Discounted payback period

Definition

The discounted payback period is the time it takes for an investment to generate cash flows sufficient to recover its initial cost, accounting for the time value of money. It provides a more accurate assessment of an investment's profitability compared to the traditional payback period by discounting future cash flows.

5 Must Know Facts For Your Next Test

1. The discounted payback period accounts for the time value of money, unlike the traditional payback period.
2. It requires calculating the present value of future cash flows using a discount rate.
3. An investment is considered acceptable if its discounted payback period is less than or equal to a specific threshold set by the company.
4. This method does not account for cash flows received after the payback period, which can be a limitation.
5. It is commonly used in capital budgeting to assess and compare different projects.

Review Questions

• What distinguishes the discounted payback period from the traditional payback period?
• Why is it important to account for the time value of money when calculating the discounted payback period?
• What could be a limitation of using only the discounted payback period in investment decisions?

Related terms

Net Present Value (NPV): A method that calculates the difference between present value of cash inflows and outflows over a project's lifetime.

Internal Rate of Return (IRR): The discount rate at which the net present value of all cash flows from an investment equals zero.

Payback Period: The amount of time it takes for an investment to generate enough cash flow to recover its initial cost without considering time value of money.