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Table of Content
Introduction ........................................................................................................................ 6 Chapter 1 Theoretical Aspect of Investment Evaluation ............................................... 7 1.1
Capital Budgeting.................................................................................................. 7
1.2
Capital Budgeting Process .................................................................................... 8
1.3
Important Factors .................................................................................................. 9
Chapter 2 Practical Aspect of Investment Evaluation ................................................. 12 2.1
Investment Decision 01 ....................................................................................... 12
2.2
Investment Decision 02 ....................................................................................... 14
2.3
Investment Decision 03 ....................................................................................... 16
Chapter 3 Comparison on Theoretical and Practical Investment Evaluation .......... 19 3.1
Investment Decision 01 ....................................................................................... 19
3.2
Investment Decision 02 ....................................................................................... 20
3.3
Investment Decision 03 ....................................................................................... 21
Chapter 4 Evaluation on Estimates and Actual Results............................................... 22 4.1
Investment Decision 01 ....................................................................................... 22
4.2
Investment Decision 02 ....................................................................................... 23
4.3
Investment Decision 03 ....................................................................................... 23
Conclusion ........................................................................................................................ 24 Reference .......................................................................................................................... 25 Appendix I Literature Review on Practical Aspect ..................................................... 26
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Introduction Assignment Objectives Identify Critical Factors of what is important in an investment evaluation. Study the Practices Adopted by companies. Compare the Practices against Theory and identify the Reasons for Variation. Compare evaluation Estimates with the Actual results at implementation stage. Context of the Assignment “…Capital budgeting is a vital activity in business. Business organizations often depend on making the right investments, as a strategy towards growth. Vast sums of money can be easily wasted if the investment turns out to be wrong or uneconomic. Capital budgeting thus seeks to build on the concept of the future value of money which may be spent now. One problem which plagues developing countries is "inflation rates" which can, in some cases, be extremely high…” The above statements have been discussed throughout document by evaluating three organizations and two investment projects from each of them. At the beginning, comprehensive set of theoretical aspects are discussed by aligning them with the literature in order to create the ground for further practical discussion. Effects of inflation and tax, Use of cost of capital and Assessment of risk are the three main aspects that this assignment revolves around. A comparison between theoretical frameworks and practical procedures are presented in order to figure out the differences. Finally, postimplementations of projects are assessed and the variations and reasons are noted down. Methodology The Literature Review has been done through Recommended Text books, Web Sites, Published Journals, Business Reports, Corporate Sites, Government Publications and Other documents available on the internet. Three interviews have been conducted in order to collect the required information about three different investments projects completed within the last five years from three separate organizations.
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Chapter 1 Theoretical Aspect of Investment Evaluation 1.1 Capital Budgeting “…Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the firm’s goal of maximizing owner wealth…” (Gitman, 2002)
Figure 1: Flow of Investment Decisions [Source: (Dayananda et al., 2002)]
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1.2 Capital Budgeting Process Even though the following capital budgeting process consists with five main steps, ‘Review and Analysis’ and ‘Decision Making’ are the most critical and time consuming steps. However, the ‘Follow-up’ step is most ignored and less often executed step.
Proposal Generation •Proposals are made at all levels within a business organization and are reviewed by finance personnel. Proposals that require large outlays are more carefully scrutinized than less costly ones.
Review and Analysis • Formal review and analysis is performed to assess the appropriateness of proposals and evaluate their economic viability. Once the analysis is complete, a summary report is submitted to decision makers.
Decision Making •Firms typically delegate capital expenditure decision making on the basis of dollar limits. Generally, the board of directors must authorize expenditures beyond a certain amount. Often plant managers are given authority to make decisions necessary to keep the production line moving.
Implementation •Following approval, expenditures are made and projects implemented. Expenditures for a large project often occur in phases.
