Capital budgeting

Habari ya leo, future CFO! Welcome to Financial Management.

Today, we're diving into one of the most powerful topics in finance: Capital Budgeting. This isn't just about crunching numbers; it's about making multi-million (and even billion) shilling decisions that will shape the future of a company. Think of yourself as the pilot of a company's financial jet. Capital budgeting is how you choose your destination – do you invest in a new route to Dubai, or do you upgrade your entire fleet? These are the big questions!

Let's get started and learn how to make these game-changing decisions with confidence.

So, What Exactly is Capital Budgeting?

Imagine your family's shamba. You have a choice: you can plant sukuma wiki, which will be ready to harvest and sell in a few weeks (a short-term decision), or you can plant a whole orchard of avocado trees. The avocado trees will require a huge initial investment (buying seedlings, preparing the land, irrigation) and won't give you any fruit for a few years. But once they start producing, they could bring in a massive income for decades to come.

Capital budgeting is the process a business uses to decide which of these "avocado tree" projects to invest in. It involves planning and managing a company's long-term investments or projects that will provide returns for many years.

• It deals with large expenditures (e.g., buying new machinery, building a factory, launching a new product line).
• The decisions are often irreversible. Once Kenya Power builds a new geothermal plant at Olkaria, they can't just pack it up and return it!
• These decisions define a company's future success or failure.

Kenyan Context: Think about Safaricom's decision to invest billions in launching M-Pesa. That was a classic capital budgeting decision. They had to forecast the costs, estimate the potential future profits over many years, and decide if the risk was worth the reward. Look how that turned out!

The Capital Budgeting Process: A Step-by-Step Journey

Making these big decisions isn't a random guess. It's a structured process. Here’s a simple map of the journey:

   +---------------------------------+
   | 1. Identify Investment Ideas    |
   | (e.g., New factory in Kisumu)   |
   +---------------------------------+
                  |
                  V
   +---------------------------------+
   | 2. Evaluate Each Proposal       |
   | (Let's do the math!)            |
   +---------------------------------+
                  |
                  V
   +---------------------------------+
   | 3. Select the Best Project      |
   | (Choose the most profitable)    |
   +---------------------------------+
                  |
                  V
   +---------------------------------+
   | 4. Implement & Fund the Project |
   | (Get the money, start building) |
   +---------------------------------+
                  |
                  V
   +---------------------------------+
   | 5. Review Performance (Post-Audit)|
   | (Did we make the money we hoped?) |
   +---------------------------------+

Our focus today will be on Step 2: Evaluating the Proposals. This is where we use financial tools to separate the winning projects from the ones that will lose money.

> **Image Suggestion:** [An illustration of a diverse team of Kenyan professionals around a boardroom table. On the table are blueprints for a new building and financial charts. The background shows the Nairobi skyline, symbolizing growth and ambition. The style is modern and optimistic.]

Our Toolkit: Capital Budgeting Techniques

To evaluate a project, we need some tools. We'll look at the three most common ones. To make it easy, we'll use one consistent example throughout.

Example Scenario: "Boda-Boda Express Ltd."
Your friend's logistics company, "Boda-Boda Express Ltd.", is considering buying a new, advanced electric delivery bike.

• Initial Cost (Investment): KES 250,000
• Expected Life of the Bike: 5 years
• Expected Cash Inflows (Profits after tax, but before depreciation):
  • Year 1: KES 70,000
  • Year 2: KES 80,000
  • Year 3: KES 90,000
  • Year 4: KES 70,000
  • Year 5: KES 60,000
• Required Rate of Return (Cost of Capital): 10% (This is the minimum return the company wants to make on its investments).

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Technique 1: The Payback Period (PBP)

This is the simplest method. It answers one question: "How long will it take to get our initial investment back?" It's all about speed.

Let's calculate the PBP for Boda-Boda Express Ltd.

Step 1: Track the cumulative cash flow year by year.

Initial Investment: -KES 250,000

Year 1:  -250,000 + 70,000  = -180,000 (Still haven't recovered)
Year 2:  -180,000 + 80,000  = -100,000 (Still haven't recovered)
Year 3:  -100,000 + 90,000  =  -10,000 (Almost there!)
Year 4:   -10,000 + 70,000  =  +60,000 (Sometime in Year 4 we made our money back)

Step 2: Calculate the exact point in Year 4.

