What is the difference between payback period and discounted payback?

Payback period, or simple payback period, is the period of time required to recoup the entity's money expended in a particular investment. Discounted payback period, on the other hand, is t he method of calculating payback period which takes into consideration the time value of money, that is, all cash inflows will be discounted at a particular discount rate first to arrive at their present values.

When a small business invests in new capital, the owners often want to know when they can expect to recover the costs of that investment. In capital budget accounting, the payback period pertains to the time period needed for the return on an investment to equal the sum of the first investment. The discounted payback period also measures the time needed to recover the original investment costs, but it also accounts for time value of money.

Function of Payback Period

The payback period of an investment functions as a crucial determining factor in whether or not a company will make the investment. Investments with shorter payback periods are more appealing, while those with longer payback periods are less rewarding. Small businesses often want to see investments with short payback periods, because they often lack the cash flow or capital streams to maintain business operations while waiting for an investment to pay for itself.

Function of Discounted Payback Period

While the discounted payback period functions in much the same way as the standard payback period, the discounted payback period accounts for the "time value of money." The time value of money means that money now is more valuable than the same amount of money in the future. This principle implies that the discounted payback period will be longer than the standard payback period, but also that the discounted payback period will give a more accurate estimate on when the company can expect a return on its investment.

The discounted payback method use a discounte rate to take into account the value for money and gives a much appropriate and realistic amount.