Follow-up •Results are monitored and actual costs and benefits are compared with those that were expected. Action may be required if actual outcomes differ from projected ones. Figure 2: Capital Budgeting Process [Source: (Gitman, 2002)]
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1.3 Important Factors A good investment evaluation should consider the Following factors. 1.3.1
Cost of Capital
Firms gain the capital as either equity or debt. Different investment may fund by different combination of the two. For example one project may use 80% equity and 20% of debt or maybe the other way round. Even though the project may funded by different sources, cost of capital should be calculated by considering the whole organization as one entity. The methods like Weighted Average Cost of Capital can be use to evaluate the cost of capital. All the investment projects should be able to cover the cost of capital. Otherwise that project should not be select to be executed. That’s why the evaluation of this factor becomes important. Evaluation of debt would be much easier that evaluating equity. 1.3.2
Inflation
This factor is subjective to change depending on the country. In some countries inflation is more consistent predictable and bearable. However, a developing country like Sri Lanka has the greatest threat in tem of inflation. Therefore, considering inflation and incorporating them in to the investment decision is very much important. Project viable today may not be viable after 6 months time. Therefore, in such situation, inflation should handle and estimate with utmost care.
1.3.3
1.
Method 1 - Based on Nominal Figures
2.
Method 2 - Based on Real Figures
Taxation
In most cases each industry will be eligible to tax benefits based on compliance with certain predefined parameters. Usually the government of a country will periodically introduce tax benefits for certain sectors/businesses in order to stimulate investment (BOI projects and related tax benefits). It is important that these parameters are considered and addressed in order to obtain the maximum possible taxation benefits when making an investment decision. This is critically important as the competition is very likely to have exploited these benefits and in order to remain competitive a sound understanding on the tax structure is essential.
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1.3.4
Organizations Future Strategy
The evaluation of the investment decision must consider the organizations vision for future growth. The investment can be an extension of the existing line of business in terms of being backward or forward integration which will result in strengthening the organizations current market position and competitiveness. Alternatively the new investment can be in a completely unrelated area which will result in diversifying risk. 1.3.5
Competitive Advantage
It is important that the organization identifies and considers its competitive advantage when evaluating new investment decisions. In most cases an organization will be able to use its pre-existing competitive advantage to leverage great benefit with the new investment it plans to make. For example, the competitive advantage for Walkers Tours Limited which is an inbound tour company is its extensive, global distribution network and its superior service standards. The company recently invested in setting up a unit to focus on Eco and Adventure Tourism and successfully translated its core strengths to the new venture which gave it a significant advantage over its rivals. 1.3.6
Competitiveness Of The Market
For example considering the local tourism market; which is saturated with several giants and a multitude of small players has resulted in an extremely high ‘competitiveness’. As Tourism being an almost generic product, the margins which can be made are minimal. This could lead a company pursuing a ‘Blue Ocean Strategy’ and invest in a niche area which will possibly have a lower competitiveness and so opportunity for greater margins and thrive profitably without enduring cut-throat competition. It is important that this element is considered. 1.3.7
Knowledge And Expertise
The availability of knowledge and expertise in the area concerning the new investment can have varying degrees of impact on the decision. It is possible that the organization already has sound knowledge of the area and so is confident to go ahead. Alternatively the organization may have no knowledge but may plan to acquire it through recruitment or training. On the other end of the spectrum the organization may have no knowledge
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and may make a conscious decision to go ahead with the investment based on the potential of the project and plan to develop expertise as the project progresses. 1.3.8
Recognizing Real Options “…Real Options…Opportunities that are embedded in capital projects that enable managers to alter their cash flows and risk in a way that affects project acceptability (NPV). Also called strategic options…”
1.3.9
(Gitman, 2002)
Business Risk
It is important that the business risk associated with the new investment is identified and evaluated. The organization must be aware of all or at least most of the possible risks that could befall the project. 1.3.10 Political Risk The organization must take in to account the stability of the government and the decisions which it makes. The continuity of government policy can have a significant impact on the viability of the project. Further the high degree corruption and the heavy political influence on the private sector have created uncertainty. For example the luxury vehicle tax in Sri Lanka has recently been dropped from 300% to 150% which is creating opportunity for the retail automobile industry. However, it is important that members of the industry remain aware that this policy could be reversed just as suddenly at some future time. 1.3.11 Exchange Risk In the event that the new investment will have any foreign currency transactions; the company must be aware of and account for (as far as possible) the fluctuations of international currency exchange rates. 1.3.12 Entry and Exit Barriers The organization should assess and be aware of all potential entry and exit barriers before committing to new investments. Appendix I summarize some surveys conducted by different researchers relating to capital budgeting techniques used by different companies during different time frames.
