Capital Budgeting & Cost of Capital: Techniques, Decisions & Real-World Use

TAKEAWAYS:

• Capital budgeting evaluates long-term projects using NPV, IRR, and PI—only accept projects where NPV > 0 and IRR > cost of capital.
• The weighted average cost of capital (WACC) blends debt, equity, and preferred stock costs to measure a company’s minimum required return.
• Cost of debt is always calculated after-tax because interest payments are tax-deductible (e.g., a 10% pre-tax debt becomes 7% after 30% tax).
• Optimal capital structure balances risk and return—too much debt increases financial risk, while too little equity limits growth.
• Real-world tie: Banks like NMB use IRR to decide whether to fund a new branch, while Daraz uses NPV to evaluate warehouse expansions.

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1. What is Capital Budgeting?

Capital budgeting is the process of planning, evaluating, and selecting long-term investment projects (e.g., buying machinery, expanding a factory, or launching a new product line). Unlike working capital (short-term funds), these decisions lock money for years—so mistakes are costly.

Why is it critical?

• High stakes: A wrong decision (e.g., investing in outdated tech) can bankrupt a company.
• Cash flow focus: Profit ≠ cash flow. A project may show profit but drain cash (e.g., a slow-selling product).
• Risk vs. return: Higher returns often mean higher risk (e.g., a new tech startup vs. a government bond).

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2. Key Capital Budgeting Techniques

Three methods dominate exams and real-world use:

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A visual side-by-side of NPV, IRR, and PI with pros/cons.

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3. Worked Example: Should Kathmandu’s Retail Shop Expand?

Scenario: Kathmandu Retail (a mid-sized shop in Thapathali) wants to invest NPR 5,000,000 in a new automated checkout system. The system will:

• Save NPR 1,200,000/year in labor costs (5 years).
• Require NPR 300,000/year for maintenance.
• Have a salvage value of NPR 500,000 after 5 years.
• The company’s WACC is 12%.

Step 1: Calculate Annual Cash Flows

Step 2: Compute NPV

Using the formula: $$\text{NPV}=\frac{900,000}{(1.12{)}^1}+\frac{900,000}{(1.12{)}^2}+\frac{900,000}{(1.12{)}^3}+\frac{900,000}{(1.12{)}^4}+\frac{1,200,000}{(1.12{)}^5}-5,000,000$$ $$\text{NPV}=802,680+714,932+636,610+567,562+675,560-5,000,000=\text{NPR 397,344}$$ Decision: Since NPV > 0, accept the project.

Step 3: Calculate IRR

Using a financial calculator or Excel (=IRR([-5M, 900K, 900K, 900K, 900K, 1.2M])): $$\text{IRR}=14.2\%>\text{WACC (12\%)}$$ Decision: Accept (IRR > WACC).

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4. Cost of Capital: The Hurdle Rate

The cost of capital is the minimum return a project must earn to justify using the company’s funds. It’s calculated as the WACC (Weighted Average Cost of Capital).

How to Calculate WACC

$$\text{WACC}=(E/V\times Re)+(D/V\times Rd\times (1-T))+(P/V\times Rp)$$ Where:

• $E$ = Market value of equity
• $D$ = Market value of debt
• $P$ = Market value of preferred stock
• $V=E+D+P$ (Total capital)
• $Re$ = Cost of equity (use CAPM: $Re=Rf+\beta (Rm-Rf)$)
• $Rd$ = Cost of debt (after-tax)
• $Rp$ = Cost of preferred stock
• $T$ = Tax rate

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A labeled diagram showing the WACC formula with arrows to each component (equity, debt, preferred stock).

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Why After-Tax Cost of Debt?

Example: Nepal Bank Ltd borrows at 10% pre-tax. With a 30% tax rate: $$\text{After-tax cost of debt}=10\%\times (1-0.30)=7\%$$ Why?

• Interest is a tax-deductible expense, reducing taxable income.
• Ignoring this overstates the true cost of debt.

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5. Capital Structure: The Debt-Equity Mix

A company’s capital structure is how it finances operations—debt vs. equity. The optimal structure balances:

• Cheaper debt (tax shield) vs. higher risk (bankruptcy if cash flows drop).
• Equity is expensive (dividends, shareholder expectations) but flexible.

