Discounted Payback Period: Revealing Insights into NPV

Imagine you are considering starting a small business, perhaps a trendy coffee cart. You need to invest in the cart, equipment, and initial supplies. The payback period, in its simplest form, is like figuring out how long it will take for your coffee sales to cover your initial investment. Let’s say your cart costs $10,000 and you expect to make a profit of $2,000 per year. The simple payback period would be five years, meaning it will take five years of profits to get your initial $10,000 back.

Now, let’s introduce the concept of ‘discounted’ payback period. Think about this: would you rather receive $2,000 today or $2,000 five years from now? Most people would prefer the money today. Why? Because money today can be invested or used immediately. This is the essence of the time value of money – money is worth more today than the same amount in the future. Inflation erodes purchasing power over time, and there’s also the opportunity cost of not having the money available to invest and earn returns.

The discounted payback period takes this time value of money into account. Instead of simply adding up your yearly profits, we ‘discount’ future profits back to their present value. This discounting process is like applying a reverse interest rate. We use a discount rate, which represents the opportunity cost of capital or the required rate of return for your investment. Essentially, we’re saying that future cash flows are worth less in today’s dollars.

So, with the discounted payback period, we’re not just asking ‘when do we get our money back?’ but ‘when do we get our money back in today’s dollars, considering the time value of money?’ This will always be a longer period than the simple payback period because we are reducing the value of future cash inflows.

Now, let’s talk about Net Present Value, or NPV. NPV is a more comprehensive measure of a project’s profitability. It calculates the present value of all expected cash inflows from a project and subtracts the initial investment. Think of it as the total value the project is expected to create for you, in today’s dollars. If the NPV is positive, it means the project is expected to generate more value than it costs, making it a potentially good investment. If the NPV is negative, the project is expected to lose value.

What specific information does the discounted payback period reveal about the NPV? The discounted payback period tells you how quickly a project recovers its initial investment on a present value basis. If a project has a discounted payback period that is shorter than a predetermined benchmark, it suggests that the project recovers its initial investment relatively quickly, considering the time value of money.

However, and this is crucial, the discounted payback period reveals very limited information about the magnitude or even the sign of the NPV. A project can have a short discounted payback period but still have a negative NPV. This happens when, after the payback period, the project generates only small or even negative cash flows.

Imagine two projects. Project A has a discounted payback period of three years. Project B has a discounted payback period of five years. Based on discounted payback alone, you might prefer Project A. However, let’s say Project A generates very little cash flow after year three, while Project B continues to generate substantial cash flows for many years after year five. In this scenario, Project B could have a significantly higher, and even positive, NPV, while Project A might have a low or even negative NPV, despite its faster discounted payback.

The discounted payback period primarily reveals information about a project’s liquidity and risk. A shorter discounted payback period is generally seen as less risky because you recover your initial investment sooner. It also means your capital is tied up for a shorter duration, improving liquidity. It is a measure of how quickly you get your initial investment back on a present value basis.

However, it completely ignores cash flows that occur after the payback period. Therefore, it is not a reliable indicator of a project’s overall profitability, which is what NPV measures. While a project that fails to meet its discounted payback period might very likely have a negative NPV, a project that does meet its discounted payback period could still have either a positive or negative NPV. The discounted payback period provides insight into the timing of cash recovery but not the total value creation of the project as NPV does. For a comprehensive assessment of a project’s financial viability, NPV remains the superior and more informative metric.