The capital recovery factor and sinking fund factor are the two different financial metrics used in investment decision-making. The CRF is different from SFF in the following ways:
Table of Contents
What Is Capital Recovery Factor?
Capital recovery factor (CRF) refers to a cost analysis tool that ascertains the present value of annuities, I.e., the present value of periodic payments for investment and the cash flow needed to recoup its initial cost. It considers the time value of money for gauging a project's financial viability.
The initial phase of an investment generates negative returns at the beginning until the invested sum is recovered from the successive cash flow. All the revenue from the project beyond this point is the actual return or profit generated from the respective asset or business. Hence, the CRF shapes the capital expenditure decisions of the companies.
Key Takeaways
- The capital recovery factor (CRF) is a financial analysis tool used to estimate the cost of an investment or project.
- It determines the current value of the regular and equal cash payments made to realize the initial cost of the project or investment.
- This metric is widely used by businesses to analyze the financial viability of investing in a capital-intensive asset or project that would generate positive cash flow in the future.
- The CRF assumptions include equal cash flow, accurate prediction of investment lifespan, and fixed interest rate.
Capital Recovery Factor Explained
The capital recovery factor is a crucial cost analysis metric that determines the feasibility or financial viability of an investment or project. It finds the current value of the series of equal and consistent payments required for recouping the initial cost of such an investment. Thus, it ascertains the profit potential of the project and uncertainties until the initial cost is recovered. Moreover, CRF estimates the time it will take for the project to reach the break-even point.
However, the CRF tool functions upon certain assumptions, as discussed below:
- Consistent Interest Rate: The discount rate or interest rate will remain constant over the lifetime of the investment.
- Accurate Prediction of Lifespan: The estimation of the project's lifetime is precise.
- Uniform Cash Flow: The investment has a stable cash flow or payment series.
These assumptions may not stand steadfast in the practical scenario, but the CRF application relies upon the consideration of these conditions.
Formula
The uniform series capital recovery factor evaluates the recovery of present monetary investment from successive future payments. It is computed as:
Where, ‘i’ is the interest rate; and
'n' is the compounding period or number of annuities.
Examples
The CRF is a valuable financial metric for planning the current cash flow of an investment or subsequent loan taken for a capital-intensive project. There are various capital recovery factor calculators available online, and analysts can go through the capital recovery factor table to compare the potential of different investment opportunities. Let us understand CRF's computation and relevance through the following examples:
Example #1
Suppose a firm has taken a loan worth $10,000 to invest in a new building. The interest rate payable by the firm is 8% per annum, and the number of annuities is 10. Let us determine the CRF of this investment.
CRF = / - 1 = 0.938 / 10.738 = 0.0874 or 8.74%
Therefore, the building's Capital Recovery Rate is 8.74% per year. Therefore, the firm cannot realize any profits from such an investment until the overall capital invested in the building is recovered.
Example #2
Suppose ABC Ltd., is a telecommunications company that is going to invest a hefty amount of $1 billion in strengthening its infrastructure and network across the USA. The present value of its series of cash outflows is determined using the Capital Recovery Factor of 3.35%. The finance team finds it relatively low, resembling that it would take a long time for the business to recoup its initial investment and that the project involves high risk since the industry is evolving at a rapid pace.
Advantages And Disadvantages
Advantages
- The CRF helps in predicting the constant cash flow of a particular project over its expected lifetime.
- It emphasizes the recovery of the initial cost of a project over the period, thus mitigating the risk of loss when the project involves enormous capital investment.
- Also, it aids in gauging the profitability of a project and its viability by acknowledging its time value for money.
- Businesses can determine the potential capital recovery of multiple projects and compare their cash flows over time to make the right choice for capital allocation.
- Further, it accounts for the period that a project would take to repay its initial cost to facilitate long-term financial planning.
Disadvantages
- This financial analysis metric depends upon certain assumptions like equal cash flow, fixed interest rate, and prediction of cash flow over the investment's life, which are unrealistic in the dynamic economic scenario.
- As the CRF involves mathematical calculation, it only considers monetary factors. It often ignores the non-financial aspects like social benefits, environmental impact, and strategic fit, which are equally essential elements of investment decision-making.
- The computation of an investment's present value is affected by the discount rate. A higher discount rate would result in falling CRF, which would make the project less profitable.
Capital Recovery Factor vs Sinking Fund Factor
| Basis | Capital Recovery Factor | Sinking Fund Factor |
|---|---|---|
| 1. Definition | It is a financial metric that evaluates the present value of the series of annuities or equal annual payments pertaining to an investment. | It is a financial metric that evaluates the present value of the series of annuities or equal annual payments pertaining to an investment. |
| 2. Determines | Present value of the successive annuities each year. | Present value of the successive annuities each year. |
| 3. Formula | i*(1+i)^n / (1+i)^n -1 | i*(1+i)^n / (1+i)^n -1 |
| 4. Relationship | It is the opposite of SFF, although the sinking fund factor serves as a component of capital recovery factor calculation, I.e., CRF = SFF + i | It is the opposite of SFF, although the sinking fund factor serves as a component of capital recovery factor calculation, I.e., CRF = SFF + i |
| 5. Use | Gauge affordability of an investment or loan. | Gauge affordability of an investment or loan. |
Frequently Asked Questions (FAQs)
1
What is the capital recovery factor of the equal payment series?
2
What is the purpose of a capital recovery factor?
3
What is the difference between WACC and capital recovery factor?
