Public Finance and Economics

Capital Budgeting

Capital budgeting is the process by which a firm evaluates and selects long-term investment proposals whose returns are expected to accrue over a period longer than one year. Such investments include purchase of plant and machinery, expansion of existing capacity, replacement of old equipment, and investment in new projects. Because these decisions involve large funds, are irreversible in nature, and affect the profitability and risk of the firm for many years, capital budgeting is regarded as one of the most important financial decisions. The basic objective is to select projects whose expected return exceeds the cost of capital, thereby maximising the wealth of shareholders.

The main steps in capital budgeting are: identification of investment proposals, screening of proposals, evaluation of proposals using appropriate techniques, selection of the best proposal, and finally implementation, review and control.

Analytical Techniques of Capital Budgeting

(1) Net Present Value (NPV) Method

Under this method, all expected cash inflows and outflows of a project are discounted to their present value using the firm's cost of capital. The NPV is the difference between the present value of cash inflows and the present value of cash outflows.

$\text{NPV} = \sum_{t=1}^{n} \frac{CF_t}{(1+k)^t} - I_0$

where $CF_t$ = cash inflow in year $t$, $k$ = cost of capital, $n$ = life of the project, and $I_0$ = initial investment.

Decision rule: Accept the project if NPV > 0, reject if NPV < 0, and if NPV = 0 the firm is indifferent. Among mutually exclusive projects, the one with the highest positive NPV is selected.

Example: A project requires an initial investment of Rs 1,00,000 and is expected to generate cash inflows of Rs 40,000, Rs 50,000 and Rs 30,000 in the first, second and third years respectively. The cost of capital is 10%.

$NPV = \frac{40{,}000}{1.10} + \frac{50{,}000}{(1.10)^2} + \frac{30{,}000}{(1.10)^3} - 1{,}00{,}000$

$= 36{,}364 + 41{,}322 + 22{,}539 - 1{,}00{,}000 = \text{Rs } 225 \text{ (approx.)}$

Since NPV is positive, the project should be accepted. The NPV method is superior because it considers the time value of money and the entire cash flow stream, and its result is expressed in absolute rupees, showing the net addition to firm value.

(2) Internal Rate of Return (IRR) Method

The IRR is the discount rate at which the present value of a project's cash inflows equals the present value of its cash outflows, i.e. the rate at which NPV equals zero.

$\sum_{t=1}^{n} \frac{CF_t}{(1+IRR)^t} = I_0$

Decision rule: Accept the project if IRR > cost of capital, reject if IRR < cost of capital. For mutually exclusive projects, the project with the highest IRR is preferred.

Example: Using the same data as above (initial investment Rs 1,00,000; inflows Rs 40,000, Rs 50,000 and Rs 30,000), we try a discount rate of 10% and get a positive NPV of about Rs 225. At 11%:

$\frac{40{,}000}{1.11} + \frac{50{,}000}{(1.11)^2} + \frac{30{,}000}{(1.11)^3} = 36{,}036 + 40{,}581 + 21{,}936 = \text{Rs } 98{,}553$

NPV at 11% = Rs 98,553 − Rs 1,00,000 = − Rs 1,447. By interpolation:

$IRR = 10\% + \frac{225}{225 + 1{,}447} \times 1\% \approx 10.13\%$

Since IRR (10.13%) is greater than the cost of capital (10%), the project is acceptable. The IRR method is widely used because it gives a percentage return that can be compared directly with the cost of capital, though it suffers from limitations such as the possibility of multiple IRRs and the reinvestment assumption.

Conclusion: Both NPV and IRR consider the time value of money and are discounted cash flow techniques. In case of conflict between the two, NPV is generally preferred because it measures the actual addition to shareholder wealth in absolute terms.

Objectives of Fiscal Policy

Fiscal policy is the deliberate use of government taxation, public expenditure and public borrowing to influence the level and pattern of economic activity. Its main objectives are:

1. To mobilise resources: Through taxes and public borrowing the government collects resources from surplus sectors for development financing.
2. To maintain economic stability: By adjusting taxes and expenditure, fiscal policy controls inflation (through surplus budgets and higher taxes) and deflation (through deficit budgets and higher spending).
3. To achieve full employment: Increased public expenditure and tax concessions raise aggregate demand, output and employment.
4. To promote economic growth: Public investment in infrastructure, education, health and energy raises productive capacity and capital formation.
5. To reduce inequality of income and wealth: Progressive taxation and welfare-oriented expenditure transfer resources from the rich to the poor.
6. To correct balance of payments disequilibrium: Tariffs, subsidies and export incentives are used to correct external imbalance.
7. To promote balanced regional development: Special grants, tax holidays and concessional finance are directed to backward regions.

Interrelationship between Monetary Policy and Fiscal Policy

Monetary policy is managed by the central bank (Nepal Rastra Bank) through bank rate, open market operations, CRR, SLR, margin requirements and moral suasion, while fiscal policy is managed by the government through the budget. The two are complementary, not substitutes, and their interrelationship can be analysed as follows:

1. Common objectives: Both aim at price stability, full employment, economic growth and balance of payments equilibrium. Since the goals are the same, the instruments must be coordinated.

2. Fiscal policy needs monetary support: Deficit financing through borrowing from the public or the central bank increases money supply and creates inflationary pressure. If the central bank simultaneously tightens credit (higher CRR, higher bank rate, sale of securities), the inflationary effect of the deficit budget is neutralised. Similarly, a tax cut meant to boost consumption and investment will succeed only if credit is cheap and easily available.

3. Monetary policy needs fiscal support: An expansionary monetary policy (lower bank rate, lower CRR) reduces the cost of credit, but investment will not rise if the government itself is borrowing heavily and crowding out private borrowers. Likewise, in a deep recession, monetary policy alone may fail because of low business confidence; public expenditure then has to create demand. Thus monetary policy works best when fiscal policy creates a favourable environment.

4. Coordination in controlling inflation: A tight monetary policy reduces credit and money supply, while a contractionary fiscal policy reduces government spending and raises taxes. Used together, they reduce aggregate demand more effectively than either alone.

5. Coordination in fighting recession: A deficit budget with increased capital expenditure plus a cheap money policy (low interest rate, liberal credit) together raise aggregate demand, output and employment.

6. Debt management: Government borrowing from the market affects interest rates and liquidity. The central bank's open market operations are used to keep interest rates at a level consistent with the government's borrowing programme. Hence debt management is a joint responsibility of the treasury and the central bank.

7. Exchange rate and external sector: A devaluation or exchange rate adjustment (monetary side) works only if fiscal discipline checks domestic absorption; otherwise the price advantage is lost through inflation. Similarly, fiscal incentives for exports succeed only with adequate and cheap export credit.

8. Institutional coordination in Nepal: In Nepal, the Ministry of Finance and Nepal Rastra Bank coordinate through the budget speech, the annual monetary policy, the Public Debt Management Act and joint review of the fiscal and monetary targets. The monetary policy is announced after the budget so that it can accommodate the fiscal stance.

Conclusion

Fiscal policy provides the resource base and demand stimulus, while monetary policy provides the liquidity and price stability needed to make that stimulus effective. Neither can succeed in isolation. For a developing country like Nepal, which faces both resource gaps and inflationary pressure, a well-coordinated mix of the two — expansionary where investment is needed and contractionary where prices are rising — is essential for sustained economic growth.