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Chapter 2 Practical Aspect of Investment Evaluation 2.1 Investment Decision 01 Organization Profile - 01 Name
ABC Company (Real Name removed Due to Request)
Organization Type
Private Owned Family Business
Industry
Coconut Industry
Interviewee’s Name
Mr. Sunil Perera
Interviewee’s Designation
Owner
Investment Date
2003
Table 1: Information on Investment Decision [Source: Research Data]
Investment Decision Description This investment has made on a tracker, trailer and a brush hog mower with the intention of using it in a coconut state to do the work such as transport coconut, coconut husks, fertilisers and clearing the field. The investment was around 680,000 rupees. The size of the estate is closely 40 Acers with 6-10 workers depending on the
Figure 3: Major Piece of the Investment [Source: Research Data]
work load Use of Cost of Capital Capital was 100% funded as equity capital by the owner. During the investment evaluation, Cost of capital was calculated based on the bank interest rate. According to the relevant time frame, bank interest was 12%.
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Figure 4: Brush Hog Mower [Source: Research Data]
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Effects of Inflation and Tax Inflation and tax were not considered during the investment evaluation. Assessment of Risk Numbers of risks have been identified during the investment evaluation as follows. A margin has been added to the final cash flow evaluation for repairs and break downs. Other risk factor are ignored during the evaluation Repairs and Breakdowns Operational Cost (Due to fuel price increase) Suitability to the requirement. Operational and technical knowledge Investment Evaluation Process The rough calculations done by the evaluator during the investment evaluation are presented below. It is based on payback period method. But it considers Cost of Capital. Initial Investment ( Tracker + Trailer + Brush Hog Mower)
680,000
Operational Cost- If invest (per annum) Licence + Service + Repair + Driver + Fuel
95,000
Cost of Capital @12(per annum) Based on Spot Bank Interest Rate
82,000
Total Expenditure- If invest (per annum)
177000
Operational Cost- If do not invested (per annum) (Labour + Rented Tractors)
240,000
Saving (per annum) (~60,000)
63000
Payback time
680000 63000
10.8 Years
Table 2: Financial Information [Source: Research Data]
A tractor can be used averagely up to 20-25 years. As it purchased under reconditioned state, another 15 years can be used before it need to be replaced. According to the calculation presented above, it proves that the investment on the equipment can be paid off very easily within 11 years under planned conditions. PPEC 130
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2.2 Investment Decision 02 Organization Profile - 02 Name
XYZ Company (Real Name removed Due to Request)
Organization Type
Private
Industry
Food Industry
Interviewee’s Name
xxxxxxxxxxxxxxx
Interviewee’s Designation
Investment Analyst
Table 3: Information on Investment Decision [Source: Research Data]
Company Background Due to privacy concerns the name of the company and its financial details will be omitted. The firm is a medium scale enterprise operating in the food industry. They have been in business for well over a century and have established a solid brand position and a reputation for excellence in their industry. The company is a private entity. Investment Decision With the liberation of the North and East provinces of Sri Lanka the company is poised to expand their presence in those regions by establishing two separate hubs that would cater to those markets. Each hub would serve as a base of operations for several outlets that would be rolled out in a controlled manner pending market conditions. Use of Cost of Capital Project funding is financed by debt and equity. The exact proportions weren’t discussed due to privacy concerns. The cost of funds will depend on the requirements of the company directors. The company uses the bank rate but will add 2-3 digits as a risk premium. Since the company is considering setting up operations in the North and East (an area that they are unfamiliar with) the risk premium will be higher than a similar investment in Colombo.
