CP

assuming both projects have a cost of capital of 10 percent. To construct Figure 7-3,

each cash inflow is divided by (1 r)t(1.10)t, where t is the year in which the cash

flow occurs and r is the project’s cost of capital. After three years, Project S will have

generated $1,011 in discounted cash inflows. Because the cost is $1,000, the dis-

counted payback is just under three years, or, to be precise, 2 ($214/$225) 2.95

years. Project L’s discounted payback is 3.88 years:

For Projects S and L, the rankings are the same regardless of which payback method

is used; that is, Project S is preferred to Project L, and Project S would still be selected

if the firm were to require a discounted payback of three years or less. Often, however,

the regular and the discounted paybacks produce conflicting rankings.

Evaluating Payback and Discounted Payback

Note that the payback is a type of “breakeven” calculation in the sense that if cash

flows come in at the expected rate until the payback year, then the project will break

even. However, the regular payback does not consider the cost of capital—no cost for

the debt or equity used to undertake the project is reflected in the cash flows or the

calculation. The discounted payback does consider capital costs—it shows the

breakeven year after covering debt and equity costs.

An important drawback of both the payback and discounted payback methods is

that they ignore cash flows that are paid or received after the payback period. For

example, suppose Project L had an additional cash flow of $5,000 at Year 5. Common

sense suggests that Project L would be more valuable than Project S, yet its payback and

discounted payback make it look worse than Project S. Consequently, both payback

methods have serious deficiencies.^2

Although the payback methods have serious faults as ranking criteria, they do pro-

vide information on how long funds will be tied up in a project. Thus, the shorter the

payback period, other things held constant, the greater the project’s liquidity.Also, since

Discounted paybackL3.0$360/$4103.88 years.

Discounted paybackS2.0$214/$2252.95 years.

264 CHAPTER 7 The Basics of Capital Budgeting: Evaluating Cash Flows

FIGURE 7-3 Projects S and L: Discounted Payback Period

01234

Project S:

Net cash flow 
1,000 500 400 300 100

Discounted NCF (at 10%) 
1,000 455 331 225 68

Cumulative discounted NCF 
1,000 
 545 
 214 11 79

PaybackS  2.95 years.

01234

Project L:

Net cash flow 
1,000 100 300 400 600

Discounted NCF (at 10%) 
1,000 91 248 301 410

Cumulative discounted NCF 
1,000 
 909 
 661 
 360 50

PaybackL  3.88 years.

(^2) Another capital budgeting technique that was once used widely is theaccounting rate of return (ARR),which
examines a project’s contribution to the firm’s net income. Very few companies still use the ARR, and it really
has no redeeming features, so we will not discuss it.

262 The Basics of Capital Budgeting: Evaluating Cash Flows