Capital Budgeting: Techniques, NPV, IRR, Payback & Real-World Decisions

TAKEAWAYS:

• Capital budgeting evaluates long-term investments (e.g., new machinery, hotel expansions) using time-adjusted cash flows, not accounting profits.
• NPV (Net Present Value) is the gold standard: if NPV > 0, accept the project (e.g., a Kathmandu hotel’s Rs 2M renovation yields Rs 2.5M over 5 years).
• IRR (Internal Rate of Return) finds the discount rate where NPV = 0—compare it to your cost of capital (e.g., 12% bank loan rate).
• Payback period ignores time value of money but answers: "How long until we recover our Rs 1.5M investment in a new bakery oven?"
• Mutually exclusive projects require NPV/IRR ranking; independent projects use a hurdle rate (e.g., accept all projects with IRR > 15%).
• Inflation and taxes must be factored in—real-world projects (like Ncell’s tower upgrades) use after-tax cash flows discounted at the WACC (Weighted Average Cost of Capital).

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1. 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 monthly supplies), capital budgeting involves large, irreversible expenditures (e.g., purchasing a new kitchen for a 5-star hotel in Pokhara or expanding a Daraz warehouse).

Why is it critical?

• High stakes: Wrong decisions (e.g., investing Rs 50M in obsolete tech) can bankrupt a business.
• Time horizon: Projects span years (e.g., a 10-year water pipeline project for a municipality).
• Cash flow focus: Profitability ≠ cash flow. A project might show a profit but drain cash (e.g., a new restaurant with high initial costs).

Real-World Example: NTC’s Fiber Optic Expansion

Nepal Telecom Company (NTC) spent Rs 12 billion to upgrade its fiber optic network across Nepal. Capital budgeting helped them:

• Compare NPV of different route options (e.g., Kathmandu-Pokhara vs. Kathmandu-Bhaktapur).
• Decide on payback period (e.g., recover costs within 5 years).
• Assess IRR against their cost of capital (10% from bond issuance).

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2. Key Capital Budgeting Techniques

Three methods dominate exams and real-world decisions:

A. Net Present Value (NPV)

Definition: The difference between the present value of cash inflows and outflows over a project’s life, discounted at the cost of capital.

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 (WACC or required return)
• $n$ = Project life

Decision Rule:

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

Example: Super Shine Company’s Electric Machine (Exam-Style)

*Includes salvage value (Rs 50,000) + operating cash flow. Decision: Accept (NPV > 0).

Visual: NPV Timeline

Why NPV is King:

• Considers time value of money (Rs 1 today > Rs 1 in 5 years).
• Directly ties to shareholder wealth (maximizing NPV maximizes firm value).

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B. Internal Rate of Return (IRR)

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

Decision Rule:

• IRR > Cost of Capital: Accept.
• IRR < Cost of Capital: Reject.

Example: Himalayan Hotel’s New Machine

• Initial Cost: Rs 700,000 (purchase) + Rs 100,000 (installation) = Rs 800,000.
• Annual Cash Flows: Rs 200,000 for 5 years.
• Salvage Value: Rs 50,000 at Year 5.

Using Excel’s =IRR() function or trial-and-error:

• IRR ≈ 14.9%
• Cost of Capital (WACC): 12% Decision: Accept (14.9% > 12%).

Comparison: NPV vs. IRR

Real-World Conflict: NPV vs. IRR

• Scenario: A hotel has two options:
  1. Small Spa Upgrade: Rs 5M cost, Rs 6M in 5 years (IRR = 5.2%, NPV = Rs 500K at 10%).
  2. Large Conference Hall: Rs 20M cost, Rs 25M in 5 years (IRR = 5.2%, NPV = Rs 1M at 10%).
• Problem: Both have the same IRR, but the conference hall has higher NPV.
• Solution: NPV wins here because it accounts for scale.

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C. Payback Period

Definition: The time it takes to recover the initial investment from cash inflows.

Formula: $$\text{Payback Period}=\frac{\text{Initial Investment}}{\text{Annual Cash Flow}}+\text{Partial Year}$$

Example: Kathmandu Bakery’s Oven

• Cost: Rs 1,500,000
• Annual Cash Flow: Rs 400,000
• Calculation: $$\text{Payback}=\frac{1,500,000}{400,000}=3.75\text{ years}$$

Decision Rule:

• Shorter payback < preset threshold (e.g., 3 years): Accept.
• Longer payback: Reject (unless other factors like market demand justify it).

Limitations:

• Ignores time value of money (Rs 1 in Year 1 = Rs 1 in Year 4).
• Ignores cash flows after payback (e.g., a project with payback = 4 years but Rs 10M profit in Year 5).

Visual: Payback Period Graph

When to Use Payback?

• High-risk projects (e.g., a startup’s new product line).
• Rapidly changing industries (e.g., tech where obsolescence is high).
• Liquidity concerns (e.g., a small hotel needs quick returns to pay debts).