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Inflation and Tax When factoring in inflation the company uses the Central Bank’s published rates. Taxation on raw materials is passed on to the consumer by adjusting the output price of their products. Thus far demand has not decreased by price hikes since quality is maintained. Interest charged on loans can be set off against corporate tax. Risk Assessment The chief risk faced by the company is environmental risk. In order to reduce damage to the environment and water reserves the company has invested time and money into developing an efficient system of waste management. To a lesser extent the company also considers market risk and liquidity risk when determining an investment. Market risk plays a strong role since the company has a strong reputation in the market and an investment that fails to deliver the correct quality standards and accumulates negative consumer reactions will endanger the whole brand, In order to mitigate risk the company conducts internal monthly audits of all its investments. As mentioned earlier the company uses a risk adjusted discount rate (RADR) when calculating NPV’s.
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2.3 Investment Decision 03 Organization Profile - 02 Name
XYZ Knitting (Pvt) Ltd (Real Name removed Due to Request)
Organization Type
Private Owned Partnership Business
Industry
Apparel Industry
Interviewee’s Name
Mr. Janaka Bandara.
Interviewee’s Designation
CEO
Investment Date
2007
Table 4: Information on Investment Decision [Source: Research Data]
XYZ knitting commenced operations in mid 2007 specializing in manufacturing cotton based fabrics for the export apparel industry. As fabric constitutes 60% of the end product it was considered as a strategic investment supporting apparel manufacturers. This is a private owned business partnership between a local company and a foreign party. Investment Decision The scope of the business is a dyeing and knitting operation. The investment in fixed assets of the project was on land, building and machinery. The capital expenditure was partly funded in foreign currency loans and partly by equity as the major portion was to import machinery for the operation. The investment had been in the range of US$ 1,500,000. The inputs (raw material) are yarn which is imported from Pakistan, India and China. So the company relies heavily in foreign currency transactions. Effects of Inflation and Tax According to the CEO, at the time of the investment evaluation they have not factored inflation. There was no real answer to this but what he commented was at the initial stage when preparing cash flows it was a percentage of sales that was allocated for all types of expenditure. This estimate has been constant over the years with no increase percentage wise. However, he stated that costs have increased in real terms by around 5% each year. For example wages, utilities, transport, raw material (which is considered as the highest cost component) has increased.
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The effects of inflation should have been factored at the time of considering the investment. This should have actually given a better understanding of rising costs over the years and to be financially prepared for such expenses. This is a BOI company and categorises as an indirect exporter. All the machinery and equipment have been imported on duty free basis.
Even consumables such as raw
material, inks and chemicals are purchased on duty free basis. The company also enjoys a five year tax holiday up until 2012. As a BOI entity the company benefits in getting all tax concessions. Use of Cost of Capital The investment is partly funded by equity and partly by debt (bank borrowings). The component of debt to equity has been 70/30. Most of the funding is in foreign currency. As stated previously the full investment has been in the range of US$ 1,500,000. It was mentioned in the discussion that viability of the investment was based on NPV. The discounting factor was based on bank rates at the time of preparing the project report. Only the debt part has been considered in this case. When asked as to why equity was not considered, the response was that since it is private business it was the discretion of the shareholders when it came to deciding on dividends and not up to the management. It was not disclosed as to whether the company was making profits, but that it was considering making further investments in expansion. We recommend that the company should have used a weighted cost of capital rather than a bank rate. This would have then captured the equity component as well. Since it’s a private company they would have opted with only the bank rate. Assessment of Risk The company is facing risks in terms of the global financial crisis, GSP + and foreign currency fluctuations. During the period 2008/09, with the down turn of global markets and with less buying from western markets they could not run up to optimum capacity. This was a setback against forecasted outputs which has resulted in idling and loss of revenue.
