Capital Budgeting Examples

The examples below use these values. Generate a new scenario to practice the same procedure with different numbers.

Generate New Scenario

Concept Summary: Accounting rate of return evaluates a capital investment using accrual accounting income rather than cash flow.

Example A: Build annual accounting income

Objective: Start from annual cash benefit and subtract depreciation to identify accounting income.

Example B: Calculate ARR and make the screening decision

Objective: Compare ARR with management's required return.

Example C: Solve for required accounting income

Objective: Rearrange the ARR formula to determine the income needed to meet the target return.

Concept Summary: Payback period measures how long it takes for cash inflows to recover the initial investment.

Example A: Convert accounting income to annual cash flow

Objective: Add back depreciation to move from accounting income to cash flow.

Example B: Calculate payback with equal annual cash flows

Objective: Divide the investment by the annual cash inflow.

Example C: Calculate payback with uneven annual cash flows

Objective: Accumulate yearly cash flows until the investment is recovered, then compute the fractional year.

Example D: Solve required annual cash flow for a target payback

Concept Summary: Net present value discounts future cash flows to today's dollars, then subtracts the initial investment.

Example A: NPV with equal annual cash flows

Objective: Use the present value annuity factor for repeated equal cash inflows.

Example B: NPV with uneven annual cash flows

Objective: Discount each year's cash flow separately.

Example C: Include salvage value and compute NPV

Objective: Add the present value of terminal salvage value, then subtract the initial investment.

Example D: Solve maximum investment supported by the cash flows

Objective: Determine the largest investment that produces NPV = 0.

Example E: Select the strongest NPV project

Objective: Compare competing projects and choose the alternative that creates the most value.

Concept Summary: Internal rate of return is the discount rate where NPV equals zero.

Example A: Interpret IRR using the live NPV result

Example B: Estimate the IRR factor for equal annual cash flows

Example C: Estimate IRR using trial discount rates

Objective: Test rates until NPV approaches zero.

Example D: Select the estimated IRR and decide

Concept Summary: Mutually exclusive alternatives compete against each other. A cost alternative usually uses the lower present value cost. A revenue alternative usually uses the higher NPV.

Example A: Compute present value cost of the purchase alternative

Example B: Compute present value cost of the lease alternative

Example C: Choose the preferred cost alternative

Example D: Compare revenue projects using NPV

Concept Summary: Profitability index measures value received per dollar invested.

Example A: Calculate and rank profitability index

Example B: Allocate limited capital

Objective: Use PI ranking to choose projects within a capital limit.

Example C: Solve required present value for a target PI

Concept Summary: Time value of money converts amounts across time so alternatives can be compared on the same date.

Example A: Choose the correct factor

Example B: Present value of a single future amount

Example C: Present value of an annuity

Example D: Future value of a single amount and annuity