Financial Management and Strategic Management · Investment Decisions

Payback Period and Discounted Payback for CA Intermediate

Updated 4 October 2026 · Fact-checked

Payback period is the time a project takes to recover its initial investment from its cash inflows. Add cumulative inflows year by year until they equal the outlay, and interpolate within the final year. Discounted payback does the same using present values of inflows at the cost of capital.

Understand Payback Period and Discounted Payback

Every investment starts with an outflow. Payback period asks one simple question: how long until the cash coming back equals the cash you put in? A shorter payback means your money is at risk for less time.

If annual inflows are equal (an annuity), divide the initial investment by the annual cash inflow. If inflows are uneven, build a cumulative cash inflow column. Find the year in which the cumulative figure crosses the investment, then take the fraction of that year needed.

Payback uses cash flows, not accounting profit. Use profit after tax plus depreciation (and other non-cash charges) if the question gives profits. This is the cash inflow after tax (CFAT).

Simple payback ignores the time value of money. A rupee received in year 3 counts the same as one received in year 1. Discounted payback fixes this. You discount each inflow at the cost of capital, then find when the cumulative present value equals the investment. Discounted payback is always longer than simple payback (for positive discount rates), and it exists only if the project's NPV over its life is not negative.

The payback reciprocal is 1 ÷ payback period, shown as a percentage. It is a rough estimate of the project's rate of return. It is a good approximation only when the project life is at least twice the payback period and the annual inflows are roughly equal.

Key rules to remember

Payback period (equal annual inflows): Payback = Initial investment ÷ Annual cash inflow; Use cash inflow after tax, not accounting profit. Add back depreciation.
Payback period (uneven inflows): Payback = Years before recovery + (Unrecovered amount at start of the year ÷ Cash inflow of that year); Assumes inflows arrive evenly through the year.
Discounted payback period: Same as payback, but use PV of inflow = Cash inflow × PV factor at cost of capital; Cumulate present values, not raw cash flows.
Payback reciprocal: Payback reciprocal = (Average annual cash inflow ÷ Initial investment) × 100 = (1 ÷ Payback period) × 100; Good approximation of IRR only if life is at least twice the payback and inflows are even.
Decision rule: Accept if payback ≤ maximum acceptable period; among alternatives choose the shortest; The cut-off is set by management, not by a formula.

How to solve Payback Period and Discounted Payback questions

Use this method for any payback or discounted payback question.

1Identify the initial outflow. Include working capital or other outlays at time zero if the question says so.
2Convert the data to annual cash inflow after tax. If profits are given, add back depreciation. Do not add back interest unless told.
3Check if inflows are equal. If yes, divide investment by the annual inflow.
4If inflows are uneven, prepare a table: year, cash inflow, cumulative inflow. For discounted payback, add columns for PV factor, PV and cumulative PV.
5Find the year in which the cumulative figure first reaches or exceeds the investment.
6Interpolate: complete years + (balance to recover ÷ that year's inflow). For discounted payback use the PV of that year.
7Compare with the cut-off or with other projects, and state the decision. Mention the limitation if asked, such as ignoring cash flows after payback.
8For the reciprocal, divide 1 by the payback period (or average inflow by investment) and write it as a percentage.

Quickest way: Cumulative column and interpolation

When to use it: Use for MCQs and for written answers with uneven cash flows. It saves time and still earns step marks.

MCQ: for equal inflows, divide mentally. Then eliminate options that are not close to your answer.
Write cumulative inflow beside each year. Stop as soon as it crosses the investment.
Do the fraction only for the crossing year. Do not recompute earlier years.
For discounted payback, calculate PVs only until the cumulative PV crosses the investment.
Written answer format: a neat table, the interpolation line, the final answer in years and months, then one line of decision. Show the PV factors you used.
Remember: discounted payback is longer than payback, so if your discounted figure is shorter, recheck your work.

