Capital Budgeting Techniques With an Example

Capital Budgeting Techniques

We have already discussed the importance of capital budgeting. It is a process that helps in planning the investment projects of an organization in long run. Let’s understand all the following capital budgeting techniques with an example.

i) Payback period

ii) Discounted payback period

iii) Net present value

iv) Accounting rate of return

v) Internal rate of return

vi) Profitability index

Example of Capital Budgeting

ABC Inc. is planning to buy machine A which will cost $ 10 million. The expected life of the machine is 5 years. The salvage value of the machine is nil. ABC Inc. is expecting cash-flow of $ 5 million for the first two years, $ 3 million for the next 2 years & $ 2 million in 5th year. Operating expense is $ 1 million for every year. Discounting rate is 10%. (Assumption: No tax)

Now let’s find out the answer by using different techniques.

Capital Budgeting Techniques

i) Payback period

Payback method is used to know how much time it will take to recover the investment.

(Amount in Millions)

YearRevenueOperating costProfitCumulative Profit
1$ 5$ 1$ 4$ 4
2$ 5$ 1$ 4$ 8
3$ 3$ 1$ 2$ 10
4$ 3$ 1$ 2$ 12
5$ 2$ 1$ 1$ 13

Here we can see it take 3 years to generate sufficient profit to recover the cost. So the payback period is 3 years.

ii) Discounted payback period

This method is the same as the payback period method. The only difference in payback period & discounted payback period is, it considers the discounted cash flow for finding payback period.

(Amount in Millions)

YearRevenueOperating costProfitDiscounting factor @ 10%Discounted CashflowCumulative discounted cash flow
1$ 5$ 1$ 40.90913.63643.6364
2$ 5$ 1$ 40.82643.30566.9420
3$ 3$ 1$ 20.75131.50268.4446
4$ 3$ 1$ 20.68301.36609.8106
5$ 2$ 1$ 10.62090.620910.4315

Discounted payback period= 4 years + (10-9.8106)*52 weeks / (10.4315-9.8106). It takes approximately 4 years & 16 weeks.

iii) Net Present Value

NPV is one of the most commonly used methods for investment appraisal techniques. It is the sum of all future discounted cash-flow less initial investment. If the amount is positive then the project should be accepted otherwise it should be rejected.

In discounting payback period we can see the sum of all future discounted cash-flow is $ 10.4315 million & initial investment is $ 10 million. It means NPV is $ 0.4315 million. It is positive, hence the project should be accepted.

iv) Accounting Rate of Return

Accounting rate of return is also known as return on investment or return on capital. It is an accounting technique to measure profit expected from an investment.

The formula of ARR is as follows:

ARR= Average annual profit after tax / Initial investment * 100

Average annual profit after tax = (total revenue – total expense) / 5 years

= ($ 18 million – $ 10 million) / 5 years

= $ 1.6 million

ARR= $ 1.6 million / $ 10 million*100

ARR= 16%

v) Internal Rate of Return

Internal Rate of Return is the discounting rate used for investment appraisal, which brings the cost of the project & its future cash flow at par with the initial investment. It is obtained by trial & error method. We already have discounted value at 10% discounting rate.

(Amount in Millions)

YearRevenueOperating costProfitDiscounting factor @ 12%Discounted CashflowCumulative discounted cash flow
1$ 5$ 1$ 40.89293.57163.5716
2$ 5$ 1$ 40.79723.18886.7604
3$ 3$ 1$ 20.71181.42368.1840
4$ 3$ 1$ 20.63551.27109.4550
5$ 2$ 1$ 10.56740.567410.0224

Difference between discounted cash-flow is $ 0.4091 million ($ 10.4315 million – $ 10.0224 million).

IRR = 12 % + (0.0224 * 2 / 0.4091)

= 12 % + 0.11

IRR for the project is 12.11%.

vi) Profitability Index

Profitability index defines how much you will earn per dollar. The present value of future cash-flow is $ 10.4315 million & investment is $ 10 million.

PI = Present value of cash inflow / Initial investment

PI = $ 10.4315 million / $ 10 million

Profitability Index is 1.04315 which means every one dollar invested is generating revenue of $ 1.04315.If the PI is more than 1 then the project should be accepted otherwise rejected.1

1.
Capital Budgeting. Investopedia. February 2019. [Source]
Last updated on : March 8th, 2019
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