Understanding Discounted Payback Period
Some of the business owners do not know how they can determine the profitability of the project they are doing. One of the methods they can do so is by using the discounting payback period, which is one of the capital budgeting procedures. By recognizing the time value of money and discounting cash flows in the future, the discounted payback period shows how many years does it take to reach the breakeven point after one has spent an amount initially. Business owners may use this data to assess the profitability as well as practicability of particular projects. If you are running a business, but you have no idea how you can do so, you may seek help from an accounting firm in Johor Bahru.
Another term that you probably have heard of is the payback period. One may calculate the payback period by summing up the amount of money it has spent on a project as well as its average yearly cash flow, then divide the former by the latter. However, this approach does not give an accurate answer on whether a company should take a project as it ignores the TVM (time value of money), and it only assumes an investment which is ahead of time.
If you want to determine the value of discounted payback period for a project, the first thing you should do is to predict the regular cash flows (Also see How to Forecast Cash Flow?) associated with it and present it by accounting period on a spreadsheet. Then, to show the process of discounting, you need to reduce the cash flows by the present value factor. The next step will be netting the future discounted cash inflows against the cash outflow that happens initially when you make an investment, with an assumption that you have put a large amount of money into an investment or a project. After that, you need to implement the process of discounted payback period to all the extra cash inflow of the accounting period and look for the point where the outflows and inflows are the same.
When you implement the discounted payback period, a simple rule that you should follow is to take the projects with a shorter payback period when compared to the targeted timeframe. You can look at the breakeven date a project requires for it to reach the point where it will breakeven by using the discounted cash flows you have used in the analysis of the discounted payback period. This helps you in identifying whether you should accept or reject a particular project.
Compared to the payback period, the discounted payback period provides a more precise outcome as it takes the TVM (time value of money) into account. It shows the amount of time needed for a business or for a person to recover investment by focusing on the current value of the estimated cash flows of a project.