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 to decide whether to continue with the existing machinery or buy a new one in place of the old machinery.

## Examples of Capital Budgeting Techniques

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With the help of capital budgeting, we can understand that some methods make decisions easy; however, some methods do not arrive at a decision; it makes it difficult for an organization to make decisions. The below example of the capital budgeting technique shows us how an organization can decide 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.

##### Table of contents

### Key Takeaways

- Capital budgeting is making long-term investment decisions, such as replacing existing machinery with a new one. It involves analyzing a project’s future cash inflows and outflows and determining whether it is financially viable.

- While capital budgeting considers only financial factors and not qualitative factors in investment decisions, it is a critical process for companies that require substantial funds for capital expenditures.

- Capital budgeting techniques include the payback period, accounting rate of return, net present value, and discounted payback period, which provides a quantitative analysis for choosing the most profitable investment.

### 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.read more 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 projects and the cost of that project is $10,000 before the company wants to analyze how long it will take a company to recover invested money in a project?**

**Solution:**

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 three years and some months. But this is not the right way to find out a payback period of initial investment because the company’s base is profit. It is not a cash flow, so profit is not the right criteria, so a company should use it here as cash flow. So profit is arrived after deducting depreciation value, so to know the cash flows, we have to add depreciation in profit. The 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.read more the company will recover the initial investment within two years. So the payback period is nothing but the time taken by cash inflows to recover the investment amount.

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#### Example #2

**Calculate the Payback Period and Discounted Pay Back PeriodDiscounted Pay Back PeriodThe discounted payback period is when the investment cash flow paybacks the initial investment, based on the time value of money. It determines the expected return from a proposed capital investment opportunity. It adds discounting to the primary payback period determination, significantly enhancing the result accuracy.read more 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 Rateread more is 11 percent. Should the company go ahead and invest in a project? The rate of return is 11%. Do we have to find it here, PB?DPB?Should the project be purchased?**

**Solution:**

After adding each year’s cash flows, the 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-(-45,000)]/75,000
**PB= 3.6 Years**

Or

- PB= Initial Investment/Annual Cash Flows
- PB= 270,000/75,000
**PB= 3.6 Years.**

The Discounted rate of return of 11% Present Value of Cash Flows are shown below.

- DPB= (Year – Last negative Balance)/Cash Flows
- DPB= [(4-(37,316.57)/44,508.85)
**DPB= 4.84 Years**

So from 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.read more, it is clear that the company should go ahead and invest in the project as though both methods will cover the initial investment before five years.

#### Example #3 (Accounting Rate of Return)

**The accounting rate of Return technique of capital budgeting measures the annual average rate of returnAverage Rate Of ReturnAverage Rate of Return (ARR) is the expected rate of return on an investment or asset divided by the initial investment cost or average investment during the project's life. The formula for calculating the average rate of return is: Average annual net earnings after taxes/Initial investment * 100%read more over the assets life. Let’s see through this example** **below**.

**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 valueResidual ValueResidual value is the estimated scrap value of an asset at the end of its lease or useful life, also known as the salvage value. It represents the amount of value the owner will obtain or expect to get eventually when the asset is disposed.read more 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.read more?

**Solution:**

First, calculate the 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** – 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.read more established by company management, 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 the 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.read more 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 MetLife Hospital invest in the attachment?**

**Solution:**

**Total investment Recovered (NPV)= 3170**

The above table shows that cash inflows of $1,000 for four years are sufficient to recover the initial investment of $3,170 and provide exactly a 10% return on investment. So MetLife Hospital can invest in X-ray attachment.

#### Example #5

**ABC limited company is looking to invest in one of the project costs of $50,000 and cash inflows and outflows of a project for five 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.read more **and Internal Rate of Return of the Project. The interest rate is 5%.**

**Solution:**

First, 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.read more during that period by Cash inflows – Cash outflows, as shown in the table below.

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)**

Calculate IRR

**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

### Frequently Asked Questions (FAQs)

**1. What are some examples of capital budgeting projects for a manufacturing company?**A manufacturing company may invest in a new production line, purchase new machinery, or construct a new factory building. These capital budgeting projects require significant capital expenditure, and the company needs to evaluate the potential returns on investment before making a final decision.

**2. What is an example of a capital budgeting project for a service-based company?**A service-based company may invest in a new software system or upgrade its IT infrastructure. These projects are important for improving the efficiency and effectiveness of the company’s operations and can generate significant cost savings or revenue growth.

**3. What is an example of a capital budgeting project for a real estate company?**A real estate company may invest in a new development project, such as constructing a new office building or shopping center. These projects require significant capital expenditure and can generate long-term returns through rental income and property appreciation.

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