Perhaps one of the most popular economic criteria for evaluating capital projects is the payback period. Payback period is the time required for cumulative cash inflows to recover the cash outflows of the project. For example, a $ 30,000 cash outlay for a project with annual cash inflows of $ 6,000 would have a payback of 5 years ( $ 30,000 / $ 6,000).
The problem with the Payback Period is that it ignores the time value of money. In order to correct this, we can use discounted cash flows in calculating the payback period. Referring back to our example, if we discount the cash inflows at 15% required rate of return we have:
Year 1 - $ 6,000 x .870 = $ 5,220 Year 6 - $ 6,000 x .432 = $ 2,592
Year 2 - $ 6,000 x .765 = $ 4,536 Year 7 - $ 6,000 x .376 = $ 2,256
Year 3 - $ 6,000 x .658 = $ 3,948 Year 8 - $ 6,000 x .327 = $ 1,962
Year 4 - $ 6,000 x .572 = $ 3,432 Year 9 - $ 6,000 x .284 = $ 1,704
Year 5 - $ 6,000 x .497 = $ 2,982 Year 10 - $ 6,000 x .247 = $ 1,482
The cumulative total of discounted cash flows after ten years is $ 30,114. Therefore, our discounted payback is approximately 10 years as opposed to 5 years under simple payback. As the required rate of return increases, the distortion between simple payback and discounted payback grows. Discounted Payback is more appropriate way of measuring the payback period since it considers the time value of money.
Written by: Matt H. Evans, CPA, CMA, CFM | Email: firstname.lastname@example.org | Phone: 1-877-807-8756
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