Capital Budgeting & Financial Decision-Making

TAKEAWAYS:

• Capital budgeting is the process of planning and evaluating long-term investments (e.g., machinery, new stores) to maximize shareholder value.
• Key techniques include NPV (Net Present Value), IRR (Internal Rate of Return), Payback Period, and Profitability Index to compare projects.
• Time value of money is critical—discounting cash flows to present value ensures accurate comparisons.
• Risk and uncertainty in capital budgeting are addressed via sensitivity analysis, scenario analysis, and decision trees.
• Working capital management (short-term assets/liabilities) supports capital projects by ensuring liquidity.
• Real-world tie-ins: Daraz’s warehouse expansion (NPV), Pathao’s new vehicle fleet (IRR), and NEPSE-listed firms’ dividend policies (capital allocation).

1. Introduction to Capital Budgeting

Capital budgeting is the long-term financial decision-making process where firms allocate funds to projects with expected returns over 1+ years. Unlike working capital (short-term), capital budgeting focuses on fixed assets (e.g., land, buildings, equipment) that generate future cash flows.

Why it matters:

• Determines a firm’s growth trajectory (e.g., Ncell expanding 4G towers vs. upgrading existing ones).
• Affects shareholder wealth—poor choices can lead to bankruptcy (e.g., failed Daraz logistics hubs).

1.1 Types of Capital Expenditures (CapEx)

Capital projects fall into three broad categories:

1.2 The Capital Budgeting Process

A structured 5-step workflow ensures sound decisions:

flowchart TD
    A["1. Generate Project Ideas"] --> B["2. Estimate Cash Flows"]
    B --> C["3. Assess Risk & Uncertainty"]
    C --> D["4. Evaluate Using Techniques"]
    D --> E["5. Implement & Monitor"]

Key Step 2: Cash Flow Estimation

• Initial Investment: Cost of acquiring assets (e.g., Rs 50M for a Daraz warehouse).
• Operating Cash Flows: Annual inflows/outflows (e.g., Rs 10M/year from reduced shipping costs).
• Terminal Cash Flow: Sale/proceeds at project end (e.g., Rs 30M from selling old equipment).

2. Capital Budgeting Techniques

Firms use quantitative methods to compare projects. Below are the four most critical:

A. Net Present Value (NPV)

Definition: Discounts all cash flows to present value and compares to initial investment. Formula: $$NPV=\sum _{t=0}^n\frac{C{F}_t}{(1+r{)}^t}-\text{Initial Investment}$$ Where:

• $C{F}_t$ = Cash flow at time t
• $r$ = Discount rate (cost of capital)
• $n$ = Project lifespan

Example: Daraz’s New Warehouse Data:

• Initial cost: Rs 120M
• Annual savings: Rs 30M (Years 1–5)
• Discount rate: 15% (cost of debt + equity)

Decision Rule:

• NPV > 0: Accept (project adds value).
• NPV < 0: Reject (project destroys value).

Why NPV?

• Considers time value of money (Rs 100 today ≠ Rs 100 in 5 years).
• Aligns with shareholder wealth maximization.

B. Internal Rate of Return (IRR)

Definition: The discount rate that makes NPV = 0. It’s the effective annual return of the project.

Example: Ncell’s 5G Upgrade Data:

• Initial cost: Rs 800M
• Annual savings: Rs 200M (Years 1–4)
• IRR = 25% (calculated via Excel’s =IRR() function).

Comparison Table:

Limitations of IRR:

• Multiple IRRs: Possible with non-conventional cash flows (e.g., initial outflow, then inflow, then outflow).
• Scale Bias: Favors larger projects (e.g., Rs 1B project with 10% IRR vs. Rs 10M project with 20% IRR).

C. Payback Period

Definition: Time taken to recover initial investment from cash inflows.

Example: Kathmandu Bookstore’s Printer Upgrade Data:

• Cost: Rs 250,000
• Annual savings: Rs 80,000

Payback Period = 2.5 years (break-even in Year 3).

Advantages:

• Simple to understand.
• Focuses on liquidity risk (e.g., Ncell prefers quick payback for tower upgrades).

Disadvantages:

• Ignores cash flows after payback.
• Doesn’t account for time value of money.

D. Profitability Index (PI)

Definition: Benefit-Cost Ratio = PV of future cash flows / Initial investment.

Formula: $$PI=\frac{{\sum }_{t=0}^n\frac{C{F}_t}{(1+r{)}^t}}{\text{Initial Investment}}$$

Example: Shalimar Paints’ New Plant

• NPV = Rs 15M, Initial Investment = Rs 100M
• PI = 1.15 (Accept if PI > 1).

Comparison with NPV:

3. Risk and Uncertainty in Capital Budgeting

Real-world projects face uncertainty (e.g., Daraz’s supply chain delays, Ncell’s spectrum auction risks). Firms use:

A. Sensitivity Analysis

• Tests how NPV/IRR changes with key variables (e.g., sales volume, discount rate).
• Example: What if Daraz’s annual savings drop by 20%?

Conclusion: NPV is sensitive to sales—Daraz should hedge against demand risks.