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GSP +, which has become a controversial topic recently play an important role in the future business of the company. GSP + over the last 4 years has ensured business in to Sri Lanka. With this trade concession now been reversed will have a hard knock effect as a whole in the apparel industry. As most of the transactions are in foreign currency, it faces the risk of exchange fluctuations. It was disclosed that during the last six months the strengthening of the rupee has not been favourable to the company.
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Chapter 3 Comparison on Theoretical and Practical Investment Evaluation 3.1 Investment Decision 01 Evaluation Factors according to Theory Pay Back
Capital Budgeting Techniques
Up to Some Extent
Risk Factor Inflation
Not Considered
Taxation
Not Considered
Cost of Capital
Considered
Capital Budgeting Refinements
Considered
Other Factors on Investment Evaluation
Considered
Table 5: Comparison between Theory and Practice [Source: Research Data]
The evaluation process considered this investment as an ‘expansion’ investment project. It enhances the level of operation of the coconut estate. It was an individual project which evaluated under limited funding and got accepted based on ‘financial’ benefits based on customized payback model. Cash flow pattern had identified as non conventional and relative cash flows had also identified. Opportunity cost had identified up to some extent by only considering cost of capital. Inflation and tax were not considered during the investment evaluation. The argument was that, those factors would most probably affect to the entire economy. If the inflation and tax effect on oil prices (or other factors) works against the investment, the coconut prices would also get increased and it would balance out the inflation problem up to a greater extent. Risk factors were evaluated up to some extends and some margins were added to the operational cost. But no other risk factors were incorporated in to the investment evaluation using accepted methodologies, as mentioned in theories.
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Recognizing real options under capital budgeting refinements had identified the potential opportunities that can created by this investment. For example, another investment on water bowser could become possible due to this investment. Therefore it may create huge opportunity to reduce labour and costs more and more. Possible Reason Variation Investor’s personality background and education level Self confidence of the Experience of the Investor Future Trends and operation efficiency Believe on qualitative fact than quantitative facts Risks involved in labour, tractor and equipment hiring Lot of hidden cost relation to labour force Quality and speed
3.2 Investment Decision 02 In order to assess an investment opportunity the company conducts a “Purchase Committee Meeting” to determine the optimal capital expenditure as well as the potential cash inflows. The committee will receive the input of the finance and marketing divisions when deliberating the numbers. Evaluating a complex investment such as setting up a hub can take up to 2-3 months. Once the company completes its comprehensive internal analysis an independent study is carried out to remove any possible biases. Each investment is considered to be an independent investment and not a mutually exclusive investment. The starting point is utilizing the traditional payback period to determine how soon the project will start making profits and then moving on to calculating NPV’s. If several investments are being evaluated they are ranked in order of priority with the appropriate risk factored in. Cash flow patterns resemble that of a non conventional cash flow since the company has traditionally mixed outflows with inflows every 3-4 years. This is due to the fact that the market is dynamic and to take advantage of changing trends.
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Evaluation Factors according to Theory Payback / NPV
Capital Budgeting Techniques
Environmental/Market
Risk Factor Inflation
Central Bank Rate
Taxation
Considered
Cost of Capital on Capital Budgeting
Considered
Capital Budgeting Refinements
Considered
Other Factors on Investment Evaluation
Considered
Table 6: Comparison between Theory and Practice [Source: Research Data]
3.3 Investment Decision 03 The following table illustrates the evaluation factors considered in the investment of XYZ knitting. One of the key aspects considered was the GSP+ preferential concession scheme at the time of investment. This had a guaranteed backing of orders to the company. Now it is withdrawn there is concern on future expansion activities. Evaluation Factors according to Theory NPV
Capital Budgeting Techniques
Up to Some Extent
Risk Factor Inflation
Not Considered
Taxation
Considered
Cost of Capital
Considered
Capital Budgeting Refinements
Considered
Other Factors on Investment Evaluation
Considered
Table 7: Comparison between Theory and Practice [Source: Research Data]
In most instances the decision making has been different to what it relates with theory. This is because decisions have been made by the top management purely on experience and expertise and to cope with the quick response that is needed in this dynamic market environment.