Common mistakes in Payback Period and Discounted Payback

Using accounting profit instead of cash inflow
The question gives profit after tax and students divide the investment by it directly.
Fix: Add back depreciation and other non-cash charges to get cash inflow before using it.
Interpolating with the wrong year's cash flow
Students divide the balance by the first year's inflow or by the average inflow.
Fix: Divide the unrecovered balance by the inflow of the year in which recovery happens.
Cumulating the discounted flows wrongly in discounted payback
Students discount the cumulative total instead of each year's inflow.
Fix: Multiply each year's inflow by its own PV factor, then cumulate those present values.
Treating the reciprocal as always equal to IRR
The reciprocal is taught as a shortcut and the conditions are forgotten.
Fix: Call it an approximation. It works only when life is long (at least twice the payback) and inflows are even.
Writing payback as a decimal and stopping
3.4 years looks complete, but some questions want years and months.
Fix: Convert the decimal part to months if asked: 0.4 × 12 = 4.8 months. Otherwise state the decimal clearly with 'years'.
Ignoring the limitation that payback ignores cash flows after the cut-off
Students focus on the calculation and forget the interpretation.
Fix: Add a line: payback measures liquidity and risk, not total profitability. Use NPV for the final decision.

Worked examples

Example 1

A project needs an initial investment of ₹10,00,000. Cash inflows after tax are ₹2,00,000 in year 1, ₹3,00,000 in year 2, ₹4,00,000 in year 3, ₹4,00,000 in year 4 and ₹2,00,000 in year 5. Calculate the payback period.

Show the solution

Cumulative inflow: year 1 = ₹2,00,000; year 2 = ₹5,00,000; year 3 = ₹9,00,000; year 4 = ₹13,00,000.
Recovery happens in year 4, since the cumulative inflow crosses ₹10,00,000 there.
Unrecovered amount at the start of year 4 = ₹10,00,000 − ₹9,00,000 = ₹1,00,000.
Fraction of year 4 needed = ₹1,00,000 ÷ ₹4,00,000 = 0.25 year.
Payback = 3 + 0.25 = 3.25 years.

Answer: Payback period = 3.25 years, that is 3 years and 3 months.

Example 2

A project costs ₹5,00,000 and gives equal cash inflows of ₹2,00,000 a year for 5 years. The cost of capital is 10%. PV factors at 10%: year 1 = 0.909, year 2 = 0.826, year 3 = 0.751, year 4 = 0.683, year 5 = 0.621. Find the payback period, payback reciprocal and discounted payback period.

Show the solution

Payback = ₹5,00,000 ÷ ₹2,00,000 = 2.5 years.
Payback reciprocal = 1 ÷ 2.5 = 0.40 = 40%. Here life (5 years) is exactly twice the payback, so it is only a rough guide.
PV of inflows: year 1 = 2,00,000 × 0.909 = ₹1,81,800; year 2 = 2,00,000 × 0.826 = ₹1,65,200; year 3 = 2,00,000 × 0.751 = ₹1,50,200; year 4 = 2,00,000 × 0.683 = ₹1,36,600.
Cumulative PV: year 1 = ₹1,81,800; year 2 = ₹3,47,000; year 3 = ₹4,97,200; year 4 = ₹6,33,800.
Recovery happens in year 4. Unrecovered at start of year 4 = ₹5,00,000 − ₹4,97,200 = ₹2,800.
Fraction = ₹2,800 ÷ ₹1,36,600 = 0.0205 year.
Discounted payback = 3 + 0.0205 = about 3.02 years.

Answer: Payback = 2.5 years; payback reciprocal = 40%; discounted payback is about 3.02 years, which is longer because inflows are discounted.

Exam tips

Read whether the question gives profit or cash flow. If profit, add back depreciation first. This is the commonest trap.
Always show the cumulative table. Even if your final figure is wrong, you still earn step marks.
For discounted payback, use the PV factors given in the question. Do not use your own.
In theory questions, write merits and demerits in pairs: simple and quick but ignores time value; favours liquidity but ignores cash flows after payback.
In MCQs, if inflows are equal, the answer is a single division. Spend your time elsewhere.

Practice questions from Investment Decisions

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 are the merits of the payback period?

It is simple to calculate and understand. It favours projects that return cash quickly, so it helps when liquidity is tight or the future is uncertain. It is also a rough measure of risk, since a shorter payback exposes you for less time.

What are the demerits of the payback period?

It ignores the time value of money and all cash flows after the payback date. It does not measure profitability and relies on a cut-off set by management. It may reject a good long-term project in favour of a quick but poor one.

How is discounted payback different from payback?

Discounted payback uses the present value of each inflow at the cost of capital instead of the raw cash flow. It therefore accounts for the time value of money. It is longer than simple payback, but still ignores flows after the recovery point.

When is the payback reciprocal a good estimate of IRR?

It is a reasonable approximation when the project life is at least twice the payback period and annual cash inflows are roughly equal. If inflows vary widely or the life is short, it can mislead.