Payback period and discounted payback: measuring investment recovery time
- Graziano Stefanelli
- Aug 18
- 2 min read
The payback period and discounted payback period are capital budgeting methods used to evaluate how quickly an investment will recoup its initial outlay.
While less sophisticated than Net Present Value (NPV) or Internal Rate of Return (IRR), these methods are valuable for assessing project liquidity and risk, particularly in environments with high uncertainty or when capital must be recovered quickly.
The payback period measures the time needed for cumulative cash inflows to equal the initial investment, while the discounted payback period adjusts those inflows for the time value of money.
The payback period emphasizes simplicity and speed of calculation.
The traditional payback method ignores the time value of money and simply adds up projected cash inflows until they match the initial investment.
It is often used as a screening tool to quickly eliminate projects with excessively long recovery times, especially in industries where technology or market conditions change rapidly.
Formula for Payback Period:
Payback Period = Time before full recovery + (Unrecovered cost at start of year / Cash flow during year)
Example:
An investment of $500,000 generates $150,000 annually.After 3 years, the cumulative inflow is $450,000, leaving $50,000 to recover in year 4.Payback Period = 3 + (50,000 / 150,000) = 3.33 years.
The discounted payback period incorporates the time value of money.
The discounted payback period improves on the traditional method by discounting each year’s cash inflows at the project’s cost of capital before accumulating them.This provides a more accurate reflection of the project’s economic break-even point.
Example:
Using the same $500,000 investment, $150,000 annual inflow, and a 10% discount rate:
Year 1 PV = $150,000 / 1.10 = $136,364
Year 2 PV = $150,000 / 1.10² = $123,966
Year 3 PV = $150,000 / 1.10³ = $112,696
Cumulative PV after 3 years = $372, cumulative gap $127, recovered in year 5.
Strengths and weaknesses differ between the two methods.
The payback period is easy to understand and calculate, making it useful for preliminary screening.
It highlights liquidity risk and the speed of capital recovery but ignores profitability beyond the payback point.
The discounted payback period adds accuracy by considering the time value of money but still fails to measure total value creation or account for cash flows after break-even.
Best practice involves combining payback measures with value-based metrics.
While neither method should be the sole decision criterion, they can complement NPV and IRR analyses.
For example, a project may have a strong NPV but a long payback period, indicating higher liquidity risk.
Management can use this information to adjust financing plans, manage cash reserves, or compare investment alternatives where capital constraints exist.
In capital-intensive industries, companies often set maximum payback thresholds (e.g., three years for technology investments, five years for infrastructure) to control risk exposure and maintain operational flexibility.
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