Other Project Evaluation Methods (Payback Period, Discounted Payback)

Introduction

Project evaluation isn’t always straightforward, especially when liquidity is a prime concern or when you want a quick sense of how soon your investment might be recouped. While Net Present Value (NPV) and Internal Rate of Return (IRR) remain the gold standards in modern capital budgeting, the Payback Period and Discounted Payback Period methods provide quick—and sometimes comfortingly simple—insights. In corporate finance, you’ll see these “payback” criteria pop up when time is of the essence or when managers face financing constraints.

I remember a friend’s family business that was investing in a new bottling machine. They didn’t go into complicated models right away. They just asked: “How many months—yes, months—until we get our money back?” This question nicely captures the essence of the Payback Period method. Of course, they eventually calculated a more thorough NPV, but the payback question gave them a helpful initial filter.

Below, we dive into both the Payback Period and the Discounted Payback Period. We’ll examine why these methods might come in handy, their shortcomings, and how you might see them show up in your exam or in real practice.

Payback Period Basics

The Payback Period calculates how long it takes for a project’s cumulative cash inflows to equal the original investment. If a company invests USD 100,000 in a project, and it generates USD 25,000 in net cash inflows each year (assuming no complication from taxes or capital structure), the payback time is 4 years. It can’t get simpler than that, right?

This measure can be quite useful if: • You need a rough, intuitive gauge of project’s payback horizon.
• Liquidity constraints are severe, so the firm wants its cash recovered quickly.
• The project is small, or the manager wants a “quick and dirty” measure before doing deeper analysis.

But the simplicity of Payback Period is also its Achilles’ heel. It doesn’t account for the time value of money (i.e., a dollar received later is worth less than a dollar received now). And it doesn’t consider what happens after that payback cutoff. You could have a project that recovers its costs in four years but yields massive returns in years 5, 6, and beyond. Under a naive payback rule, that robust future cash flow gets totally ignored after the cutoff is reached.

Payback Period Formula

Although the Payback Period is conceptually straightforward, it helps to see a formulaic approach. If “Investment” is the initial outlay and “Annual Cash Inflow” is the uniform annual inflow:

Payback Period = Investment ÷ Annual Cash Inflow

This, however, only works when annual cash inflows are uniform. If cash flows fluctuate, you typically accumulate them period by period until you reach the initial outlay.

Discounted Payback Period

Because missing time value of money is a big oversight, the Discounted Payback Period improves on the original approach by discounting each future cash flow to its present value. So you still track how many years (or months, or quarters) it takes to cover the initial outlay, but each cash inflow is first brought back to present-day dollars. That makes the measure more accurate.

Advantages of Discounted Payback Period

• Incorporates time value of money, giving a more conservative and realistic outlook.
• Still straightforward and easy to explain—albeit slightly more complex than the plain Payback Period.
• Potentially more suitable when a firm is extremely risk-averse and wants to ensure it recovers its money (in present value terms) rapidly.

Limitations

• Ignores cash flows beyond the cutoff—the same shortcoming as the simple Payback Period.
• Typically yields a longer payback horizon than the simple payback method, which could cause managers to reject projects that might be good in the long run.
• Doesn’t directly measure profitability, only time to get your money back in present value terms.

Discounted Payback Calculation

Let’s consider a quick example. Suppose you invest USD 100,000 in a project that yields the following net after-tax cash flows at year-end:

• Year 1: USD 20,000
• Year 2: USD 30,000
• Year 3: USD 40,000
• Year 4: USD 50,000

Assume a 10% cost of capital (or discount rate). We discount each cash flow:

Present Value of Cash Flow in Year t = (Cash Flow in Year t) ÷ (1 + r)^(t)

So:

• PV at end of Year 1: 20,000 ÷ (1.10)^1 = 18,182
• PV at end of Year 2: 30,000 ÷ (1.10)^2 = 24,793
• PV at end of Year 3: 40,000 ÷ (1.10)^3 = 30,053
• PV at end of Year 4: 50,000 ÷ (1.10)^4 = 34,155

You accumulate these discounted values until you reach the initial 100,000 outlay:

• End of Year 1: 18,182
• End of Year 2: 18,182 + 24,793 = 42,975
• End of Year 3: 42,975 + 30,053 = 73,028
• End of Year 4: 73,028 + 34,155 = 107,183

We see the initial cost of 100,000 is fully recovered sometime between Year 3 and Year 4—because at the end of Year 3, the total is 73,028, which is still below 100,000, but after Year 4 it’s 107,183. If you do a fractional approach, you see how many months into Year 4 it takes. Roughly you need (100,000 – 73,028) = 26,972 more to break even on a discounted basis. Since the Year 4 discounted inflow is 34,155, you can estimate:

Fraction in Year 4 = 26,972 ÷ 34,155 ≈ 0.79 of a year.

Hence, the Discounted Payback Period for this project is about 3.79 years.

Illustrative Diagram

It sometimes helps to visualize the difference between the two measures. Below is a Mermaid diagram showing cumulative cash inflows (simple vs. discounted) catching up to the initial outlay:

    flowchart LR
	    A["Time (years)"] --> B["Cumulative Inflows (Simple)"]
	    A --> C["Cumulative Inflows (Discounted)"]
	    style A fill:#f9f,stroke:#333,stroke-width:1px
	    style B fill:#bbf,stroke:#333,stroke-width:1px
	    style C fill:#bfb,stroke:#333,stroke-width:1px

Imagine that B rises more quickly (because it’s not discounted) while C rises more slowly. Both eventually meet and surpass the initial cost. B signals the regular Payback Period, C signals the Discounted Payback Period.

