Financial Management and Business Data Analytics · Capital Budgeting

Payback Period and Discounted Payback Period Method

Updated 10 October 2026 · Fact-checked

Payback period is the time a project takes to recover its initial investment from its cash inflows. For even inflows, divide investment by annual cash inflow. For uneven inflows, add cumulative cash flows until they reach the investment. Discounted payback does the same using present values of inflows.

Understand Payback Period and Discounted Payback

Every project asks you to spend money now and wait for cash later. The first question many managers ask is simple: how long until I get my money back? Payback period answers exactly that. It is measured in years and months.

A shorter payback means the money is tied up for less time. So the project is seen as less risky and better for liquidity. Firms with limited cash or in fast-changing industries like this method. Under the decision rule, you accept a project if its payback is less than or equal to a cut-off period set by management. When you compare mutually exclusive projects, you choose the one with the shortest payback.

The basic method ignores the time value of money. A rupee received in year 3 is counted the same as a rupee received in year 1. It also ignores every cash flow after the payback point. So a project can look good on payback and still be a poor project overall.

The discounted payback period fixes the first problem. You discount each inflow at the cost of capital, then find how long it takes for the cumulative present values to recover the investment. It is always longer than (or equal to) the simple payback for the same project. It still ignores cash flows after the payback point.

The payback reciprocal is a quick estimate of the rate of return. It is 1 ÷ payback period. It is a good approximation of the IRR only when the project life is at least about twice the payback period and the annual inflows are roughly equal.

Key rules to remember

Payback period (even inflows): Payback = Initial investment ÷ Annual cash inflow; Use net cash inflow after tax, before depreciation is deducted (add back depreciation to profit after tax).
Payback period (uneven inflows): Payback = Years fully recovered + (Unrecovered amount at start of the year ÷ Cash inflow of that year); Assumes inflows arise evenly within the year. Multiply the fraction by 12 to get months.
Payback reciprocal: Payback reciprocal = (Annual cash inflow ÷ Initial investment) × 100 = (1 ÷ Payback) × 100; Approximates IRR only if life is at least twice the payback and inflows are constant.
Present value of an inflow: PV = Cash inflow × 1 ÷ (1 + r)^n; Use the cost of capital as r. Use the given PV factors in the exam.
Discounted payback period: Years fully recovered (on cumulative PV) + (Unrecovered PV ÷ PV of inflow of that year); Same interpolation as simple payback, but on discounted cash flows.
Decision rule: Accept if payback ≤ cut-off period; among alternatives choose the shortest; 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. Decide first whether inflows are even or uneven and whether discounting is asked.

1Find the initial outflow. Include working capital and installation cost if they are given as part of the investment. Reduce it by any scrap or salvage on old assets if the question says so.
2Compute annual net cash inflow: profit after tax plus depreciation (or EBIT less tax plus depreciation). Do not subtract depreciation as a cash outflow.
3If inflows are equal each year, divide investment by annual inflow. Stop here for simple payback.
4If inflows are uneven, build a table of year, cash inflow and cumulative cash inflow. Find the year in which cumulative inflow crosses the investment.
5Apply interpolation: full years before crossing plus unrecovered amount divided by that year's inflow. Convert the fraction to months.
6For discounted payback, add a column of PV factors at the cost of capital and a column of present values. Then do the cumulative table on present values.
7Compare with the cut-off or with other projects and state the decision in one line.
8If asked, compute the payback reciprocal as annual inflow ÷ investment, and comment on whether it is a fair estimate of return.

Quickest way: Cumulative table with a running balance

When to use it: Use this when inflows are uneven or discounting is asked and time is short.

Write the investment as a negative opening balance.
Add each year's inflow (or PV) to the balance, one row at a time.
Stop at the first year the balance turns positive.
Fraction = last negative balance ÷ that year's inflow (or PV). Add it to the previous completed years.
For discounted payback, compute PVs only until the balance turns positive. Do not discount later years.

Common mistakes in Payback Period and Discounted Payback

Using profit after tax instead of cash inflow
The question gives profit figures and depreciation separately, and students forget payback is a cash measure.
Fix: Always add back depreciation (and other non-cash charges) to profit after tax before computing payback.
Deducting depreciation again from investment or cash flows
Students treat depreciation as a cost to be recovered.
Fix: Depreciation is non-cash. It only affects tax. Include its tax shield through profit after tax, then add it back.
Wrong interpolation base in the uneven case
Students divide by the total cumulative inflow or the previous year's inflow.
Fix: Divide the unrecovered amount at the start of the year by the inflow of the year in which recovery happens.
Using the cumulative undiscounted inflow for discounted payback
Students discount the cash flows but then forget to cumulate the discounted values.
Fix: Build a separate column for cumulative present values and read the payback from that column only.
Treating payback reciprocal as always equal to IRR
It is taught as a shortcut and the conditions get forgotten.
Fix: State that it is a fair approximation only when life is at least about twice the payback and inflows are even. Otherwise it overstates or understates return.
Calling payback a measure of profitability
Shorter payback feels like higher return.
Fix: Say it measures liquidity and risk. It ignores cash flows after the payback point, so it cannot show total profit.

