Capital Budgeting primarily refers to the decision making process related to investment in long term projects, an example of which includes the capital budgeting process conducted by an organization in order to decide that whether to continue with the existing machinery or buy a new one in place of the old machinery.
Examples of Capital Budgeting Techniques
The below example of capital budgeting technique shows us how an organization can arrive on the decision by comparing future cash inflows and outflows of the individual projects. The point to be remembered on capital budgeting is that it considers only financial factors in investment, as explained in the below examples and not a qualitative factor. With the help of capital budgeting, we can understand that some of the methods make decisions making easy; however, some methods do not arrive at a decision; it makes organization difficult to make decisions.
Top 5 Examples of Capital Budgeting
Let’s see some simple to advanced examples of capital budgeting to understand it better.
Example #1 (Pay Back Period)
Pay Back Period DefinitionPay Back Period DefinitionThe payback period refers to the time that a project or investment takes to compensate for its total initial cost. In other words, it is the duration an investment or project requires to attain the break-even point. and how to understand that let’s discuss this by considering the below example?
An XYZ limited company looking to invest in one of the new project and cost of that project is $10,000 before investing company want to analyze that how long it will take a company to recovered invested money in a project?
Let’s say in a year one, and so on, the company recovers a profit as listed in the table below.
So how long will it take the company to recover invested money from the above table it shows 3 years and some months. But this is not the right way to find out a payback period of initial investment because the base what the company is considering here is profit, and it is not a cash flow, so profit is not the right criteria, so a company should use here is cash flow. So profit is arrived after deducting depreciation value, so to know the cash flows, we have to add depreciation in profit. Let say depreciation value is $2,000, so net cash flows will be as listed in the below table.
So from Cash flow analysis,Cash Flow Analysis,Cash flow analysis refers to examining or analyzing the company's different cash inflows and outflows during the period under consideration from the various activities, including operating activities, investing activities, and financing activities. the company will recover the initial investment within 2 years. So the payback period is nothing but the time taken by cash inflows to recover the investment amount.
Calculate the Pay Back Period and Discounted Pay Back Period for the project, which costs $270,000 and projects expected to generate $75,000 per year for the next five years? The company required rate of returnRequired Rate Of ReturnRequired Rate of Return (RRR), also known as Hurdle Rate, is the minimum capital amount or return that an investor expects to receive from an investment. It is determined by, Required Rate of Return = (Expected Dividend Payment/Existing Stock Price) + Dividend Growth Rate is 11 percent. Should the company go ahead and invest in a project? The rate of Return 11%.Do we have to find here, PB?DPB?Should the project be purchased?
After adding the cash flows of each year, balance will come, as shown in the below table.
From the above table positive balance is in between 3 and 4 years so,
- PB= (Year – Last negative Balance)/Cash Flows
- PB= 3.6 Years
- PB= Initial Investment/Annual Cash Flows
- PB= 270,000/75,000
- PB= 3.6 Years.
With the Discounted rate of return of 11% Present Value of Cash Flows as shown in the below table.
- DPB= (Year – Last negative Balance)/Cash Flows
- DPB= [(4-(37,316.57)/44,508.85)
- DPB= 4.84 Years
So from above both capital budgeting methodsCapital Budgeting MethodsCapital budgeting methods are used to aid the decision-making process. Various methods are Payback Period, Net Present Value, Internal Rate of Return, and Profitability Index., it is clear that the company should go ahead and invest in the project as though both methods, the company will cover the initial investment before 5 years.
Example #3 (Accounting Rate of Return)
The accounting rate of Return technique of capital budgeting measures the annual average rate of return over the assets life. Let see through this below example.
XYZ limited company planning to buy some new production equipment, which costs $240,000, but the company has unequal net cash inflows during its life, as shown in the table, and $30,000 residual value at the end of its life. Calculate the accounting rate of returnAccounting Rate Of ReturnAccounting Rate of Return refers to the rate of return which is expected to be earned on the investment with respect to investments’ initial cost.?
First, calculate Average Annual Cash Flows
- =Total cash Flows/Total Number of Year
Average Annual Cash Flows =$60,000
Calculate Annual Depreciation Expenses
Annual Depreciation Expenses =$35,000
- ARR=Average Annual net cash flows – Annual Depreciation Expenses/ Initial Investment
- ARR=$60,000- $35,000/$240,000
- ARR=$25,000/$240,000 × 100
Conclusion – So if ARR is higher than the hurdle rateHurdle RateThe hurdle rate in capital budgeting is the minimum acceptable rate of return (MARR) on any project or investment required by the manager or investor. It is also known as the company’s required rate of return or target rate. established by company management, than it will be considered, and vice versa, it will be rejected.
Example #4 (Net Present Value)
Met Life Hospital is planning to buy an attachment for its X-ray machine, The cost of attachment is $3,170, and life of 4 years, Salvage valueSalvage ValueSalvage value or scrap value is the estimated value of an asset after its useful life is over. For example, if a company's machinery has a 5-year life and is only valued $5000 at the end of that time, the salvage value is $5000. is zero, and an increase in cash inflows every year is $1,000. No investment is to be made unless having an annual of 10%. Will the Met Life Hospital invest in the attachment?
Total investment Recovered (NPV)= 3170
From the above table, it is clear that cash inflows of $1,000 for 4 years are sufficient to recover the initial investment of $3,170 and to provide exactly a 10% return on investment So MetLife Hospital can invest in X-ray attachment.
ABC limited company looking to invest in one of the Project cost that project is $50,000 and cash inflows and outflows of a project for 5 years, as shown in the below table. Calculate Net Present ValueNet Present ValueNet Present Value (NPV) estimates the profitability of a project and is the difference between the present value of cash inflows and the present value of cash outflows over the project’s time period. If the difference is positive, the project is profitable; otherwise, it is not. and Internal Rate of Return of the Project. The interest rate is 5%.
First, to calculate net cash flowsCalculate Net Cash FlowsNet cash flow is calculated by adding the net cash flow from operating activities, net cash flow from Investing activities and net cash flow from financing activities. It can also be calculated by subtracting the cash payments of the company during the period from the cash receipts. during that time period by Cash inflows – Cash outflows, as shown in the below table.
NPV= -50,000+15,000/(1+0.05)+12,000/(1+0.05)²+10,000/(1+0.05)³+ 10,000/(1+0.05)⁴+
NPV= $3,004.84 (Fractional Rounding of)
Internal Rate of Return = 7.21%
If you take IRR 7.21% the net present value will be zero.
Points to Remember
- If IRR is > than Discount (interest) rate, than NPV is > 0
- If IRR is < than Discount (interest) rate, than NPV is < 0
- If IRR is = to Discount (interest) rate, than NPV is = 0
This has been a guide to Capital Budgeting Examples. Here we provide the top 5 examples of Capital budgeting techniques along with explanations. You may learn more about accounting from the following articles –