Business owners and other decision-makers need to make informed decisions about their investments, projects and next clients. They need to be able to choose the options that are profitable. One way to do this is to calculate the discounted payback period or DPP.
Find out what the discounted payback period is, how to calculate payback period and how you can use DPP at your business.
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What Is the Discounted Payback Period?
The DPP is a capital budgeting method that determines how long it will take you to earn your investment back. The payback period formula divides a project’s cost by the annual cash inflows to help you understand when you will earn back your investment.
In most businesses, you need to commit money or an investment upfront and make a return on that investment later. For example, you might need to pay for overhead and staff to complete a marketing project this month, and your client will pay you next month. It’s important to make sure that the money you’re spending now will be worth it when you’re paid by calculating discounted cash flows in payback period.
Payback Period vs. Discounted Payback Period
Both the payback period and discounted payback period are about figuring out the length of time for a project or investment to earn back its initial investment. What makes them different is that the payback period treats all money as the same, while the discounted payback period formula considers money’s changing value. One dollar invested today will not be worth the same five years from now due to inflation and other factors.
The discounted payback period treats earlier cash flow as having a higher value than the same amount of cash flow that happens later. The formula uses a discount rate or interest to take this into account.
How to Calculate DPP
You can calculate the discounted payback period with an online calculator or this discounted payback period formula:
y + abs(n) / p,
Let’s look at what each part of the formula means:
- y = the period before which the cumulative cash flow becomes positive
- p = the discounted cash flow value during the period where cumulative cash flow is zero or more than zero
- abs(n) = the value of the cumulative discounted cash flow in y
It’s not as simple as just plugging in the numbers. You will need to first establish the values for y, n and p. You will also need to make a table that lists the different periods, cumulative discounted cash flows, discounted cash flows and cash flows.
Example of Using DPP
Now that we have the formula to calculate the discounted payback period, let’s look at an example to better understand how it works.
A staffing company wants to start work with a new client. The client is expected to need $3000 in services in the second year, $4000 in the third and $4000 the fourth year. They are forecast to need $3000 in services every year after that. The agency calculates they will need to invest $3000 in staffing and other costs upfront to meet the client’s needs. They will need to invest $2500 the next year, $1000 in the year after that and $500 in every subsequent year.
According to the formula:
4 + abs(-920) / 1419 = 4.65 (DDP)
The project will become profitable after the fourth year.
Does it make sense to take the project? Ultimately, DDP is only one part of the equation. The staffing agency may want to look at future possible projects from this partnership, how much this client aligns with long-term goals, the prestige of the client and other factors.
How Can Porter Capital Help?
Once you have taken a closer look at cash flow by calculating your discounted payback period, you may realize your business may be in danger of cash flow gaps. This happens to enterprises, large corporations, startups and businesses of every size and in every industry. Many successful companies turn to invoice factoring to resolve this issue and keep growing.
Porter Capital will review your invoices and advance you cash within 24 hours. You can then keep moving your company forward while waiting for invoices to be paid.
To find out more about Porter Capital or get a quote, contact us today.