Discounted payback period is a slight modification of the payback period, where it considers the discounted cash flows instead of normal cash flows. Based on the discounted cash flows the payback period or the period required to recover the initial investment money is calculated.
Example of Discounted payback period
Suppose for project X, the initial investment or cash outflow is 1000 USD. So net cash flow at the beginning is -1000 USD.
The project will generate cash inflows for next 5 years. The cash inflows for project X are 400 USD, 350 USD, 300 USD, 250 USD and 200 USD respectively. Total Cash inflow will be 1500 USD over the next 5 years.
The discounted cash inflows after each year will be (400/(1+ 0.10)^1) , (350/(1+ 0.10)^2), (300/(1+ 0.10)^3), (250/(1+ 0.10)^4) and (200/(1+ 0.10)^5) which will be same as 363.64, 289.26, 225.39, 170.75 and 124.18.
After first year the net cash flow will be (-1000 + 363.64) = -636.36 USD.
After second year the net cash flow will be (-636.36 + 289.26) = -347.10 USD
After third year the net cash flow will be (-347.10 + 225.39) = -121.71 USD
After third year the net cash flow will be -121.71 USD and fourth year discounted cash inflow is 170.75 USD. So the payback period will be after 3 years, (121.71/170.75) = 0.7128 years, which makes the total discounted payback period as 3.7128 years.
This is more than the normal payback period as it considers the discounted cash flows.
It can be used for companies with liquidity constraints as lower payback period ensures more liquidity. Using discounted method makes this evaluation method more useful.