How to Calculate ROI in a Capital Budgeting Model
Capital budgeting refers to the practice of determining whether a long-term project makes sense financially for a business. Some long-term projects for capital budgeting include buying new machines and buying land for a new building. Capital budgeting analyzes the cash flows from the project so managers can determine whether the business will benefit financially from taking it on. There are several different capital budgeting methods, one of which is to calculate the project's return on investment, or ROI.
Estimate the amount of money the company will earn from the project. Include all the cash inflows over the life of the project. For example, if you buy a new machine to manufacture your products, you may increase your productivity and drive up your profit by $5,000 each year for five years. After five years, you expect the machine to have deteriorated to a point where you need to buy a new one. This means that the project earns you $25,000 over its useful life (from 5 X $5,000)
Calculate the amount of money you have to spend to take on the project. For example, you may have to spend $15,000 to buy the new machine.
Deduct the cost of the project from its benefits to get the profit. In the example, you have a profit of $10,000 from the new machine (from $25,000 - $15,000).
Divide the profit by the cost of the project to get the return on investment and express it as a percentage. With $15,000 investment and $10,000 profit, you have a return on investment of 66.67 percent (from $10,000 / $15,000).