The payback period is the time it takes for an investment to pay back for itself taking into account the present value of future money flows.
The present value is the value NOW of money to be received in the future. A dollar received tomorrow is worth less than a dollar received today. The further into the future the receipt, the less is the value, depending on the opportunity cost of money.
The opportunity cost is the sacrifice of not being able to use the funds in their next most profitable alternative. It is thus the rate we use to discount future cash flows.
If we have the cash for the investment in a current account in a bank, then the applicable discount rate could be the interest rates offered by banks on ordinary deposits.
On the other hand, if the funds have to be borrowed the discount rate may be the interest rate charged by the lending institution.
Discount Rate, Time and Value
The lower the discount rate the higher the present value of a given cash flow. On the other hand, the earlier the cash flow the higher is its present value.
It is more valuable because the uncertainty and risk for earlier is less than for later. A lower discount rate implies less risk and hence the prospects of earlier return of investment.
The Payback Period Calculator below makes the following assumptions:-
There is a one-time capital outflow at the beginning of the project (Time 0).
The Discount Rate is the annual discount rate.
All future periodic inflows are the same (constant).
All incomes are received at the end of each period.
Cash flows are discounted at the appropriate rate, whether daily, weekly or annually.