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Chapter 4 Evaluation on Estimates and Actual Results 4.1 Investment Decision 01 The following table summarize the first four years of investment Yr
Estimated Saving
Actual Saving
1
Less than 63000
24000
2
63000
-5000
3
63000
85000
4
63000
85000
Figure 5: Comparison on Estimated Vs Actual Savings [Source: Research Data]
The first year did not achieve the estimated saving due to operation inefficiencies, inexperience operations, labour issues‌etc. Then the second year was also not good in financial terms due to additional cash flow requirements on major repairs and services, infrastructure development (shelters, roads‌etc). From the third year, investment started to pay off. It went beyond the estimated savings by 20,000 due to reduction of hidden costs relating to labour and other factors. On the other hand, this investment creates more opportunities to reduce the cost and inefficiencies of the process. For example, business invested on a water tank which can supported by the tractor to transport the water around the estate. That also would reduce the cost up to a greater extent.
Figure 6: Water Bowser [Source: Research Data]
Finally, this investment adds lot of benefits to the business in many forms. It helped to reduce costs and increase profits, reduce labour issues, tractor and equipment hiring issues, uncertainties on labour and many more. It also create a new opportunities to rent out the tractor and other equipment when they are idling and make additional income.
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4.2 Investment Decision 02 In theory it may be beneficial to conduct a post implementation audit in order to assess how much of a variation occurred between the estimated figures and actual figures. This gives a company to improve its future investment/decision making process. In the case of XYZ audits occur from the time the investment is initiated and is an ongoing process. There is a project manager assigned to each investment and he/she will conduct monthly audits - constantly checking for deviations from the original investment plans and calculations. Waiting for a year let alone 4-5 years to do a post implementation audit has not proven to be prudent given the ever changing market conditions.
4.3 Investment Decision 03 Information was not disclosed and was mentioned that they do not compare results of the initial investment evaluation against actual results. What is constantly monitored is the bottom line which they review on a monthly basis.
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Conclusion It is clear that companies across the broad spectrum from sole traders to family owned businesses and large listed companies all carryout some form of investment decision evaluation. However, based on our research findings, the degree to which companies carry out detailed investment appraisal calculations varies greatly depending on the availability of resources in terms of finances, knowledge and expertise. We observed that where companies did carry out detailed calculations, a fair amount of consideration was given to the selection of the appropriate cost of capital and approaches to dealing with inflation and tax. While the smaller companies mostly consider the bank lending rate to be the cost of capital for the project evaluation, the larger companies are more in line with theory and use a weighted average cost of capital approach. Our research also revealed that the payback method of calculation is a more prevalent than NPV or IRR when determining investments. All three interviewees mentioned that explaining the payback method to executives with a non finance background as well as to regular workers was a much easier task than explaining the intricacies of NPV calculation. It is likely that most companies in Sri Lanka prefer to use as simple method of calculation versus a complex method even though that method may yield better results. All the entrepreneurs we interviewed depend on ‘gut feeling’ and their inherent tacit knowledge when making important investment decisions. Our research also confirmed that organizations, regardless of size, spend a significant amount of resources considering other qualitative factors which can affect the success of the investment decision. We believe that in a volatile country such as Sri Lanka, a qualitative evaluation is as critical for success as its quantitative side given that cost of capital is still high and there is very little margin for error.
