What is the Difference Between Payback Period and Discounted Payback Period?
🆚 Go to Comparative Table 🆚The payback period and discounted payback period are both investment appraisal techniques used to assess how long it takes to recover the initial investment in a project. However, there are key differences between the two:
- Time Value of Money: The payback period does not account for the time value of money, while the discounted payback period does. This means that the discounted payback period provides a more accurate estimate of when the initial investment will be recovered, as it considers the present value of future cash flows.
- Cash Flows: The payback period uses normal cash flows, whereas the discounted payback period uses discounted cash flows. Discounted cash flows are derived by applying a discount rate to future cash flows, which reflects the time value of money.
- Calculation: The payback period is calculated by dividing the initial investment by the annual cash flows. The discounted payback period, on the other hand, involves calculating the net present value (NPV) of the project's cash flows, using a discount rate.
In summary, the main difference between the payback period and the discounted payback period is that the latter accounts for the time value of money and uses discounted cash flows, providing a more accurate estimate of when the initial investment will be recovered. However, both methods should not be used as the sole criterion for investment decisions, as they do not account for cash flows after the payback period.
Comparative Table: Payback Period vs Discounted Payback Period
The Payback Period and Discounted Payback Period are both investment appraisal techniques used to evaluate investment projects. They differ in their consideration of the time value of money. Here is a table summarizing the differences between the two:
| Feature | Payback Period | Discounted Payback Period |
|---|---|---|
| Definition | The Payback Period is the number of years required to recover the initial investment in a project. | The Discounted Payback Period is the number of years required to recover the initial investment in a project, taking into account the time value of money. |
| Time Value of Money | Does not consider the time value of money. | Considers the time value of money by discounting future cash flows. |
| Formula | Payback Period = (Initial Investment - Cash Flow) / Cash Flow | Discounted Payback Period = Actual Cash Flow / (1 + Discount Rate)^n, where n = number of years, C = actual cash flow, discount rate (r), and n = period of the individual cash flow. |
| Calculation | Calculates the time it takes to recover the initial investment in a project. | Calculates the time it takes to recover the initial investment in a project, considering the present value of future cash flows. |
| Usage | Used to assess the feasibility and profitability of a project. However, it may not be sufficient for decision-making due to its neglect of cash flows after the payback period. | Incorporates discounted cash flows to provide a more accurate assessment of a project's feasibility and profitability. |
In summary, the main difference between the Payback Period and Discounted Payback Period is that the Discounted Payback Period considers the time value of money, making it a more accurate assessment of a project's feasibility and profitability.
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- Trade Discount vs Cash Discount
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- Cost of Equity vs Return on Equity
- Long-term vs Short-term Financing
- Compound Interest vs Simple Interest
- IRR vs NPV
- Cost of Capital vs Cost of Equity
- Period Cost vs Product Cost
- Present Value vs Future Value