Capital Rationing at Dala Packaging
Dala Packaging Limited is a Nigerian manufacturer with a capital budget of N80 million for 2025 and a weighted average cost of capital of 18%. Two independent projects are being considered. Project A, an automated carton line, costs N60 million, has a five-year life and is expected to generate annual net cash inflows of N22 million. Project B, a warehouse expansion, costs N50 million, has a four-year life and is expected to generate annual net cash inflows of N19 million. Neither project can be delayed or repeated. The company will not part-finance a project, so each project must be accepted or rejected as a whole. The finance director prefers B because its payback is shorter. The operations director prefers A because it 'looks bigger'. The board wants a recommendation based on value creation, not payback. Cash flows are stated in nominal terms and already reflect inflation. Ignore tax and depreciation.
1. Evaluate the two projects using NPV and profitability index, and recommend which project the board should approve under the N80 million budget.
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Calculations at 18%:
| Project | Initial cost | Annual inflow | Life | Annuity factor | PV of inflows | NPV | PI |
|---|---|---|---|---|---|---|---|
| A | N60m | N22m | 5 years | 3.127 | N68.8m | N8.8m | 1.15 |
| B | N50m | N19m | 4 years | 2.690 | N51.1m | N1.1m | 1.02 |
Reasoning: Both projects have positive NPVs at 18%, so both create value in principle. But the budget is N80 million and the combined cost is N110 million, so the company cannot do both and cannot part-finance one. The choice is therefore A or B.
Project A has the higher NPV (N8.8m versus N1.1m) and the higher profitability index (1.15 versus 1.02). It also leaves N20 million of the budget unused, but there is no third project to absorb that amount. Choosing B would leave N30 million unused and sacrifice about N7.7 million of value.
Recommendation: Approve Project A. Payback is not the right primary criterion here because it ignores cash flows after payback and the time value of money. The finance director's preference for B is based on a shorter payback of about 2.6 years versus 2.7 years for A, a trivial difference that does not justify the much lower NPV.
2. Assess the sensitivity of the decision to the discount rate. What does this tell the board about risk?
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Sensitivity: Project A's NPV falls to zero at an IRR of about 24%. Project B's NPV falls to zero at an IRR of about 19.3%. Both exceed the 18% cost of capital, but by very different margins.
- Project A can absorb an increase of about 6 percentage points in the cost of capital before it destroys value.
- Project B can absorb only about 1.3 percentage points.
Interpretation: Project B is much more marginal. A small rise in interest rates, a higher risk premium or an upward revision of the cost of capital could turn its NPV negative. Project A has a larger margin of safety. The board should not treat the two positive NPVs as equally robust.
Caveat: The IRR ranking and NPV ranking agree here, but the board should still use NPV as the decision rule because it measures value in naira. The sensitivity analysis should be extended to the annual cash inflows. For example, a 10% shortfall in Project A's inflows would reduce annual cash flow to N19.8 million and NPV to about N1.9 million; Project B would already be negative. This reinforces A's superior risk profile.
3. What qualitative and strategic factors should the board consider before finalising the choice?
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The board should consider factors that the NPV calculation does not capture:
- Strategic fit. Does the automated carton line support Dala's core manufacturing strategy, or is the warehouse expansion more important for distribution and customer service?
- Execution risk. Automation may require new skills, supplier support and staff retraining. Warehouse expansion may involve property, planning and construction risks.
- Operational flexibility. A five-year versus four-year life affects replacement timing and future capital needs.
- Market demand. Are the projected inflows dependent on a small number of customers or on stable packaging demand?
- Inflation and cost escalation. The cash flows are nominal, but are maintenance, energy and labour costs realistically reflected?
- Financing and liquidity. The N20 million left unused under A provides a buffer for working capital or contingencies.
- Tax and incentives. Although the question says to ignore tax, the board should confirm whether capital allowances or incentives would change the ranking.
- Non-financial risk. Reputation, safety, environmental impact and compliance with local content or environmental rules may matter.
Recommendation: Approve A, subject to confirming that the automation supplier is credible, the workforce can operate the line, and the N20 million residual budget is retained as a contingency rather than spent on low-value additions.