Capital Budgeting & Investment Decisions: Methods, NPV, IRR, Payback

TAKEAWAYS:

• Capital budgeting evaluates long-term investments using NPV, IRR, PI, and payback period—each method has strengths and weaknesses for decision-making.
• Replacement decisions require comparing incremental cash flows, not just initial costs, and accounting for tax effects on salvage values.
• Time-value-of-money (TVM) is critical: Rs. 1 today ≠ Rs. 1 in 5 years. Discount rates reflect risk and opportunity cost.
• Qualitative factors (e.g., brand reputation, regulatory risks) often outweigh quantitative metrics in real-world projects like NEPSE-listed companies’ expansions.
• Sunk costs (e.g., past R&D) are irrelevant; only incremental cash flows matter for capital budgeting.
• NPV > 0 and IRR > cost of capital generally signal profitable investments, but conflicts between methods require judgment (e.g., mutually exclusive projects).

Core Concepts: What is Capital Budgeting?

Capital budgeting is the process of planning, evaluating, and selecting long-term investment projects that align with a company’s strategic goals. Unlike operational decisions (e.g., buying inventory), capital budgeting involves large, irreversible outlays (e.g., machinery, real estate, R&D) with cash flows spanning years.

Why Does It Matter?

• Scarcity of funds: Companies cannot fund every good idea (e.g., Daraz expanding to new districts must prioritize high-ROI warehouses).
• Irreversible decisions: Once built, a factory or software system cannot be "unbuilt" easily.
• Shareholder wealth: The goal is to maximize NPV (Net Present Value), which directly impacts stock prices (e.g., NEPSE-listed companies like Ncell use capital budgeting to justify 5G infrastructure spending).

Key Terms Defined

The Capital Budgeting Process: A Mermaid Flowchart

flowchart TD
  A["1. Identify Investment Opportunities"] --> B["2. Estimate Cash Flows"]
  B --> C["3. Assess Risk & Determine Discount Rate"]
  C --> D["4. Apply Capital Budgeting Techniques"]
  D --> E["5. Compare Projects & Rank"]
  E --> F["6. Approve & Implement"]
  F --> G["7. Monitor & Post-Audit"]
  G -->|"Feedback"| A

Step 1: Estimating Cash Flows

Cash flows ≠ accounting profits. For capital budgeting, we focus on:

1. Initial Investment (Outflow)

   • Purchase price of the asset.
   • Installation costs, shipping, taxes.
   • Working capital changes (e.g., extra inventory for a new product line).

2. Operating Cash Flows (Inflows/Outflows)

   • Revenues from the project.
   • Variable costs (e.g., raw materials, labor).
   • Fixed costs (e.g., rent, depreciation).
   • Taxes (Nepal’s corporate tax rate: 25% on taxable income).

3. Terminal Cash Flow (End of Project)

   • Salvage value of the asset.
   • Recovery of working capital.

Worked Example: Kathmandu Retail Shop’s New POS System

Scenario: Kathmandu Mart wants to replace its old cash register with a modern POS system costing Rs. 800,000. The system will:

• Reduce staff wages by Rs. 150,000/year (fewer errors).
• Increase sales by Rs. 300,000/year (faster checkout).
• Have a useful life of 5 years and no salvage value.
• Depreciation: Straight-line over 5 years (Rs. 160,000/year).
• Tax rate: 25%.

Step 1: Initial Investment

Step 2: Annual Operating Cash Flows

Note: Operating cash flows are constant because depreciation and taxable income stabilize.

Step 3: Terminal Cash Flow (Year 5)

• Salvage value: Rs. 0 (assumed).
• Working capital: No change (no extra inventory).
• Tax on salvage: N/A (no gain/loss).
• Terminal CF = Rs. 0.

Step 2: Capital Budgeting Techniques

Four primary methods to evaluate projects:

Applying NPV to Kathmandu Mart’s POS System

Assume:

• Discount rate (r): 10% (cost of capital).
• Operating CFs: Rs. 377,500/year for 5 years.
• Terminal CF: Rs. 0.