Practical Use Cases

• Liquidity Screening: Firms that worry about short-term liquidity often prefer simpler methods that measure how fast cash outlays can be recovered.
• High Risk or Rapidly Changing Technology: When obsolescence is a concern, managers may want to see if the project can repay itself before potential technology or regulatory shifts wipe out the project’s viability.
• Support for NPV/IRR Decisions: Major capital budgeting decisions ordinarily rely on NPV or IRR. However, payback calculations can offer a “sanity check” or a quick initial screen.

Integrating with Regulatory Frameworks

While IFRS or US GAAP do not directly dictate which capital budgeting approach a firm should use, they do guide how firms record capital expenditures, depreciation, and the treatment of intangible assets. For instance:
• Depreciation under IFRS or US GAAP can affect the after-tax cash flows you use for payback calculations, though the payback methods themselves are typically done on a cash flow basis (not purely accounting income).
• If your firm capitalizes certain development costs (under IFRS) that would be expensed under US GAAP, the timing of cash flows might be different in practice.

Neither standard endorses or forbids the Payback or Discounted Payback methods. In a real corporate environment, these simpler metrics might appear alongside official budgeting documents that project future financial statements. Ultimately, compliance with your chosen financial reporting framework doesn’t tell you how to choose a capital budgeting method—it just helps ensure you record capital flows consistently.

Best Practices and Common Pitfalls

• Don’t Rely on Payback Alone: While the payback approach is a useful screening tool—and definitely easier to explain in a casual conversation—great (and profitable) projects might have a long payback period that extends well beyond your cut-off.
• Careful with Rough Discount Rates: If you’re doing discounted payback, ensure the discount rate is reflective of the project’s actual cost of capital. Using a single firm-wide cost of capital might also be misleading if the project risk differs from the firm’s average.
• Watch Out for Office Politics: Sometimes, managers use the quickest measure (Payback Period) simply because it’s the easiest to “sell” to internal stakeholders. But skipping advanced methods can lead to misallocation of capital.
• Incorporate Realistic Cash Flow Estimates: Overly optimistic or simplistic cash flow forecasts can cause payback-based decisions to be flawed. If your incoming cash flows are significantly off, the entire concept of “recouping your investment” may be moot.

A Quick Python Calculation Snippet

For those who like to see it in code, here’s a small Python example showing how you might compute the discounted payback for an array of cash flows (assuming a uniform discount rate). This snippet might help you handle a scenario with irregular flow patterns:

 1import numpy as np
 2
 3initial_investment = 100000
 4cash_flows = [20000, 30000, 40000, 50000]
 5discount_rate = 0.10
 6
 7discounted_sum = 0
 8years = 0
 9
10for i, cf in enumerate(cash_flows, start=1):
11    pv = cf / ((1 + discount_rate) ** i)
12    discounted_sum += pv
13    if discounted_sum >= initial_investment:
14        # Fractional year calculation
15        overshoot = discounted_sum - initial_investment
16        fraction = 1 - (overshoot / pv)
17        years = i - 1 + fraction
18        break
19
20print(f"Discounted Payback Period: {years:.2f} years")

You’d see the snippet giving you the same 3.79 years we discussed in the earlier example.

Comparing Payback to NPV and IRR

Although the Payback and Discounted Payback approaches do factor into exam questions (especially the more conceptual ones), remember that the standard value-maximizing metric in corporate finance is Net Present Value (NPV), or equivalently, IRR if you interpret it carefully. Here’s why NPV and IRR remain the go-to:

• NPV explicitly values all project cash flows over the entire life of the project and uses your actual cost of capital.
• IRR provides a single rate of return associated with those cash flows.
• Both NPV and IRR reflect the time value of money for every period (not just up to the payback cutoff).

Still, from a practical standpoint, if you have 10 potential projects in front of you and you need a quick, gut-check metric, a short payback might signal a lower risk of capital loss—especially in industries with uncertain futures.

Exam Relevance

On the CFA exam (particularly at Levels I and II), you might see direct questions about computing both the Payback Period and the Discounted Payback Period. Even at advanced levels, there may be scenario-based questions highlighting the strengths and weaknesses of these methods in comparison to more comprehensive tools like NPV or IRR. Expect questions that test your conceptual understanding—like why a discounted payback is typically longer than a simple payback, or how to handle irregular cash flows. You could also get item set or constructed-response scenarios where you must weigh the impetus for short-term liquidity with the long-term viability of a project.

Final Exam Tips

• Understand the Mechanics: Practice calculating both payback metrics using uniform and non-uniform cash flows. Know how to dissect the fraction-of-year calculation.
• Interpret the Result in Context: Be ready to explain why managers might prefer these quick metrics in certain high-risk or high-uncertainty environments.
• Integrate with Other Methods: On the exam, do not mention that payback is “better” or “worse” in isolation without referencing NPV or IRR. Typically, exam rubrics reward holistic comparisons.
• Watch for Trick Questions: Some items might highlight that payback metrics overlook significant cash inflows that occur right after the cutoff. Make sure you highlight that deficiency in your answer.
• Manage Time: Computations are generally quicker than NPV or IRR. Still, keep an eye on your time. For constructed-response, a neat layout of your calculations is essential.

References

• Ross, S., Westerfield, R., & Jaffe, J. Corporate Finance. (Various editions)
• CFA Institute Level I Curriculum, Capital Budgeting Readings
• Emergent CFO Blogs on Capital Allocation for SMEs

Test Your Knowledge: Payback and Discounted Payback Metrics