Payback period is very simple to calculate. Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment. It is one of the simplest investment appraisal.
Payback Period = Initial Investment / Cash Inflow per Period
Accept the project only if it’s payback period is less than the target payback period.
It can be a measure of risk which is natural to a project. Since cash flows that occur later in a project's life are considered more uncertain, payback period provides an indication of how certain the project cash inflows are. For companies facing liquidity problems, it provides a good ranking of projects that would return money early.
Discounted payback period is a bit different than the calculation for regular payback period. This is due to cash flows used in the calculation are discounted by the weighted average cost of capital used, interest rate, and the year in which the cash flow is received. Here is an example of a discounted cash flow:
Discounted Cash Inflow = Actual Cash Inflow / (1 + i)n
DPP = Year before DPP occurs + Cumulative cash flow in year before recovery/discounted cash flow in year after recovery
An example of the calculation for discounted payback period is the following:
Imagine that a company wants to invest in a project costing $10,000 and expects to generate cash flows of $5,000 in year 1, $4,000 in year 2, and $3,000 in year 3. The weighted average cost of capital is 10%.
First, discount the cash flows back to the present or to their present value. Here are the calculations:
Year 0: -$10,000/(1+.10)^0 = $10,000
Year 1: $5000/(1+.10)^1= $4,545.45
Year 2: $4000/(1+.10)^2= $3,305.79
Year 3: $3000/(1+.10)^3= $2,253.94
Step 2 is to calculate the cumulative discounted cash flows:
Year 0: -$10,000
Year 1: -$ 5,454.55
Year 2: -$ 2,148.76
Year 3: $ 105.18
Discounted payback period occurs when the negative cumulative discounted cash...