Discounted Payback Period Overview

Overview

This lecture explains the Discounted Payback Period (DPP) technique in capital budgeting, compares it with the Simple Payback method, and demonstrates DPP calculation through an example problem.

Simple Payback Period

• Measures how long a project takes to recover its initial investment from future cash inflows.
• Formula (for constant cash flows): Initial Investment ÷ Annual Cash Inflow.
• Decision criterion: Choose projects with the shortest payback period.
• If management sets a maximum payback period, reject projects exceeding that.
• For uneven cash flows, use cumulative calculation and determine exact period using decimals (years plus months).

Discounted Payback Period (DPP)

• DPP is like simple payback but uses discounted (present value) cash flows.
• DPP is also called the "adjusted payback" as it considers time value of money.
• Steps: Discount future cash flows to present value using a discount rate, then apply payback calculation on present values.
• Use “cumulative present value” (not just cash flows) to track investment recovery.
• Main difference: DPP discounts cash flows, addressing simple payback’s limitation of ignoring time value of money.
• Decision rule: Choose projects with DPP less than or equal to the management’s target period (e.g., ≤ 3 years).

Example Calculation

• Given: Initial investment = ₹1,00,000; annual cash inflows for 5 years; discount rate = 10%.
• Calculate discount factors for each year using 1/(1+rate)^n.
• Multiply each cash inflow by its discount factor to get present values.
• Calculate cumulative present value by adding present values to the (negative) initial investment each year.
• The first year the cumulative amount turns positive indicates recovery.
• If DPP exceeds target (e.g., DPP = 3.067 years > 3 years), reject the project.
• To convert the decimal year to months, multiply just the decimal by 12.

Key Terms & Definitions

• Simple Payback Period — Time taken to recover initial investment using actual cash inflows.
• Discounted Payback Period (DPP) — Time taken to recover initial investment using discounted (present value) cash inflows.
• Discount factor — Present value multiplier: 1/(1+rate)^n.
• Time Value of Money — Principle that money now is worth more than the same amount in the future.
• Cumulative Present Value — Sum of discounted inflows added to the initial investment balance over time.

Action Items / Next Steps

• Practice DPP calculation with given cash flows and discount rates.
• Review simple and discounted payback formulas and decision rules.
• Prepare for potential exam questions involving both payback methods.