chron.com, 19 July 2011. Web. 06 Apr. 2017.
3.”Discounted Payback Period.” Investopedia. N.p., 13 Jan. 2016. Web. 06 Apr. 2017.
Peavler, Rosemary. “Pros and Cons of Using the Discounted Payback Period.” The Balance. N.p., n.d. Web. 06 Apr. 2017.