We learned that one of the drawbacks of payback period is that it does not consider time value of money. An alternative is to use the discounted payback period.
The discounted payback period is the number of years it takes to recover the initial investment in terms of the present value of the cash flows. The present value of each cash flow is calculated and then added to arrive at the discounted payback period.
Let’s take the same example with the cash flows for 5 years. Assuming that the firm has a cost of capital of 10%, the discounted cash flows are presented in the third column. Column 4 shows the cumulative discounted cash flows.
|Year||Cash Flow||Discounted Cash Flows||Cumulative Discounted Cash Flows|
As you can see, the project generates a total of $4973.70 in 3 years. By the end of four years, the total cash inflow is $5656.72. This means that the discounted payback period is between 3 and 4 years.
The discounted payback period can be calculated as follows:
Discounted Payback Period = 3 + (5000-4973.70)/683.01 = 3.04 years
Note that the discounted payback period is more than the simple payback period. This is because the cash flows have been discounted.
However, this method is still not considered a good measure of profitability because it doesn’t consider the cash flows that occur after the payback period.