The discounted payback period is the period of time over which the cash flows from an investment pay back the initial investment, factoring in the time value of money. This approach adds discounting to the basic payback period calculation, thereby greatly increasing the accuracy of its results. The basic formula to determine the payback period is:
Amount invested ÷ Average annual cash flows
The discounted payback period is instead derived by following these steps:
- Create a table in which is listed the expected cash outflow related to the investment in Year 0.
- In the following lines of the table, enter the cash inflows expected from the investment in each subsequent year.
- Multiply the expected annual cash inflows in each year in the table by the applicable discount rate, using the same interest rate for all of the periods in the table. No discount rate is applied to the initial investment, since it occurs at once.
- Create a column on the far right side of the table that lists the cumulative discounted cash flow for each year. The calculation in this final column is to add back the discounted cash flow in each period to the remaining negative balance from the preceding period. The balance is initially negative because it includes the cash outflow to fund the project.
- When the cumulative discounted cash flow becomes positive, the time period that has passed up until that point represents the payback period.
To make the calculation even more accurate, include in subsequent periods any additional cash outflows to pay for the project, such as may be associated with upgrades or maintenance.
This approach is significantly more accurate than the basic payback period formula. However, it also suffers from a higher level of complexity, which is what makes the payback period such a commonly-used calculation.