Final answer:
The discounted payback rule is a method for evaluating the profitability of an investment, taking into account the time value of money to determine when the investment's discounted future cash flows will cover its initial cost.
Step-by-step explanation:
The discounted payback rule is a capital budgeting method used to evaluate the profitability of an investment. This rule takes into consideration the time value of money by discounting the future cash flows from the investment and then determining the period it takes for the present value of future cash flows to cover the initial investment cost.
Unlike simple payback time that ignores the time value of money, discounted payback period includes this aspect, providing a more accurate representation of the investment's breakeven point.
To calculate the discounted payback period, one must: 1) Estimate the future cash flows from the investment. 2) Determine the appropriate discount rate to apply, often the cost of capital or required rate of return.
3) Calculate the present value of each future cash flow using the formula Present Value = Future Cash Flow / (1 + Discount Rate)^n, where n is the number of periods. 4) Accumulate these discounted cash flows until they equal or exceed the initial investment. The point at which this happens is the discounted payback period.
For example, if a project requires a $1,000 upfront investment and generates $400 in cash flow each year, with a discount rate of 10%, the present value of the cash flows for the first four years would be calculated, and the year in which the total reaches $1,000 would be the discounted payback period.