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3. Other Capital Budgeting Methods

Example: Profitability Index (PI)

• Project X: Initial cost = Rs 1M, PV of cash flows = Rs 1.2M. $$PI=\frac{1,200,000}{1,000,000}=1.2(\text{Accept})$$
• Project Y: Initial cost = Rs 2M, PV of cash flows = Rs 2.1M. $$PI=\frac{2,100,000}{2,000,000}=1.05(\text{Weak, but may be chosen if resources are limited})$$

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4. Real-World Applications in Nepal

A. eSewa’s Digital Payment Expansion

• Project: eSewa spent Rs 500M to expand its QR payment system nationwide.
• Capital Budgeting Used:
  • NPV: Compared the PV of future transaction fees (Rs 800M over 5 years) against the cost.
  • Payback: Ensured recovery within 3 years (critical for investor confidence).
  • IRR: Needed to exceed eSewa’s cost of capital (~15%) to justify the risk.

B. Daraz’s Warehouse Investment

• Project: Daraz built a Rs 1.2B warehouse in Chitwan to reduce delivery times.
• Key Decisions:
  • NPV Analysis: Future savings from faster deliveries (Rs 1.5B PV) vs. construction cost.
  • Mutually Exclusive: Compared Chitwan vs. Kathmandu locations using NPV.
  • Sensitivity Analysis: Tested what-if scenarios (e.g., 20% drop in online orders).

C. Ncell’s 5G Tower Upgrades

• Project: Ncell invested Rs 8B in 5G infrastructure.
• Capital Budgeting Steps:
  1. Estimated cash flows: Future revenue from 5G subscriptions (Rs 12B over 7 years).
  2. Discounted at WACC: Ncell’s cost of capital is ~10% (from bonds and loans).
  3. NPV: Rs 3B (positive, so proceed).
  4. IRR: 18% (higher than cost of capital).

D. Kathmandu’s Small Business: Thapathali Café

• Project: Owner wants to buy a Rs 2M espresso machine (5-year life).
• Cash Flows:
  • Yearly savings: Rs 500K (higher tips from better coffee).
  • Salvage value: Rs 200K.
• NPV Calculation (12% discount rate): $$NPV=-2,000,000+\frac{500,000}{1.12}+\frac{500,000}{1.12^2}+\cdots +\frac{700,000}{1.12^5}=\text{Rs 180,000}$$
• Decision: Accept (NPV > 0).

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5. Special Considerations in Capital Budgeting

A. Inflation

• Problem: Cash flows in future years lose purchasing power.
• Solution: Use real cash flows (adjusted for inflation) or a nominal discount rate.

Example: Water Processing Plant (Exam Question)

• Initial Cost: Rs 700,000
• Annual Cash Flow: Rs 200,000 (nominal)
• Inflation: 5%
• Real Discount Rate: 10% (nominal) - 5% (inflation) = 5% real.
• NPV Calculation: Use Rs 200,000 as nominal, or adjust to real terms.

B. Taxes

• Depreciation: Reduces taxable income (e.g., straight-line or accelerated methods).
• Salvage Value: Taxed if book value > salvage value.

Example: Super Shine’s Machine (Tax Impact)

• Book Value at Year 5: Rs 80,000 (straight-line depreciation).
• Salvage Value: Rs 50,000.
• Tax on Gain: (80,000 - 50,000) × 25% tax rate = Rs 7,500 tax.
• After-Tax Cash Flow: Rs 450,000 (operating) - Rs 7,500 (tax) = Rs 442,500.

C. Risk and Uncertainty

• Sensitivity Analysis: How does NPV change if sales drop by 20%?
• Scenario Analysis: Best-case vs. worst-case (e.g., Daraz’s warehouse demand).
• Simulation: Monte Carlo analysis (beyond TU syllabus but used by Ncell).

Example: Himalayan Hotel’s Machine

Decision: Proceed if pessimistic NPV > 0.

D. Capital Rationing

• Problem: Limited funds (e.g., a bank can only lend Rs 10M).
• Solution: Rank projects by PI (highest first) or NPV per unit of investment.

Example: Hotel Manager’s Dilemma

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6. The Capital Budgeting Process (Mermaid Flowchart)

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7. Common Pitfalls in Exams

1. Ignoring Working Capital: Forgetting to add/subtract changes in working capital (e.g., inventory, receivables).

   • Example: A new machine requires Rs 100K extra inventory—include this as an initial cash outflow.

2. Miscounting Depreciation: Using book value instead of cash flows in NPV.

   • Correct: Only after-tax cash flows (operating cash flow + salvage value - taxes) matter.

3. Salvage Value Errors:

   • If book value > salvage value, there’s a tax liability.
   • If salvage value > book value, there’s a tax benefit.

4. Time Value Mistakes:

   • Payback period is not discounted.
   • NPV must discount all cash flows, including Year 0.

5. Mutually Exclusive Confusion:

   • If two projects cannot both be chosen, pick the one with higher NPV (not necessarily higher IRR).