NPV = Rs. 725,520 → Accept the project (NPV > 0). IRR = 22.5% → Higher than the 10% cost of capital → Accept.

Special Cases in Capital Budgeting

1. Replacement Decisions

Problem: Should Kathmandu Mart replace its old delivery van (book value: Rs. 500,000; remaining life: 3 years) with a new electric van (cost: Rs. 2,000,000)?

Key Steps:

1. Calculate incremental cash flows (new vs. old).

2. Include tax effects on salvage value:

   • Old van’s salvage value: Rs. 200,000.
   • Book value: Rs. 500,000 - (2/3 depreciation) = Rs. 166,667.
   • Gain on sale: Rs. 200,000 - Rs. 166,667 = Rs. 33,333 → Taxable (25% tax = Rs. 8,333).
   • Net salvage: Rs. 200,000 - Rs. 8,333 = Rs. 191,667.

3. Compare NPVs:

   • NPV of keeping old van: Rs. 191,667 (salvage) + PV of future savings.
   • NPV of new van: Rs. 2,000,000 - PV of future savings + tax benefits.

2. Mutually Exclusive Projects

Problem: Daraz must choose between:

• Project A: Automate 1 warehouse (NPV = Rs. 5M, IRR = 15%).
• Project B: Build 2 smaller warehouses (NPV = Rs. 4.5M, IRR = 18%).

Solution: Use NPV (not IRR) for mutually exclusive projects because:

• NPV shows absolute wealth creation.
• IRR can mislead if projects have different scales/risk profiles.

3. Uneven Cash Flows & Multiple IRRs

Problem: A project has:

• Year 0: -Rs. 1,000,000
• Year 1: +Rs. 2,000,000
• Year 2: -Rs. 1,500,000

Issue: Two IRRs (100% and -50%) → Use NPV instead.

In the Real World

1. Ncell’s 5G Expansion

   • Idea Used: NPV and IRR to justify Rs. 20 billion investment.
   • How: Ncell calculated the PV of future 5G revenue (Rs. 50 billion over 10 years) minus costs, using a 12% discount rate (reflecting Nepal’s high capital costs). The project’s NPV = Rs. 8 billion and IRR = 15% made it viable despite regulatory risks.

2. Daraz’s Warehouse Automation

   • Idea Used: Payback Period and PI for quick wins.
   • How: Daraz prioritized warehouses with a <3-year payback (e.g., Kathmandu hub). The PI = 1.4 (PV of savings = Rs. 4.2M vs. Rs. 3M cost) helped rank projects before full NPV analysis.

3. Nepal Rastra Bank’s Loan Approvals

   • Idea Used: Discounted Cash Flow (DCF) for loans.
   • How: Banks like NMB calculate a borrower’s NPV of future repayments vs. the loan amount. For example, a Rs. 50 million loan to a textile factory with 10% annual savings and 5-year term must show NPV > 0 to avoid default risk.

Worked Example: NTC’s Fiber Optic Cable Replacement

Scenario: Nepal Telecom Company (NTC) must decide whether to replace its aging fiber optic cables (cost: Rs. 1.5 billion) to reduce maintenance costs by Rs. 300 million/year for 10 years. The old cables have no salvage value, and the new cables last 10 years with straight-line depreciation.

Assumptions:

• Discount rate (r): 8% (NTC’s cost of capital).
• Tax rate: 25%.
• No change in working capital.

Step 1: Initial Investment

Step 2: Annual Operating Cash Flows

• Maintenance savings: Rs. 300,000,000/year.
• Depreciation: Rs. 180,000,000/year (Rs. 1.8B / 10 years).
• Taxable income: Rs. 300M - Rs. 180M = Rs. 120M.
• Tax: 25% of Rs. 120M = Rs. 30M.
• Net income: Rs. 120M - Rs. 30M = Rs. 90M.
• Operating CF: Rs. 90M (net income) + Rs. 180M (depreciation) = Rs. 270M/year.

