Discounted payback period

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The discounted payback period (DPP) is the amount of time that it takes (in years) for the initial cost of a project to equal to discounted value of expected cash flows, or the time it takes to break even from an investment. [1] It is the period in which the cumulative net present value of a project equals zero.

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Calculating DPP

Cumulative Discounted cash flows will start with a negative value due to the original cost of investment, but as cash is generated each year after the original investment the discounted cash flows for those years will be positive, and the cumulative discounted cash flows will progress in a positive direction towards zero. When the negative cumulative discounted cash flows become positive, or recover, DPP occurs.

Discounted payback period is calculated by the formula:

DPP = Year before DPP occurs + Cumulative Discounted Cash flow in year before recovery ÷ Discounted cash flow in year after recovery [2]

Advantages

Discounted Payback Period helps businesses reject or accept projects by helping determine their profitability while taking into account the time-value of money. [1] This is done via the decision rule: If the DPP is less than its useful life, or any predetermined period, the project can be accepted. If the DPP is greater than the specified period or the project's useful life, the project should be rejected. The DPP also helps compare mutually exclusive projects, as the project with the shorter DPP should be accepted.

Disadvantages

The Discounted Payback method still does not offer concrete decision criteria to determine if an investment increases a firms value. In order to calculate DPP, an estimate of the cost of capital is required. Another disadvantage is that cash flows beyond the discounted payback period are ignored entirely with this method. [3]

See also

Related Research Articles

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References

  1. 1 2 Staff, Investopedia (2009-12-08). "Discounted Payback Period". Investopedia. Retrieved 2017-10-23.
  2. "Pros and Cons of Using the Discounted Payback Period". The Balance. Retrieved 2017-10-23.
  3. Peterson-Drake, Pamela. "Advantages and Disadvantages of Capital Budgeting Techniques" (PDF). Retrieved 23 October 2017.