It is a modified form of payback period method that we have discussed. As you know that PBP ignores time value of money and this is the main reason, analyst tries to avoid this method. However, they prefer to use discounted payback period as it is one of the most valuable technique for long term project’s evaluation. Using a pre-determined discount rate, we find out the present value of future cash flows and then determine the number of years, the project is repaying back its initial investment.
Example
ABC is engaged in the production of FMCG. It is considering investing in a capital project which requires initial investment of $ 30,000. The cash inflows of $ 6,000 per annum are expected to occur from year 1 to year 10. Evaluate this project using discounted PBP method with a discount rate of 15 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c}. Accept the project if the project is repaying itself up to the 5th year.
Solution
| Year | Cash flow | Discount factor | Discounted Cash Flow | Accumulated Cash Flow |
| 0 | -30,000 | 1.0 | -30,000 | -30,000 |
| 1 | 6,000 | 0.870 | 5,220 | -24,780 |
| 2 | 6,000 | 0.756 | 4,536 | -20,244 |
| 3 | 6,000 | 0.658 | 3,948 | -16,296 |
| 4 | 6,000 | 0.572 | 3,432 | -12,864 |
| 5 | 6,000 | 0.497 | 2,982 | -9,882 |
| 6 | 6,000 | 0.432 | 2,592 | -7,290 |
| 7 | 6,000 | 0.376 | 2,256 | -5,034 |
| 8 | 6,000 | 0.327 | 1,962 | -3,072 |
| 9 | 6,000 | 0.284 | 1,704 | -1,368 |
| 10 | 6,000 | 0.247 | 1,482 | 114 |
From the calculation above, it is evident that project is repaying its initial investment in the 10th year. As per the question, the project would be accepted if it repays itself within 05 years. So, ABC should ignore this capital project over the basis of Discounted PBP.