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What is the Capital Recovery Factor (CRF)?
Capital recovery factor is a financial formula that helps determine how much money needs to be earned annually to recover an initial investment, given a fixed interest rate.
Key Takeaways
- Capital recovery factor is a ratio that only requires two inputs: interest rate and number of periods of a loan/investment.
- CRF is useful for businesses when budgeting, calculating loan amortization, and looking at new potential projects.
- As a standard ratio, CRF can be a good tool to compare different investments or loans.
- A low CRF can mean lower risk for an investment, while a high CRF can indicate the investment needs to return more money each year to recoup your original investment.
- Capital recovery factor isn’t useful in situations with variable financing or intermittent cash flows.
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How to Use Capital Recovery Factor
Here’s how you might use CRF to help choose between two new potential projects that both need a large capital investment:
- Determine the inputs for calculating CRF for Project #1 (initial investment, time period, interest rate).
- Calculate the capital recovery factor for that project.
- Complete the first two steps for Project #2.
- Compare the CRF between Project #1 and Project #2.
Whichever project has the lower capital recovery factor means that it needs to earn less money annually, which may make it a better choice.
However, CRF shouldn’t be the only factor used when choosing between projects or investments, so make sure to factor in all other scenarios and variables before making a decision.
Calculation of Capital Recovery Factor
The capital recovery factor formula is as follows:
Application of the Capital Recovery Factor
CRF is a useful tool in several areas:
Limitations of the Capital Recovery Factor
CRF is a useful tool for businesses that are looking at new investments or loans. However, it’s a limited financial metric that only works in the right circumstances.
Here are several areas where the capital recovery factor fails to account for:
- Non-standard cash flows: CRF works assuming that cash flows are consistent and regular. If cash flows are variable or irregular, consider using another valuation method, like net present value (NPV).
- Varying risk profiles: Two investments with the same CRF could have very different risks.
- Projects with multiple phases: Projects with different cash patterns in various phases aren’t accounted for in a CRF calculation.
- Inflation: CRF assumes the value of money remains consistent and doesn’t account for inflation or other currency fluctuations that affect purchasing power.
Capital Recovery Factor Example
Here is a capital recovery factor example that can help you better understand how the formula might work in a real world scenario:
Imagine you are a small business owner who is considering the purchase of a new piece of equipment. The equipment costs $50,000, so you want to finance your purchase with a 5-year loan at a 5% interest rate. Given this information, you want to figure out how much you’ll need to pay yearly to offset the cost of the equipment and interest payments.
You will first calculate the capital recovery factor formula and then use it to calculate the annual payment needed to pay back your equipment purchase in 5 years.
CRF=(1+0.05)5−10.05(1+0.05)5
CRF = 0.23097
To get the annual payment, simply multiply the CRF by the total loan amount (in this case, the cost of the equipment).
Annual Payment = 0.23097 x 50,000
Annual Payment = 11,548.50
Therefore, you’ll need to pay $11,548.50 per year to recover the cost of your equipment purchase in 5 years. This can allow you to set a fixed budget and plan out your financing to ensure you can cover your costs in the long run.
Capital Recovery Factor Pros and Cons
- Easy to calculate and understand
- Accounts for the time value of money
- Creates a fixed, predictable payment schedule, which is better for long-term planning
- Helps with comparing investments, new projects, and loans
- Cannot be solely used when making financial decisions
- Sensitive to interest rate changes and doesn’t account for inflation
- Isn’t useful for projects with intermittent cash flows, variable financing, or other irregular circumstances
- May oversimplify complex investments
The Bottom Line
CRF is an important financial tool to help determine the cash flows needed to recoup an investment or pay back a loan over a given time period. Based on the capital recovery factor definition and formula, CRF is most useful in situations where there are regular, predictable cash flows.
Yet, this metric won’t be helpful if the investment or loan has irregular cash flows, is highly speculative, or subject to changes in currency values. If you do choose to use CRF in your modeling, make sure to combine it with other financial metrics to make more informed financial decisions.
