How to Calculate the Rate of Return on Capital
Capital budgeting boils down to the idea that you should look at capital investments (machinery, vehicles, real estate, entire businesses, yard art, and so on) just as you look at the CDs (certificates of deposits) that a bank offers.
You want to earn the highest return possible on your money. Therefore, you want a CD that pays a high interest rate.
You can also look at the interest rates earned on capital investments. However, interest rates don't typically go by that name in capital investing. For some strange reason, the interest rate that a capital investment earns is called a return on investment, or a rate of return. But it's the same thing.
Calculating a rate of return on a capital expenditure requires three steps:
Calculate the investment amount.
The first step in calculating a return is estimating the amount that you need to invest. This amount is similar to the check you write to a bank in order to buy a CD.
Estimate the net cash flows paid by the investment.
Sit down and think carefully about any additional revenues and any additional costs that the investment produces.
Use either a financial calculator, such as one of those fancy Hewlett-Packard calculators, or a spreadsheet program, such as Microsoft Excel, to calculate the rate of return measure.
To calculate a rate of return with Microsoft Excel, you first enter the cash flows produced by the investment. Then you enter the cash flows. After you provide the cash flow values of the investment, you tell Excel the rate of return that you want calculated.
To calculate an internal rate of return, you enter an internal rate of return function formula into a worksheet cell. In the case of this worksheet, you click cell G4 and then type the following:
=IRR(B2:B22,.1)
If you've never seen an Excel function before, this probably looks like Greek. But all this function does is tell Excel to calculate the internal rate of return for the cash flows stored in the range, or block of cells, that goes from cell B2 to cell B22. The .1 is the internal rate of return used to calculate the return in this example.
To calculate the net present value by using Excel, you use another function. In the case of this worksheet, you click cell G6 and type the following formula:
=NPV(0.1,B3:B22)+B2
This formula looks at the cash flows for years 1 through 20, discounts these cash flows by using a 10 percent rate of return, and then compares these discounted cash flows with the initial investment amount, which is the value stored in cell B2.
The net present value formula looks at the cash flows stored in the worksheet and calculates the present value amount by which these cash flows exceed a 10 percent rate of return.
Accounting Glossary
accounting equation
The equation Assets = Liabilities + Equity, which demonstrates the two-sided nature of accounting and is useful for explaining the concept of double-entry accounting (or double-entry bookkeeping).
Accounting Glossary
accounting period
The time period for which financial information is being tracked in a business, such as monthly, quarterly, or annually.
Accounting Glossary
accounts receivable
An account that records the amounts that customers owe to a business.
Accounting Glossary
adjusting entry
A correction made to a bookkeeping account that adjusts for accounting errors or other necessary changes at the end of the accounting period.
Accounting Glossary
cash flows
Used to describe the source or sources of cash or how cash is used.
Accounting Glossary
Chart of Accounts
A list of all the accounts used by a business, including what types of transactions go into each account.
Accounting Glossary
debit
An accounting entry that increases an asset or expense account, and decreases a liability or income account.
Accounting Glossary
dividends
A portion of a company’s profits paid by share of common stock on a quarterly or annual basis.
Accounting Glossary
FASB
Financial Accounting Standards Board. FASB is the highest-ranking authority in the private (non-government) sector of the U.S. for making pronouncements on GAAP and for keeping accounting standards up-to-date.
Accounting Glossary
Federal Unemployment Tax
In the U.S., the fund that used to be known simply as Unemployment. Employers contribute to the fund, and states also collect taxes to fill their unemployment fund reserves. (The acronym FUTA means Federal Unemployment Tax Act.)
Accounting Glossary
fidelity bonds
A type of insurance — typically carried by employers for their employees — that helps guard against theft and reduce the risk of loss.
Accounting Glossary
FIFO
First-in, first-out. A method for costs of goods sold in which a business charges out product costs to cost of goods sold expense in the chronological order in which the goods were acquired.
Accounting Glossary
fungible
Describes a product that is interchangeable and virtually indistinguishable from another product.
Accounting Glossary
General Ledger
A summary of all of a business’s accounts and transactions.
Accounting Glossary
IASB
International Accounting Standards Board. The IASB (based in London) is the main authoritative accounting standards setter outside the U.S.
Accounting Glossary
Journals
The location in which bookkeepers keep records (in chronological order) of daily company transactions.
Accounting Glossary
LIFO
Last-in, first-out. A method for costs of goods sold that selects the last item you purchased first, and then works backward until you have the total cost for the total number of units sold during the period.
Accounting Glossary
LLP
Limited liability partnership. A legal structure that state laws offer to qualified professionals in which all the partners have limited liability.
Accounting Glossary
PC
Professional corporation. A legal structure that state laws offer to qualified professionals who otherwise would have to operate as an unlimited partnership liability.
Accounting Glossary
petty cash
A cash account that businesses keep on hand for unexpected expenses.
Accounting Glossary
revenue
Monies that are collected in the process of selling a company’s goods and services.
Accounting Glossary
salvage value
The amount that an asset is worth after it has been fully depreciated.
Accounting Glossary
statement of cash flows
A financial statement that summarizes a business’s cash inflows and outflows during an accounting period.
Accounting Glossary
transactions
Economic exchanges between a business or other entity and the parties with which the entity interacts and makes deals.
Accounting Glossary
worker’s compensation insurance
A type of insurance carried by employers that covers its employees in case they are injured on the job.
