Payback period approach vs discounted payback period approach
What is the payback period approach?
The ‘payback period approach’ determines how many years it will take to recover the initial project investment cost. Two limitations of the payback period approach is that it does NOT consider the time value of money or the profitability of the project beyond the payback period.
The calculation is simple: you take the upfront project cost and you divide it by the expected annual cash flows. If the project cost will be recovered in the specified time, you would accept the project. If not, you would reject the project.
Let’s run through an example payback period approach question! In the example, you will have to calculate the payback period and then determine whether the project will be accepted or rejected:
What is the discounted payback period approach?
The ‘discounted payback period approach’ determines how many years it will take to recover the initial investment for a project recognizing the time value of money. Remember, the ‘payback period approach’ does not recognize the time value of money. The formula and approach is very similar, except we will need to apply present value factors to any future cash flows.
Let’s run through an example discounted payback period approach question! In the example, you will have to calculate the discounted payback period and then determine whether the project will be accepted or rejected:
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