Wednesday, February 3, 2010


Discounted Payback Period

One of the serious objections to the payback method is that it does not discount the cash flows for calculating the payback period. We can discount cash flows and then calculate the payback. The discounted payback period is the number of periods taken in recovering the investment outlay on the present value basis. The discounted payback period still fails to consider the cash flows occurring after the payback period.

Let us consider an example. Projects X and Y involve the same outlay of 8000$ each. The opportunity cost of capital may be assumed as 10%. Project X and Y have 2 years payback but Project X discounted payback 2.6 years and project Y payback 2.9 years.

The projects are indicated of same desirability by the simple payback period. When cash flows are discounted to calculate the discounted payback period, project X recovers the investment outlay faster than project Y, and therefore, it would be preferred over project Y. Discounted payback period for a project will be always higher than simple payback period because its calculation is based on the discounted cash flows. Discounted payback rule is better as it discounts the cash flows until the outlay is recovered. But it does not help much. It does not take into consideration the entries series of cash flows.

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