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Reference
Dayananda, D. et al., 2002. Capital Budgeting Financial Appraisal of Investment Projects. 1st ed. Cambridge: CambridgeUniversity Press. Fremgen, J., 1973. Capital Budgeting Practices: A Survey. Management Accounting, pp.19-25. Gitman, L.J., 2002. Principles of Managerial Finance. Boston: Addison Wesley. Gitman, L.G. & Forrester, J.R., 1977. A survey of Capital Budgeting Techniques Used by Major U.S. Firms. Financial Management, pp.66-71. Graham, J. & Harvey, C., 2002. How Do Cfos Make Capital Budgeting And Capital Structure Decisions? Journal Of Applied Corporate Finance, 15(1), pp.8-23. InvestorWords, 2010. Capital Budget. [Online] Available at: http://www.investorwords.com/699/capital_budget.html [Accessed 20 June 2010]. Kim, S.H. & Farragher, E.J., 1981. Current Capital Budgeting Practices. Management Accounting, pp.26-30. Klammer, T.P. & Walker, M.C., 1984. The Continuing Increase in the Use of Sophisticated Capital Budgeting Techniques. California Management Review, pp.137-48. Petry, G.H., 1975. Effective Use of Capital Budgeting Tools. Business Horizons, pp.5765. Ross, M., 1986. Capital Budgeting Practices of Twelve Large Manufactures. Financial Management, pp.15-22.
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Appendix I Literature Review on Practical Aspect According to a research done by Marc Ross and his team in 1972, revealed that even though there are more methods that use discounted cash flows, organizations are more heavily reliant on a simple payback model, mostly in smaller projects. On the other hand organization may use discounted cash flow methods by simplifying it. Most of the organizations do not adjust their analysis for risk and consider project lives as equal (Ross, 1986) Another research done by Klammer and Walker in 1972 relating to manufacturing corporations which spend at least one million capital expenditure per year. They have found out that many corporations getting used to incorporate present value during invetment evaluations. (Klammer & Walker, 1984) A research done by Fremgem in 1973 was found that organization consider the internal rate of return model as the first choice for investment decision making again he has found that most companies has increased their profitability requirements to adjust for risk. During this time period companies have considered the cash flow projection as the most important and the difficult stage of the entire investment evaluation process. The survey has conducted relating to manufacturing, retailing, mining, transportation, land development, entertainment, public utilities and conglomerates. (Fremgen, 1973) Petry and his team have done a research in 1965 based on fortune 500 companies at that time. They have found out that internal rate of return was the widely accepted and used method in capital budgeting. At the same time present value methods were used more in new product line developments. (Petry, 1975) Research done by Gitman and the team in 1977 based on 110 firms which had the greatest stock price growth at that time, have found that discounting cash flow methods have become more and more famous and the main preference is on internal rate of return. Many organizations use payback method as a secondary approach and most of the firms adjust for risk as well. As same as in the early research, these corporation also believed that cash flow estimations the most difficult and critical stage (Gitman & Forrester, 1977) PPEC 130
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Figure 7: Survey Evidence on the Popularity of Different Capital Budgeting Methods [Source: (Graham & Harvey, 2002)]
In 1981, further research on capital budgeting based on fortune 100 corporations and found that majority of the firms relied on a discounted cash flow method, either NPV or IRR as their primary method while keeping payback method as their secondary method. (Kim & Farragher, 1981) Gitman has explained the practical view point on capital budgeting in his book ‘Principles of Managerial Finance’ as follows: “…Evidence suggests that in spite of the theoretical superiority of NPV, financial managers prefer to use IRR. The preference for IRR is due to the general disposition of businesspeople toward rates of return rather than actual dollar returns. Because interest rates, profitability, and so on are most often expressed as annual rates of return, the use of IRR makes sense to financial decision makers. They tend to find NPV less intuitive because it does not measure benefits relative to the amount invested. Because a variety of techniques are available for avoiding the pitfalls of the IRR, its widespread use does not imply a lack of sophistication on the part of financial decision makers…”
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Capital Budgeting In Small Firms The capital budgeting process of small business is likely to be different from that of a large business. Factors such as size and availability of capital, investment opportunities, and the nature of the decision makers will be different for small firms Grablowsky and Burns (1980) study, cites lack of understanding as well as expertise of the concepts of capital budgeting as the reasons behind small businesses less use of modern capital budgeting techniques, Small businesses rely on gut feel or easy techniques like payback period. Other characteristics are short operating history, credit constraints, difficulties in quantifying future cash flow, and limited discretionary alternatives for investments.
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