Examples of Capital Budgeting Techniques
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. 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)
What is Pay Back Period 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?
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Solution:
Let’s say in a year one and so on company recover a profit as listed in the table below.
So how long it will take the company to recover invested money from the above table it shows 3 year and some months. But this is not the right way to find out a payback period of initial investment because base what 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 below table.
So from Cash flow analysis, company will recover initial investment within 2 years. So the payback period is nothing but the time taken by cash inflows to recover the investment amount.
Example #2
Calculate the Pay Back Period and Discounted Pay Back Period for the project which cost $270,000 and projects expected to generate $75,000 per year for the next five years? Company required rate of return 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?
Solution:
After adding cash flows of each year Balance will come as shown in 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-(-45,000)]/75,000
- PB= 3.6 Years
Or
- 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 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 method, it is clear that the company should go ahead and invest in the project as though both methods the company will cover initial investment before 5 years.
Example #3 (Accounting Rate of Return)
Accounting Rate of Return technique of capital budgeting measures the average annual 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 return?
Solution:
First, calculate Average Annual Cash Flows
- =Total cash Flows/Total Number of Year
- =360,000/6
Average Annual Cash Flows =$60,000
Calculate Annual Depreciation Expenses
=$240,000-$30,000/6
=210,000/6
Annual Depreciation Expenses =$35,000
Calculate ARR
- ARR=Average Annual net cash flows – Annual Depreciation Expenses/ Initial Investment
- ARR=$60,000- $35,000/$240,000
- ARR=$25,000/$240,000 × 100
- ARR=10.42%
Conclusion – So if ARR is higher than the hurdle rate established by company management than it will be considered and in vice versa it will be rejected.
Example #4 (Net Present Value)
MetLife Hospital is planning to buy an attachment for its X-ray machine, cost of attachment is $3,170 and life of 4 years, Salvage value is zero and increase in cash inflows every year is $1,000. No investment is to be made unless having annual of 10%. Will the MetLife Hospital invest in the attachment?
Solution:
Total Investment Recovered (NPV)= 3170
From the above table, it is clear that cash inflows of $1,000 during 4 years is sufficient to recover the initial investment of $3,170 and to provide exactly 10% return on investment So MetLife Hospital can invest in X-ray attachment.
Example #5
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 during 5 years as shown in below table. Calculate Net Present Value and Internal Rate of Return of the Project. An interest rate is of 5%.
Solution:
First to calculate net cash flows during that time period by Cash inflows – Cash outflows as shown in 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+
14,000/1+0.05)5
NPV= -50,000+14,285.71+10,884.35+8,638.56+8,227.07+10,969.21
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
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