B. Scenario Analysis

• Evaluates best-case, worst-case, and expected outcomes.
• Example: Pathao’s EV fleet under 3 scenarios:

C. Decision Trees

• Graphically represents sequential decisions under uncertainty.
• Example: NEPSE-listed firm deciding to expand into hydropower.

flowchart TD
    A["Expand?"] -->|"Yes"| B["Build Dam (Rs 5B)"]
    B --> C["High Demand: NPV = Rs 1B"]
    B --> D["Low Demand: NPV = -Rs 2B"]
    A -->|"No"| E["Retain Current Assets"]

4. Capital Budgeting and Working Capital

Capital projects require working capital to fund short-term operations (e.g., inventory, receivables). The Cash Conversion Cycle (CCC) affects working capital needs:

$$CCC=\text{Inventory Conversion Period}+\text{Receivables Collection Period}-\text{Payables Deferral Period}$$

Example: Kathmandu Retailer’s New Store

• CCC = 60 days (high inventory turnover).
• Working Capital Needed: Rs 15M (to cover 3 months of operations).

Impact of CCC on Capital Budgeting:

• Longer CCC → Higher working capital → Lower NPV (more cash tied up).
• Solution: Negotiate supplier credit (e.g., 60-day payables) to reduce CCC.

5. Real-World Applications in Nepal

In the Real World

1. Daraz’s Warehouse Expansion (NPV)

   • Idea Used: NPV analysis to justify Rs 120M investment in a new logistics hub.
   • How: Daraz discounted future savings (Rs 30M/year) at 15% to confirm NPV = Rs 20.57M > 0.
   • Result: Hub reduced delivery times by 40%, boosting customer retention.

2. Pathao’s Electric Vehicle Fleet (IRR)

   • Idea Used: IRR comparison between diesel and EV fleets.
   • How: Pathao calculated IRR = 25% for EVs (vs. 18% for diesel) after accounting for fuel subsidies and lower maintenance.
   • Result: 30% reduction in operational costs within 2 years.

3. NEPSE’s Dividend Policy (Capital Allocation)

   • Idea Used: Capital budgeting trade-offs between dividends and reinvestment.
   • How: Listed firms like Nepal Bank use NPV to decide whether to pay dividends (shareholder returns) or fund new projects (growth).
   • Example: Nepal Bank’s 2022 NPV analysis led to a 15% dividend payout while allocating Rs 500M to digital banking upgrades.

6. Financial Decision-Making Beyond Capital Budgeting

Capital budgeting is one part of a firm’s financial strategy. Other key decisions include:

A. Financing Decisions (Capital Structure)

• Debt vs. Equity: Firms like Ncell use NPV of debt (after tax) to decide leverage.
• Cost of Capital: Blend of debt (8%) and equity (15%) → WACC = 12% (used in NPV calculations).

B. Dividend Policy

• Retained Earnings vs. Dividends: NEPSE firms like Standard Chartered Nepal use dividend discount model to decide payouts.
• Formula: $$P_0=\frac{D_1}{r-g}$$ Where:
  • $P_0$ = Current stock price (Rs 360)
  • $D_1$ = Next dividend (Rs 24)
  • $r$ = Required return (12%)
  • $g$ = Growth rate (5%)

Exam Tip

1. Master NPV/IRR Calculations:

   • Always show work for discounting cash flows (use tables or Excel).
   • For IRR, mention limitations (multiple rates, scale bias) in discussions.

2. Link to Real Scenarios:

   • Use Nepali examples (Daraz, Pathao, Ncell) to explain concepts.
   • For working capital, relate CCC to inventory/receivables management.

3. Compare Techniques:

   • In exams, contrast NPV vs. IRR (e.g., "NPV considers time value; IRR doesn’t account for scale").
   • For payback period, highlight its liquidity focus vs. NPV’s value maximization.

4. Risk Analysis is Key:

   • Always include sensitivity/scenario analysis in answers.
   • Example: "If Daraz’s warehouse NPV drops by 30% due to supply chain risks, the project may not be viable."

5. Working Capital Integration:

   • Explain how CCC affects capital budgeting (e.g., "A longer CCC increases working capital needs, reducing NPV").

6. Numerical Problems:

   • Practice with real data: Use NPR amounts (e.g., Rs 50M project) and Nepali firms (e.g., Jagadamba Trading).
   • Show all steps: Initial investment → cash flows → discounting → NPV/IRR.

Final Visual Recap:

mindmap
  root((Capital Budgeting))
    - Techniques
      - NPV["Net Present Value: Discounts cash flows to PV"]
      - IRR["Internal Rate of Return: Rate where NPV=0"]
      - Payback["Time to recover initial investment"]
      - PI["Profitability Index: PV/Cost"]
    - Risk Tools
      - Sensitivity["How NPV changes with variables"]
      - Scenario["Best/worst/expected outcomes"]
      - DecisionTree["Graphical sequential decisions"]
    - Real-World
      - Daraz["NPV for warehouse expansion"]
      - Pathao["IRR for EV fleet"]
      - NEPSE["Dividend policy via capital allocation"]
    - Working Capital
      - CCC["Cash Conversion Cycle affects liquidity"]
      - Financing["Debt/equity trade-offs"]