With that, let’s jump into our first decision-making method, which is the payback period. With these decision-making methods, we’re going to see that some use the time value of money, and others do not. The payback period does not use the time value of money. This method asks, “How much time until we are paid back for our initial investment?” It’s measured in terms of years.

For example, let’s say that we invest $100,000 in a new office building, and it’s going to create cash inflows of $25,000 a year for the next 10 years. We invested $100,000, and then after four years of cash inflows, we get back our initial investment. That means that our payback period is four years.

Payback Period = Investment / Undiscounted Cash Flows

Once again, we don’t calculate the present value for the payback period. The payback period is quite straightforward to calculate, but it’s limited because it doesn’t use the time value of money.

Discounted Payback Period

The next decision-making method we’re going to talk about is called the discounted payback method. The goal of the discounted payback method is the same as the payback period method, but the discounted payback method uses the time value of money. We’re going tofigure out the present value of the future cash flows.Instead of using the amount of $25,000 for our cash flow, we’re going to calculate the present value of the $25,000 cash flow, which is going to be less than $25,000. The discounted payback period method creates a payback period that is longer than the payback method because the time value of money makes the present value of the cash flows lower.