The fundamental distinction between nominal and discounted payback lies in the consideration of the cost of capital (the remuneration of investors) and the time value of money.
Here are the detailed differences:
1. The Nominal Payback (or simple repayment period)
The nominal payback measures the minimum amount of time it takes for the cumulative sum of undiscounted cash flows to exceed the amount of the initial investment.
- Function: It indicates the time it takes to repay the capital contributed by investors.
- Limit: This is an indicator considered “incomplete” because it neglects the remuneration of investors. It simply checks whether the money going out has come in, without taking into account the fact that a euro of tomorrow is worth less than a euro of today because of inflation and risk.
2. The Discounted Payback
The discounted payback measures the time it takes to recoup the initial stake using the sum of the discounted cash flows at the Weighted Average Cost of Capital (WACC).
- Function: It reflects the minimum period required to not only repay the capital invested, but also to compensate investors at the rate they charge (the WACC) for the risk taken.
- Link to NPV: The moment when the discounted payback is reached corresponds to the moment when the cumulative Net Present Value (NPV) of the project becomes positive (or zero). This means that the project has generated enough cash to cover the initial investment and the cost of financing.
In summary
- Nominal Payback : “When do I get my stake back?” (Principal repayment only).
- Payback Update: “When do I get my stake back and still have earned the minimum return required?” (Repayment of principal + interest/risk compensation).
It is recommended to compare this payback period (updated payback) with the visibility that the company has on the project (order book, patents, contracts). A long payback (e.g. 7 years) can be acceptable if the visibility on future flows is excellent (e.g. 20 years), but very risky if the visibility is low.