FREE online courses on Capital Budgeting Analysis - Three Economic Criteria
for Evaluating Capital Projects - Discounted Payback Period
The final economic criteria we will use is the Discounted
Payback Period. Payback refers to the number of years it takes to recover our
net investment. In our previous example (Example 6), we could use a simple
payback calculation as follows:
$ 24,100 / $ 5,788 = 4.2 years
However, this method does not recognize the time value of
money and as we previously indicated, we must consider the time value of money
because of inflation, uncertainty, and opportunity costs. Therefore, we will use
the discounted cash flows to calculate the payback period (discounted payback
period).
Example 14 - Calculate Discounted Payback Period
Referring back to Example 6, we can calculate the discounted
payback period as follows:
Year
Cash Flow x
P.V. Factor =
P.V. Cash Flow Total to Date
1 $ 5,788
.893
$ 5,169
$ 5,169
2
5,788
.797
4,613
9,782
3
5,788
.712
4,121 13,903
4
5,788
.636
3,681 17,584
5
5,788
.567
3,282 20,866
5
3,250
.567
1,843 22,709
Under the Discounted Payback Period, we would never receive a
payback on our project; i.e. the total to date present cash flows never reached
$ 24,100 (net investment). If we had relied on the regular payback calculation,
we would falsely assume that this project does payback in the fourth year.
In summary, we use economic criteria that have realistic
economic assumptions about capital investments. Three economic criteria that
meet this test are:
Net Present Value
Modified Internal Rate of Return
Discounted Payback Period
