Definition
Discounted payback period is the time it takes for cumulative discounted cash flows to recover the initial investment. Unlike simple payback, it accounts for the time value of money.
Discounted payback vs simple payback
| Metric | Accounts for time value- | Best for | Common pitfall |
|---|---|---|---|
| Simple payback | No | Quick sanity checks when discounting is less important. | Underestimates payback when cash flows are far in the future. |
| Discounted payback | Yes | Comparing projects at a chosen discount rate and risk level. | Using it alone (it ignores cash flows after payback). |
How to calculate discounted payback
- Choose a discount rate (your required return / MARR).
- Discount each cash flow: PV_t = cash flow_t / (1 + r)^t.
- Sum discounted cash flows cumulatively until the total reaches the initial investment.
- Interpolate within the year for partial-year payback.
When discounted payback is most useful
- Projects with long cash flow tails where time value matters.
- Comparing initiatives with similar lifetimes but different timing profiles.
- Capital allocation decisions where risk-adjusted timing matters.
- Early screening before deeper NPV modeling.
How to interpret the result
- Shorter discounted payback improves liquidity resilience.
- Use it alongside NPV to avoid ignoring post-payback value.
- Compare payback to expected product lifecycle or contract duration.
Common mistakes
- Using discounted payback alone instead of NPV for value creation.
- Ignoring risk (discount rate should reflect required return).
- Mixing nominal and real assumptions (inflation consistency).