Financial Management · Investment appraisal techniques

Payback Period and Discounted Payback Explained

Updated 11 October 2026 · Fact-checked

Payback period is the time a project takes to recover its initial outlay from its cash inflows. Add up cash flows year by year until the total equals the outlay, then interpolate within the final year. Discounted payback does the same using present values, so it is longer and allows for the time value of money.

Understand Payback Period and Discounted Payback

Payback period answers a simple question: how long until I get my money back? You invest cash at time 0. The project then returns cash in later years. Payback is the point at which the cumulative cash inflows equal the initial outlay.

Companies use it because it is quick and easy to explain. It also favours projects that return cash early. That matters when cash is tight, when the business is worried about risk, or when the future is hard to predict. The longer you wait for cash, the more can go wrong.

Discounted payback fixes the biggest flaw of simple payback. Simple payback treats $1 in year 3 the same as $1 today. Discounted payback converts each cash flow to present value at the cost of capital first. Then you find when the cumulative present values recover the outlay. Because discounting shrinks later cash flows, discounted payback is always longer than simple payback when the discount rate is positive.

Both methods are decision rules with a target. The firm sets a maximum payback period, for example three years. A project is accepted if it pays back within that time. When comparing projects, the shorter payback is preferred.

Neither method measures profitability. Both ignore cash flows after the payback point. A project can pay back quickly and still have a poor overall return. That is why payback is a supporting measure and NPV is the main one.

Key rules to remember

Payback period (interpolation): Payback = full years before recovery + (unrecovered outlay at start of the recovery year ÷ cash flow in that year); Assumes cash flows arise evenly through each year. Use actual cash flows, not profits.
Present value of a cash flow: PV = cash flow × 1 ÷ (1 + r)ⁿ; In the exam you normally take the discount factor from the tables provided.
Discounted payback: Discounted payback = full years before recovery + (unrecovered outlay in PV terms ÷ PV of cash flow in the recovery year); Use the same cost of capital as for NPV. Cumulate present values, not undiscounted cash flows.
Constant annual inflow shortcut: Payback = initial outlay ÷ annual cash inflow; Only valid for simple payback when every year's inflow is the same. Do not use it for discounted payback.
Decision rule: Accept if payback ≤ target period; Compare projects by choosing the shortest payback, but only for projects that meet the target.

How to solve Payback Period and Discounted Payback questions

Use this method for any payback or discounted payback question. Draw a small table so you can see where the cumulative total crosses the outlay.

1Read the question for the cash flow timings. The initial outlay is normally at time 0, and later flows at the end of each year.
2Decide whether the question asks for simple payback, discounted payback or both. Note the cost of capital if discounting is needed.
3For discounted payback, multiply each year's cash flow by its discount factor to get present values. For simple payback, use the cash flows as they are.
4Build a cumulative column. Start with the negative outlay and add each year's flow (or PV) until the total turns positive.
5Find the year in which the total turns positive. Take the full years before it as the whole-year part.
6Interpolate: divide the unrecovered balance at the start of that year by that year's cash flow (or PV). Add this fraction to the whole years.
7Compare with any target period and state the decision. Add a brief comment on limitations if the question asks for evaluation.

Quickest way: Cumulative balance method

When to use it: Use it in Section A and Section B objective questions, where you need a fast, reliable answer to one or two decimal places or in years and months.

Write the outlay as a negative balance, for example (400,000).
Add each year's cash flow in turn, noting the balance after each year.
Stop when the balance would turn positive. The balance just before is the amount still to recover.
Divide that balance by the next year's cash flow and add to the completed years.
For discounted payback, convert each flow to PV first and repeat the same process.
Check your answer lies between the last negative year and the first positive year. If not, you have made an arithmetic slip.

Common mistakes in Payback Period and Discounted Payback

Using profits instead of cash flows
Students see depreciation or accounting profit in the question and include it automatically.
Fix: Payback uses cash flows only. Remove depreciation and other non-cash items. Include relevant tax and working capital cash flows if the question gives them.
Dividing the whole outlay by the year's cash flow in the recovery year
Students forget that part of the outlay was recovered in earlier years.
Fix: Divide only the balance still unrecovered at the start of that year by that year's cash flow.
Cumulating undiscounted cash flows in discounted payback
Students calculate present values but then add up the original cash flows.
Fix: Add the present values in the cumulative column. Check the table heading says PV.
Using the annuity shortcut for discounted payback
Equal annual flows make outlay ÷ annual flow tempting.
Fix: Discount each year separately and cumulate. The shortcut only works for simple payback.
Counting the time 0 outlay as a year
Students number years from 1 at the outlay and are one year out.
Fix: Time 0 is now. The first inflow is at the end of year 1. Payback is measured from time 0.
Treating payback as a measure of profitability
A short payback feels like a good project.
Fix: Payback ignores flows after the cut-off and does not measure value added. Say so in any evaluation, and point to NPV as the better measure.

