Calculating Payback and Discounted Payback
This calculator can be used to determine both simple payback as well as discounted payback for an investment. The calculator needs a total of five inputs, including:
- The value of the initial investment, stated as a nominal value, meaning not adjusted for the discount rate or inflation. This calculator assumes the investment occurs in Period 0
- The nominal cash flow per period. When examining cash flows and payback, one period is typically equal to one year
- The number of periods over which the cash flow occurs
- The discount rate, also known as the investor’s opportunity cost, which for a business could be their weighted average cost of capital
- The final value of the investment, if any. This is sometimes known as the investment’s salvage value. Once again, this would be a nominal value, meaning not adjusted for inflation or discounted for the opportunity cost
The calculator then provides the user with three sets of outputs:
- The simple payback for the investment. In the case of no payback, the calculator will return a value of zero
- The discounted cash flows for each period, which would include the investment’s final discounted value
- Finally, the calculator provides the discounted payback period. Once again, In the case of no payback the calculator will return a value of zero
Note: Under certain conditions, the calculator will return a value for simple payback and a zero for discounted payback. This is expected behavior if the discounted cash flows do not result in a payback before the final period.
Understanding Payback and Discounted Payback
This calculator can be used by both individuals and small businesses to assess the value of a investment using payback. Typically, projects or investments are assessed using several measures of profitability. In addition to payback and discounted payback, net present value, internal rate of return (IRR), and profitability index can also provide useful insights.
Payback is a simple concept; it measures the number of periods (typically years) it takes to return to the original investment. For example, if a business invests in a new machine costing 10,000 and that machine supplies profits of 5,000 per year, the simple payback on that machine would be two years. In the same way, an investment of 100,000 providing profits of 10,000 per year would have a simple payback of ten.
One of the drawbacks of simple payback is that it ignores the time value of money. When a business makes an investment in a new machine, they are foregoing the opportunity to invest that money elsewhere. This opportunity cost, also known as the discount rate for a company might be their weighted average cost of capital. For an individual, it could be the return they might have earned by placing the money in the stock market or buying a bond. To account for this lost opportunity, we can discount the cash flows occurring in the future. That is precisely what the discounted payback calculation does.
Interpreting the Results of this Calculator
All the monetary inputs for our calculator should be in nominal values, meaning they are not adjusted for inflation. The calculator does not show the information used to derive the simple payback period since those values are as entered into the calculator and without any adjustment. The calculator does show the discounted cash flows for the number of periods selected. The calculator also assumes that in the case where the original investment (such as a machine) had a salvage value, this additional cash inflow would occur during the terminal year or period selected. For example, if the number of periods selected is ten, the calculator determines the discounted Final Investment Value and provides that positive cash flow in period ten.
Finally, the calculator will provide fractions of a period. If the period is equal to one year, a payback of 5.5 would be equal to five years and 0.5 x 12, or six months. In the same manner, a payback of 5.9 would be equal to five years and 0.9 x 12, or 11 months.