Question

I am calculating the expected cash flow for a project. However, I am not sure that I should use the net cash flow (after tax) or cash flows (before tax) to identify the payback period and the discounted payback period? Thank you

Answer 1

Payback period : It is the number of years to be taken to recover your intial amount invested in the project. (tells the break even point)

Payback Period = Investment /Annual cash Flow

Discounted Payback Period : It is the number of years in which discounted cash flow will cover the initial invested amount.

It is same as we calculate the payback period , only change is that here we consider the time value of money.

Present value of cash flows are calculated first.

Calculation as follows :

In the current year that is Year = 0; you have made the Initial Investment.

Then , Calculate the present value od each yera cash flow .

Now Calculate the cu,ulative discounted cash flow by taking effect of Outflow and respective infloews until you reach at the negative cumulative discounted cash flow .

so, Discounted payback period =

Last year in which we have negative cumulative discounted cash flow + the value of negative discounted cash flow at the end of last year in which we have negative cumulative discounted cash flow /Discounted cash flow of the year after the year in which we have negative cumulative discounted cash flow.

now, we get to know in how many years we will be able to recover our intial invested amount.

USE THE NET CASH FLOW AFTER TAX FOR THE CALCULATION OF PAYBACK PERIOD AND DISCOUNTED PAYBACK PERIOD.