Worked examples

Example 1

A project costs $400,000 at time 0. Net cash inflows are $120,000 in year 1, $150,000 in year 2, $160,000 in year 3 and $100,000 in year 4. The cost of capital is 10%. Discount factors at 10% are 0.909, 0.826, 0.751 and 0.683 for years 1 to 4. The company requires payback within three years. Calculate the payback period and the discounted payback period and advise whether the project meets the target.

Show the solution

Simple payback, cumulative cash flow: year 1 = 120,000; year 2 = 270,000; year 3 = 430,000.
The outlay of 400,000 is recovered during year 3. At the start of year 3, 400,000 − 270,000 = 130,000 is unrecovered.
Fraction of year 3 needed = 130,000 ÷ 160,000 = 0.8125. Payback = 2.81 years, about 2 years 10 months.
Discounted cash flows: year 1 = 120,000 × 0.909 = 109,080; year 2 = 150,000 × 0.826 = 123,900; year 3 = 160,000 × 0.751 = 120,160; year 4 = 100,000 × 0.683 = 68,300.
Cumulative PV: year 1 = 109,080; year 2 = 232,980; year 3 = 353,140; year 4 = 421,440.
After year 3, 400,000 − 353,140 = 46,860 is still unrecovered. Fraction of year 4 = 46,860 ÷ 68,300 = 0.686.
Discounted payback = 3 + 0.686 = 3.69 years.
Compare with the three-year target: simple payback of 2.81 years meets it, but discounted payback of 3.69 years does not.

Answer: Payback is 2.81 years and discounted payback is 3.69 years. The project meets the three-year target on simple payback but fails it once the time value of money is allowed for. Total PV of inflows is 421,440, which exceeds the outlay by 21,440, so NPV is positive. The target is a liquidity or risk screen, not a value test.

Example 2

A project requires an outlay of $250,000 now and produces net cash inflows of $80,000 at the end of each of the next five years. The cost of capital is 8%. Discount factors at 8% for years 1 to 5 are 0.926, 0.857, 0.794, 0.735 and 0.681. Calculate the payback and discounted payback periods, and state two limitations of payback.

Show the solution

Simple payback: equal annual inflows, so 250,000 ÷ 80,000 = 3.125 years, about 3.13 years.
Present values: year 1 = 80,000 × 0.926 = 74,080; year 2 = 80,000 × 0.857 = 68,560; year 3 = 80,000 × 0.794 = 63,520; year 4 = 80,000 × 0.735 = 58,800; year 5 = 80,000 × 0.681 = 54,480.
Cumulative PV: year 1 = 74,080; year 2 = 142,640; year 3 = 206,160; year 4 = 264,960.
The outlay is recovered in year 4. Unrecovered at the start of year 4 = 250,000 − 206,160 = 43,840.
Fraction of year 4 = 43,840 ÷ 58,800 = 0.746. Discounted payback = 3.75 years.
Limitations: simple payback ignores the time value of money, and both methods ignore cash flows after the payback point, so they do not measure the total return or the increase in wealth.

Answer: Payback is 3.13 years and discounted payback is 3.75 years. The discounted figure is longer because later inflows are worth less in present value terms. Both methods ignore cash flows after payback, and simple payback also ignores the time value of money.

Exam tips

In a Section A or B objective question, check whether the question wants simple or discounted payback before you start. The two answers differ, and the wrong one scores zero because marking is all or nothing.
Check the answer format: years to two decimals, or years and months. Convert a decimal fraction of a year to months by multiplying by 12.
In Section C, set out a neat table with columns for year, cash flow, discount factor, PV and cumulative PV. Markers can give credit for correct method even if there is an arithmetic slip.
When asked to discuss payback, give balanced points: it is simple, favours liquidity and reduces exposure to uncertain later flows, but it ignores the time value of money (simple version), ignores cash flows after payback and is not linked to shareholder wealth.
Always state the decision against the target period, and comment on any conflict with NPV. A project can meet a payback target and still destroy value, or the reverse.

Practice questions from Investment appraisal techniques

Payback Period and Discounted Payback in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Payback Period and Discounted Payback: frequently asked questions

What is the difference between payback and discounted payback?

Payback adds up the actual cash flows until the outlay is recovered. Discounted payback converts each flow to present value at the cost of capital first. Discounted payback is therefore longer and takes the time value of money into account.

What are the advantages and disadvantages of the payback period?

Its advantages are that it is simple, easy to understand and favours projects that return cash quickly, which helps liquidity and reduces risk exposure. Its disadvantages are that simple payback ignores the time value of money, both versions ignore cash flows after payback and it does not measure the increase in shareholder wealth. It also relies on an arbitrary target period.

Can discounted payback be used when NPV is negative?

If the NPV is negative over the whole project life, the cumulative present value never recovers the outlay, so there is no discounted payback within the project life. If NPV is positive, a discounted payback exists within the life. The method itself does not tell you the size of the NPV.

How do I show payback in years and months?

Calculate the decimal fraction of the final year, then multiply it by 12. For example, 0.8125 × 12 = 9.75, so 2.8125 years is about 2 years 10 months. Round sensibly and follow the format the question asks for.