Modigliani-Miller (MM) Theory

• Proposition I: In a perfect world, a company’s value does not depend on capital structure (only on its cash flows).
• Proposition II: The cost of equity rises with more debt (investors demand higher returns for risk).
• Reality: Taxes and bankruptcy costs make some debt optimal.

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Capital structure trade-off (Image: Suicup, CC BY-SA 3.0, via Wikimedia Commons) *A graph showing:

• Left (too little debt): Low tax benefits, high cost of equity → Low value.
• Middle (optimal): Balanced tax shield and risk → Highest value.
• Right (too much debt): High bankruptcy risk → Low value.*

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Real-World Example: NMB Bank’s Capital Structure

Decision: NMB uses 40% debt because:

• Debt is cheaper than equity.
• The tax shield offsets the higher cost of equity.

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6. In the Real World

1. eSewa’s Mobile Top-Up System (NPV & IRR)

• How it uses capital budgeting: eSewa evaluates whether to expand its QR-based payment network in rural areas.
• Example: To add 50 new villages, eSewa needs NPR 20M. The project generates NPR 5M/year in transaction fees for 4 years.
• NPV Calculation (WACC = 15%): $$\text{NPV}=\frac{5M}{1.15}+\frac{5M}{(1.15{)}^2}+\frac{5M}{(1.15{)}^3}+\frac{5M}{(1.15{)}^4}-20M=\text{NPR 1.8M}$$ Result: Accept (NPV > 0). eSewa expanded to 1,200+ villages using this logic.

2. Daraz’s Warehouse Expansion (PI Ranking)

• How it uses capital budgeting: Daraz ranks warehouse projects by Profitability Index (PI) when capital is limited.
• Example: Two projects:
  • Project A: NPR 10M investment, PV of CFs = NPR 12M → PI = 1.2
  • Project B: NPR 5M investment, PV of CFs = NPR 5.5M → PI = 1.1
• Decision: Daraz picks Project A (higher PI) even though it costs more, because it generates more value per rupee.

3. Ncell’s 5G Rollout (IRR vs. WACC)

• How it uses capital budgeting: Ncell compares the IRR of 5G infrastructure to its WACC (14%).
• Example: 5G project costs NPR 8B and has an IRR of 16%.
• Decision: Accept (16% > 14%). Ncell’s 5G expansion was approved based on this.

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7. Common Mistakes in Capital Budgeting

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8. Exam Tip: How to Score Full Marks

1. Always show calculations:

   • For NPV/IRR, write the formula and plug in numbers.
   • For WACC, label each component (debt, equity, tax rate).

2. Compare methods:

   • If NPV and IRR give different decisions, explain why (e.g., multiple IRRs or mutually exclusive projects).

3. Real-world tie-ins:

   • Link answers to Nepali companies (e.g., "Like NMB Bank, a company should use after-tax cost of debt...").

4. Watch for traps:

   • Question: "Why is cost of debt after-tax?" Answer: "Because interest is tax-deductible, reducing the net cost to the firm."
   • Question: "Which method is best?" Answer: "NPV is theoretically superior, but IRR is simpler for standalone projects."

5. Diagrams save marks:

   • Draw a T-account for cost of capital components.
   • Use a mermaid flowchart for the capital budgeting process (see below).

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9. Quick Revision Table

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10. Final Worked Example: Shalimar Paints (Exam-Style)

Given:

• Capital Structure: Debt (30%), Preferred Stock (15%), Equity (55%).
• Tax Rate: 30%.
• Costs:
  • Debt: 10% (pre-tax).
  • Preferred Stock: 9% dividend.
  • Equity: $Re=12\%$ (from CAPM).
• Market Values: $D=30\%$, $P=15\%$, $E=55\%$.

Calculate WACC:

1. After-tax cost of debt: $$Rd=10\%\times (1-0.30)=7\%$$
2. WACC: $$\text{WACC}=(0.55\times 12\%)+(0.30\times 7\%)+(0.15\times 9\%)=10.15\%$$ Decision: Shalimar Paints should only accept projects with IRR > 10.15%.

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*A pie chart showing:

• Equity (55% at 12%)
• Debt (30% at 7% after-tax)
• Preferred Stock (15% at 9%) with a label "WACC = 10.15%".*