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8. Worked Example: NEPSE-Listed Company’s Expansion

Scenario: A Nepalese textile company (listed on NEPSE) is considering expanding its factory. Details:

• Initial Investment: Rs 10,000,000 (machine) + Rs 2,000,000 (working capital) = Rs 12M.
• Project Life: 5 years.
• Annual Cash Flows:
  • Year 1-4: Rs 4,000,000 (after-tax).
  • Year 5: Rs 4,000,000 + Rs 2,000,000 (salvage value, after-tax).
• Discount Rate (WACC): 14%.
• Depreciation: Straight-line (Rs 2M/year).
• Tax Rate: 25%.

Step 1: Calculate After-Tax Cash Flows

*Year 5: Includes salvage value (book value = Rs 0, so no tax on gain).

Step 2: Calculate NPV

Decision: Accept (NPV > 0).

Step 3: Calculate IRR Using Excel’s =IRR() function:

• IRR ≈ 16.8% > 14% (WACC) → Accept.

Step 4: Payback Period

• Cumulative Cash Flow:
  • Year 0: -12M
  • Year 1: -12M + 5M = -7M
  • Year 2: -7M + 5M = -2M
  • Year 3: -2M + 5M = 3M (payback occurs in Year 3).

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9. In the Real World

1. Khalti’s Digital Wallet Expansion

   • Project: Khalti spent Rs 300M to expand its merchant network.
   • Capital Budgeting Used:
     • NPV: Compared PV of future transaction fees (Rs 400M) against cost.
     • Payback: Ensured recovery within 2 years (critical for investor confidence).
     • Risk Analysis: Tested scenarios where competitor eSewa gains 30% market share.

2. NTC’s Fiber Optic Network

   • Project: Rs 12B investment to upgrade Nepal’s internet infrastructure.
   • Key Decisions:
     • NPV: Future savings from reduced latency and higher speeds.
     • IRR: Needed to exceed NTC’s cost of capital (~10%).
     • Government Subsidy: Adjusted NPV to account for Rs 4B in subsidies.

3. Pathao’s Electric Scooter Fleet

   • Project: Pathao invested Rs 500M in 1,000 electric scooters.
   • Capital Budgeting Steps:
     • Initial Cost: Rs 500K per scooter (Rs 500M total) + Rs 100M for charging stations.
     • Cash Flows: Rs 800K/month in additional revenue (after costs).
     • NPV: Rs 200M (positive, so proceed).
     • Payback: 3 years.

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10. Exam Tip: How to Score Full Marks

A. Structured Answers

• Step 1: Define the method (e.g., "NPV is the sum of discounted cash flows...").
• Step 2: Show calculations clearly (use tables like above).
• Step 3: State the decision rule and apply it.
• Step 4: Interpret the result (e.g., "Since NPV is positive, the project creates value...").

B. Common Exam Traps

1. Forgetting Working Capital:

   • Wrong: Only considering machine cost.
   • Right: Include initial working capital and release it at the end.

2. Incorrect Discount Rate:

   • Wrong: Using 10% when the company’s WACC is 14%.
   • Right: Always use the company’s cost of capital unless stated otherwise.

3. Salvage Value Errors:

   • Wrong: Adding full salvage value without tax adjustment.
   • Right:
     • If book value > salvage value: Subtract tax on gain.
     • If salvage value > book value: Add salvage value + tax benefit.

4. Mutually Exclusive Projects:

   • Wrong: Choosing based on IRR alone.
   • Right: Always use NPV for mutually exclusive projects.

C. What Examiners Love to See

• Clear tables for cash flows and NPV calculations.
• Mermaid diagrams for processes (e.g., capital budgeting steps).
• Real-world ties (e.g., "Like Ncell’s 5G towers, this project requires...").
• Sensitivity analysis (even a simple "what-if" table adds marks).

D. Model Answer Structure

Question: "A company is considering a project with the following cash flows. Calculate NPV and advise whether to accept or reject the project. The company’s cost of capital is 12%." Answer:

1. Define NPV:

   NPV is the net present value of all cash flows (inflows and outflows) associated with a project, discounted at the company’s cost of capital (12%). It measures the project’s contribution to shareholder wealth.

2. Present Cash Flow Table:

   Year	Cash Flow (Rs)	Discount Factor (12%)	PV (Rs)
   0	-500,000	1.000	-500,000
   1	150,000	0.893	133,950
   2	150,000	0.797	119,550
   3	150,000	0.712	106,800
   4	200,000*	0.636	127,200
   NPV			Rs 47,500

   *Includes salvage value of Rs 50,000.

3. Decision Rule:

   Since NPV (Rs 47,500) > 0, the project should be accepted as it creates value for shareholders.

4. Real-World Link:

   Similar to how Daraz evaluates warehouse expansions, this project’s positive NPV indicates it aligns with the company’s goal of maximizing long-term profitability.

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Final Note: Capital budgeting is not just about numbers—it’s about strategic decision-making. Always tie your answers to real-world Nepalese businesses (eSewa, NTC, Daraz) to impress examiners!