We can improve the payback method by using discounted cash flows instead of the nominal (undiscounted, unadjusted) estimates.

Let’s review the example:

JuxtaPos makes interlocking wooden puzzles. One of the machines is old and management is considering either replacing it or refurbishing it. Replacing it will cost $80,000. The new machine would last 10 years and have a residual value of $10,000. Refurbishing the old machine for $56,000 will keep it in service for another eight years, and it will have no residual value at the end of that time.

You have estimated production under both scenarios and used those numbers to compute revenue. You have also estimated operating costs and have created the following table of net cash inflows:

Net cash inflows (additional cash revenues – additional cash expenses)

None of these values are adjusted for the time value of money. For instance, $12,000 ten years from now is not the same as $12,000 today.

Let’s assume JuxtaPos uses a 10% hurdle or discount rate for capital budgeting purposes. If we use a present value table, we find that the factor of 10% and 10 years is 0.386. Multiplying the factor by our $12,000 future value for year 10 gives us a present value of $4,632. That means that if we translate all of the future numbers back to Year 0 when we make the initial purchase (beginning of Year 1), the $12,000 future cash flow in Year 10 would be the equivalent of a $4,632 cash flow back at the beginning of Year 1.

More precisely (because factors in the tables are rounded), the present value of $12,000 at 10% for 10 years is $4,626.5194732… which we could round to $4,626.52.

If we were to invest that amount in a mutual fund that gave us an annual return of 10%, we would see the following results:

In other words, $4,626.52 invested at 10% today will grow to $12,000.02 at the end of the tenth year. So, the present value of $12,000 is $4,626.52. The future value of $4,626.52 invested at 10% for 10 years is $12,000.02.

If we apply this logic to all of the cash flow numbers, using 10% as our discount rate and the appropriate number of years for each cash inflow, we get the following table of discounted cash flows:

Discounted net cash inflows

Applying these numbers to our payback analysis, we find that the amount of time it takes for the refurbish option to pay for itself is five years four months:

Refurbish

And the payback period for a new machine is six years ten months.

Purchase

This is an improvement over the simple payback method, but it still does not take into account the overall rate of return, and it does not address cash flows that occur after the payback period.

Before we address those issues, check your understanding of the payback method using discounted cash flows.