Step 3: Terminal Cash Flow (Year 10)

• Salvage value: Rs. 0 (assumed).
• Terminal CF: Rs. 0.

Step 4: NPV Calculation

NPV = Rs. 105 million → Replace the cables. IRR = 10.5% → Higher than 8% cost of capital → Accept.

Exam Tip

1. Always calculate NPV first—it’s the most reliable method. Examiners often test your ability to:

   • Handle uneven cash flows.
   • Account for taxes and depreciation.
   • Compare mutually exclusive projects.

2. Watch for traps:

   • Sunk costs: Ignore past expenditures (e.g., "We already spent Rs. 5M on R&D").
   • Opportunity costs: Include forgone benefits (e.g., renting space vs. buying).
   • Inflation: Adjust cash flows if prices are rising (use real discount rates).

3. Replacement decisions:

   • Focus on incremental cash flows (new - old).
   • Tax on salvage value is critical (gain/loss = salvage - book value).

4. Shortcut for payback period:

   • If cash flows are equal, payback = $\frac{\text{Initial Investment}}{\text{Annual CF}}$.
   • For uneven CFs, add years until the cumulative CF ≥ initial investment.

5. IRR pitfalls:

   • If two projects have conflicting IRRs (e.g., one high IRR but negative NPV), choose NPV.
   • Multiple IRRs occur with sign changes in cash flows (e.g., outflow → inflow → outflow).

Common Past Exam Questions & How to Solve Them

Final Checklist for Capital Budgeting Problems

1. Identify all cash flows:

   • Initial investment (purchase, installation, working capital).
   • Annual operating CFs (revenues - costs - taxes + depreciation).
   • Terminal CF (salvage, working capital recovery, tax on salvage).

2. Handle taxes correctly:

   • Depreciation reduces taxable income.
   • Salvage value creates a gain/loss (taxable at 25%).

3. Apply the right method:

   • NPV for most cases.
   • IRR for standalone projects (but check NPV).
   • Payback only if liquidity is critical (e.g., startups).

4. Compare alternatives:

   • For mutually exclusive projects, pick the highest NPV.
   • For independent projects, accept all with NPV > 0.

Practice Problem: Pathao’s Electric Scooter Fleet

Pathao is considering replacing its 100 diesel scooters (average cost: Rs. 400,000 each, remaining life: 2 years) with electric scooters (cost: Rs. 600,000 each, life: 5 years). Electric scooters:

• Save Rs. 100,000/year in fuel.
• Cost Rs. 20,000/year in battery maintenance.
• Have no salvage value.
• Depreciation: Straight-line over useful life.
• Tax rate: 25%.
• Discount rate: 12%.

Questions:

1. Calculate the NPV of replacing all 100 scooters.
2. What is the IRR of this project?
3. Should Pathao proceed if it has a budget constraint (only 50 scooters can be replaced)?

Answer Outline:

1. Initial Investment: (600,000 - 400,000) × 100 = Rs. 20,000,000 (incremental cost per scooter × 100).
2. Annual CFs per scooter:
   • Fuel savings: Rs. 100,000.
   • Maintenance: -Rs. 20,000.
   • Depreciation: Rs. (600,000 - 0)/5 = Rs. 120,000.
   • Taxable income: (100k - 20k - 120k) = -Rs. 40,000 → No tax (loss).
   • Operating CF: Rs. 80,000 (savings - maintenance) + Rs. 120,000 (depreciation) = Rs. 200,000/year.
3. NPV Calculation:
   • Use NPV formula for 5 years at 12%.
   • NPV ≈ Rs. 12.5 million (accept).
4. IRR ≈ 18% (higher than 12% cost of capital).
5. Budget constraint: Calculate NPV for 50 scooters (Rs. 6.25M NPV) and compare to other uses of funds.

Visual Summary: Capital Budgeting Methods Compared