• Explanation

Businesses use capital budgeting techniques to select projects with the most potential for profit. One technique is the payback period method, which estimates how long it will take to recover the initial cost of a project. The payback period The payback period and discounted payback period both approximate the number of years required to recover a project's original investment. The payback point occurs when the total cash inflows equal the original investment. The discounted payback point occurs when the total discounted cash inflows equal the original investment. is the point at which the cumulative cash flows equal the cost. Payback can be calculated on a discounted or nondiscounted basis. In this scenario, the cash flows are discounted.

The $1,000 cost of the asset occurs at the beginning of the project, so it is not discounted. At the end of Year 3 (36 months), the present value (PV) of cumulative cash flows (ie, cash inflows net the cash outflows) is ($150). Another $150 is needed to reach the initial cost amount of $1,000. That is 50% ($150 / $300) of Year 4, or 6 months. Therefore, payback will be reached at the end of month 42 (36 + 6), calculated as follows:

Things to remember
Discounted payback is a capital budgeting technique used to determine the amount of time it takes to recover the cost of an investment (ie, asset acquisition). The point at which the cumulative discounted cash flows (ie, inflows net of the outflows) equals $0 (ie, breakeven) is the discounted payback period.