We needed KES 10,000 to break even at the start of Year 4.
The cash flow for all of Year 4 is KES 70,000.

Fraction of the year needed = (Amount still needed) / (Cash flow for that year)
                           = 10,000 / 70,000
                           = 0.14 years

Step 3: State the final Payback Period.

The PBP is 3 years + 0.14 years = 3.14 years.

• Pros: Simple to understand and calculate. Good for measuring risk (faster payback = less risk).
• Cons: It completely ignores the time value of money (a shilling today is worth more than a shilling tomorrow!) and any profits made after the payback period. What if the bike exploded in Year 4? PBP wouldn't care!

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Technique 2: Net Present Value (NPV) - The KING of Techniques!

NPV is the gold standard because it solves the problems of the Payback Period. It understands that money received in the future is worth less than money in your hand today. It does this by "discounting" future cash flows back to their present value.

The core idea is: What is the total value of all future cash flows in today's money, minus the initial cost?

The formula looks scarier than it is:

    NPV = [ CF1 / (1+r)^1 ] + [ CF2 / (1+r)^2 ] + ... + [ CFn / (1+r)^n ] - Initial Investment

    Where:
    CF = Cash Flow for the year
    r  = Required rate of return (our discount rate, 10% or 0.10)
    n  = The year number

Let's calculate the NPV for our Boda-Boda Express project.

> **Image Suggestion:** [A simple, clear infographic showing a KES 1,000 note today. An arrow points to the future, where the same note is physically smaller and labeled "KES 909 in one year" and even smaller labeled "KES 826 in two years", visually demonstrating the concept of discounting and time value of money.]

Let's discount each cash flow back to its Present Value (PV) using r = 10% (0.10).

Year 1: 70,000 / (1 + 0.10)^1 = 70,000 / 1.10  = KES 63,636
Year 2: 80,000 / (1 + 0.10)^2 = 80,000 / 1.21  = KES 66,116
Year 3: 90,000 / (1 + 0.10)^3 = 90,000 / 1.331 = KES 67,618
Year 4: 70,000 / (1 + 0.10)^4 = 70,000 / 1.464 = KES 47,814
Year 5: 60,000 / (1 + 0.10)^5 = 60,000 / 1.611 = KES 37,244
-----------------------------------------------------------------
Total Present Value of all Cash Inflows      = KES 282,428
-----------------------------------------------------------------

Now, calculate NPV:
NPV = Total PV of Inflows - Initial Investment
NPV = 282,428 - 250,000
NPV = KES 32,428

The Decision Rule for NPV is simple:

• If NPV is positive (> 0), ACCEPT the project. It means the project is expected to earn more than our required rate of 10% and will add value to the company.
• If NPV is negative (< 0), REJECT the project. It will destroy value.

Since our NPV is +KES 32,428, we should accept the project! It adds KES 32,428 of value to Boda-Boda Express Ltd. in today's money.

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Technique 3: Internal Rate of Return (IRR)

The IRR answers a slightly different question: "What is the exact percentage return this project is giving us?"

Technically, the IRR is the discount rate at which the NPV of a project equals zero. Think of it as the project's break-even interest rate.

Calculating IRR by hand is very difficult and requires trial and error. In the real world, we use financial calculators or spreadsheet software like Microsoft Excel (using the `=IRR()` function). But what's important is understanding what it tells us.

For our Boda-Boda Express example, the IRR is approximately 14.5%.

The Decision Rule for IRR is:

• If IRR > Cost of Capital, ACCEPT the project.
• If IRR < Cost of Capital, REJECT the project.

In our case:

• Our project's return (IRR) is 14.5%.
• The minimum return we require (Cost of Capital) is 10%.

Since 14.5% > 10%, we once again decide to accept the project!

Conclusion: Making the Right Call

You've just learned the core skills of a top financial manager! You've seen how to take a business idea and analyze it with professional tools.

• The Payback Period gives us a quick look at risk.
• The NPV tells us exactly how much value (in today's shillings) a project will add.
• The IRR tells us the project's true percentage return.

For Boda-Boda Express Ltd., all signs point to GO! The project pays back reasonably quickly, adds over KES 32,000 in value to the company, and generates a return well above the minimum requirement.

Capital budgeting is your lens to see the future. By mastering these techniques, you're not just preparing for an exam; you're learning how to build and grow successful, profitable enterprises right here in Kenya. Now, go find a company's annual report online and see if you can spot their capital expenditure plans!