Discounted Payback Period

The ordinary payback period treats all cash flows as if they had the same value, regardless of when they arrive. The discounted payback period fixes this by first discounting each year's cash flow at the required rate of return.

Take a machine costing 50,000 that brings in 15,000, 18,000, 20,000 and 12,000 over four years. Discounted at 8%, these are worth about 13,889, 15,432, 15,877 and 8,820. After three years, the discounted total is about 45,198, leaving 4,802 to recover. Year four's discounted cash flow is 8,820, so the cost is recovered about 54% of the way through the year. The discounted payback period is about 3.5 years, compared with about 2.9 years using simple payback.

Because discounting makes future cash smaller, the discounted payback period is always longer than the simple one.

It is a more realistic measure of how long money is at risk, but it still ignores cash flows after the payback point. It is therefore best used as a secondary check alongside net present value.