The discounted payback period of a project is the length of the period from the beginning of investments to the moment of their payback, taking into account discounting. The meaning of the method is to discount all the cash flows generated by the project, and sum them in a sequential order until they cover the initial investment costs.
In a general sense, the discount formula determines the present value of cash that relates to future periods and shows the future income that is determined at the moment. In order to make a correct assessment of future income, one should have information on forecast values of revenue, investments, expenses, residual value of property, discount rate, capital structure.
The discounted payback period reflects a more objective and more conservative characterization of the project assessment than the usual payback period. This indicator partially takes into account the risks inherent in the project, which include an increase in expenses, a decrease in income, and the emergence of alternative, more profitable investment opportunities.
The discount rate is equal to the sum of the risk-free investment rate and the risk adjustment for a specific project. In the second case, this indicator reflects the internal rate of return of an alternative project similar in risk.
In addition, there are the following methods that determine the discounted payback period and the discount rate.
The calculation is based on the weighted average cost of capital, using own investments. This method has both advantages and a number of disadvantages. The positive aspects include the fact that the cost of capital can be calculated accurately, and then determine the possible options for the alternative use of resources. The disadvantage is that the calculations are based on dividends and interest on borrowed funds, however, these criteria include risk adjustments, which when discounting are taken into account when determining the compound interest, which causes a uniform increase in risk over time.
The discounted payback period and rate are calculated on the basis of interest on borrowed capital. In this case, we mean the percentage at which the company can currently borrow funds. If it is possible to invest or return capital to creditors, the interest rate on borrowed funds will be equal to the opportunity cost of capital. It should be noted that to determine the discount rate should be used only the effective interest rate that differs from the nominal, as the period of capitalization may vary.
Settlements are also made on the basis of a safe investment rate, it is also considered as the opportunity cost of cash. The next method includes the same rate, but adjusted for various risk factors - the possibility of not receiving the income provided by the project, the unreliability of project participants, country risk.
The discount rate and then the discounted payback period are determined taking into account the cost of debt and risk adjustments. As a result, the risk difference between the investment projects of the company is leveled. A possible approach is to discount cash flows at a rate that reflects only the risk of the project itself and does not take into account the effect of financing.
To determine the discount rate, the alternative cost of money is used, for which they accept the internal rate of return of the marginal accepted and unaccepted projects. The disadvantage of this method is the practical difficulty of determining this value, and there is also confusion in the calculations due to the difference in interest rates on projects.