Needed a Document for Method to calculate capital bujting? Related: Capital Budgeting Process, Accountancy and Financial management

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Capital Budgeting Examples

Let's take an example: The Hasty Rabbit Corporation, which makes sneakers for rabbits, is considering a plant expansion costing $750,000 to produce more of its top-selling shoe, the Fleet Feet. The other option is to build a new plant that will cost $500,000 to make the new model, the Blazing Hare.

The expansion for Fleet Feet will bring in an additional cash flow of $175,000 per year for five years. The company's accountants estimate that new sales of Blazing Hare will produce $160,000 per year in cash flow for at least five years. The company's cost of capital is 5 percent.

The Simple Payback Period

The payback period method of evaluating capital projects is the simplest approach. It is calculated by dividing the cost of the project by the annual cash return. The project with the shortest time to return the investment gets the approval. Consider the example:

Fleet Feet: $750,000 investment/$175,000 cash flow per year = 4.3 years

Blazing Hare: $500,000 investment/$160,000 cash flow per year = 3.1 years

Using the payback method, the investment in a new plant for Blazing Hare would win the approval, because it has the shorter payback period. While this is a nice, quick and easy calculation, it does not consider the time value of money or additional future cash flows from each project after the payback period.

Net Present Value Method

The net present value technique considers the time value of money. It discounts a series of future cash flows back to a present value. The discount rate used could be the company's cost of borrowing or a minimum required rate of return. If the present value of future cash flows exceeds the initial investment outlay, then the project would be acceptable. A project with a negative net present value would be declined.

Back to the example of Hasty Rabbit.

Fleet Feet expansion: The present value of five years of cash flow at $175,000/year at a discount rate of 5 percent is $757,658. After subtracting the initial outlay of $750,000, the net present value of this project is $7,658.

Blazing Hare new product: The present value of five years of projected cash flow of $160,000 discounted at 5 percent is $692,716. But this project has a lower initial investment of $500,000, so the net present value of introducing a new model is $192,716.

The Blazing Hare project is the choice because it has the higher net present value: $192,716 versus $7,658.

Internal Rate of Return Technique

This method compares the rates of return from different projects. It is the rate where the net present value of the project is zero. Projects with higher internal rates of return are preferable.

Fleet Feet: Calculations show that the internal rate of return for the initial investment of $750,000 and five years of $160,000 cash inflows is 5.4 percent.

Blazing Hare: The new production model has a lower initial cost of investment, $500,000, and its internal rate of return with five years of $160,000/year is 18 percent.

Comparison of the internal rates of return for the two projects again shows that introducing the new Blazing Hare shoe is preferable, because it has a higher rate of return – 18 percent versus 5.4 percent.

Profitability Index Calculation

The profitability index is the ratio of the present value of future cash flows divided by the initial cash investment. The discount rate used to calculate the present value is the company's cost of capital. In the example for Hasty Rabbit, the cost of capital is 5 percent. The formula for the profitability index is:

Profitability index = Net present value of cash flows/Initial cash outlay

Fleet Feet: $757,658/$750,000 = 1.01

Blazing Hare: $692,716/$500,000 = 1.4

The Blazing Hare is again the better choice, because it has the higher profitability index.

Small business owners make capital budgeting decisions each time they buy something or invest in a project. It could be something as simple as buying a new truck or a more productive piece of equipment, or more complicated, like investing $1 million in a new plant. These capital budgeting techniques are helpful tools for the owner to analyze and determine which investments are best for the business.

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