Discounted payback period

The discounted payback period is the length of the period from the beginning of the investment to the time of their payback, taking into account the discounting. The meaning of the method is to discount all the cash flows generated by the project, and to summarize them in a sequential order until they cover the initial investment costs.

In general terms, the discount formula determines the present value of cash that relates to future periods, and shows the future revenues that are determined at the moment. To make a correct estimate of future earnings, you should have information about the forecasted values of revenues, investments, costs, residual value of property, discount rate, capital structure.

The discounted payback period reflects a more objective and more conservative characterization of the project evaluation than the usual payback period. This indicator partially takes into account the risks inherent in the project, which include rising costs, lower incomes, and the emergence of alternative, more profitable investment opportunities.

The discount rate equals the amount of the risk-free investment rate and the risk adjustment for a particular project. In the second case, this indicator reflects the internal rate of return of an alternative project similar in risk.

In addition, there are the following methods that determine the discounted payback period and the discount rate.

The calculation is made based on the weighted average cost of capital, when using its own investments. This method has both advantages and disadvantages. The positive things are that the cost of capital can be calculated accurately, and then identify possible options for alternative use of resources. The disadvantage is that the calculations are made on the basis of dividends and interest on borrowed funds, however, these criteria include risk adjustments that are taken into account when determining the compound interest, which causes a uniform increase over time of the risk.

Discounted payback period and rate are calculated on the basis of interest on borrowed capital. In this case, we mean the percentage at which the enterprise can now take the funds. If it is possible to invest or return capital to creditors, the interest rate on borrowed funds will equal the alternative cost of capital. It is worth noting that in order to determine the discount rate, only the effective interest rate, which is different from the nominal one, should be used, since the period of capitalization may differ.

Settlements are made and based on the rate of safe investment, it is also considered as an alternative cost of money. The following method includes the same rate, but adjusted for a variety of risk factors - the possibility of shortfall in the income provided by the project, the insecurity of project participants, the country risk.

The discount rate and then the discounted payback period are determined taking into account the cost of debt and the risk adjustment. As a result, the risk difference between the company's investment projects is leveled. A possible approach is to discount the flow of money at a rate that reflects only the risk of the project itself and does not take into account the effect of financing.

To determine the discount rate, use the alternative value of money, for which the internal rate of profitability of the marginal accepted and unaccepted projects is accepted. The disadvantage of the method lies in the practical complexity of determining this value, and there is also confusion in the calculations because of the different interest rates for projects.