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Discounted Payback Period
This is similar to the regular payback method except that it discounts cash flows at the project's cost of capital. It considers the time value of money, but it ignores cash flows beyond the payback period.
Again, assume the cost of capital for the firm is 10%:
Discounted PaybackA = 2 + (1000 - 682 - 289)/113 = 2.26 years
Discounted PaybackB = 3 + (1000 - 91 - 207 - 338)/512 = 3.71 years
The payback provides an indication of a project's risk and liquidity because it shows how long the invested capital will be tied up in a project and "at risk." The shorter the payback period, the greater the project's liquidity, the lower the risk, and the better the project. The payback is often used as one indicator of a project's risk.