Worked examples

Example 1

Sundaram Textiles Ltd is considering a machine costing ₹5,00,000 with a life of 8 years and no scrap value. Profit after tax and after depreciation is ₹60,000 per year. Depreciation is on straight line basis. Compute (a) the payback period and (b) the payback reciprocal. Comment on whether the reciprocal is a good estimate of return.

Show the solution

Annual depreciation = ₹5,00,000 ÷ 8 = ₹62,500.
Annual cash inflow = PAT + depreciation = ₹60,000 + ₹62,500 = ₹1,22,500.
Payback period = ₹5,00,000 ÷ ₹1,22,500 = 4.08 years (about 4 years 1 month).
Payback reciprocal = ₹1,22,500 ÷ ₹5,00,000 × 100 = 24.5%.
Life is 8 years and payback is 4.08 years. Life is about twice the payback, so the reciprocal is a rough approximation of IRR, but it is only approximate.

Answer: Payback period is about 4.08 years. Payback reciprocal is 24.5%. It is only a rough guide to the return because the life is just about twice the payback.

Example 2

Kaveri Industries is evaluating a project with an initial outlay of ₹10,00,000. Cash inflows are Year 1: ₹3,00,000; Year 2: ₹4,00,000; Year 3: ₹4,00,000; Year 4: ₹3,00,000. 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. Find the payback period and the discounted payback period.

Show the solution

Simple payback. Cumulative inflow: Year 1 ₹3,00,000; Year 2 ₹7,00,000; Year 3 ₹11,00,000.
Recovery happens in Year 3. Unrecovered at start of Year 3 = ₹10,00,000 − ₹7,00,000 = ₹3,00,000.
Fraction = ₹3,00,000 ÷ ₹4,00,000 = 0.75. Payback = 2.75 years (2 years 9 months).
Present values: Year 1 = 3,00,000 × 0.909 = ₹2,72,700. Year 2 = 4,00,000 × 0.826 = ₹3,30,400. Year 3 = 4,00,000 × 0.751 = ₹3,00,400. Year 4 = 3,00,000 × 0.683 = ₹2,04,900.
Cumulative PV: Year 1 ₹2,72,700; Year 2 ₹6,03,100; Year 3 ₹9,03,500; Year 4 ₹11,08,400.
Recovery happens in Year 4. Unrecovered at start of Year 4 = ₹10,00,000 − ₹9,03,500 = ₹96,500.
Fraction = ₹96,500 ÷ ₹2,04,900 = 0.471. Discounted payback = 3.47 years (about 3 years 6 months).
Discounted payback is longer because later inflows are worth less today.

Answer: Payback period is 2.75 years. Discounted payback period is about 3.47 years.

Exam tips

In the MCQ section, expect a quick division for payback or a statement on merits and limitations. Check whether the figure given is profit or cash inflow before dividing.
In written answers, show a table with columns for year, inflow, PV factor, PV and cumulative PV. Each correct column earns step marks even if the final fraction slips.
Always show the interpolation line with the unrecovered amount and the inflow used. Examiners look for this.
Write one line of interpretation: payback shows liquidity and risk, not profitability. Mention what it ignores.
If the question asks for a comparison with NPV or IRR, state that payback can accept a project NPV would reject, because it ignores cash flows after the cut-off.

Practice questions from Capital Budgeting

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 formula for payback period?

When annual cash inflows are equal, payback period is initial investment divided by annual cash inflow. When they are uneven, add cumulative inflows until the investment is recovered and interpolate in the final year.

What are the advantages and disadvantages of the payback period?

It is simple, easy to explain, and highlights liquidity and risk, so it suits firms short of cash. It ignores the time value of money, ignores cash flows after the payback point, and relies on an arbitrary cut-off period. It does not measure profitability.

What is the payback reciprocal and when is it reliable?

It is 1 divided by the payback period, shown as a percentage. It is a reasonable approximation of the IRR only when the project life is at least about twice the payback period and annual inflows are roughly even.

How is discounted payback different from simple payback?

Discounted payback discounts each cash inflow at the cost of capital and then finds when the cumulative present value recovers the investment. It accounts for time value of money, so it is never shorter than simple payback. It still ignores inflows after the payback point.