Capital Budgeting

Table of Contents

CHAPTER ONE 1

INTRODUCTION 1

1.1 Background 1

1.2 Historical Development in Capital Budgeting 2

1.3 Capital Budgeting Techniques 4

1.4 Theories in capital budgeting 5

1.5 Critique of the Capital Budgeting Techniques 10

CHAPTER TWO 11

2.1 EMPIRICAL EVIDENCE 11

3.1 RESEARCH METHODOLOGY 15

CONCLUSIONS AND UNRESOLVED ISSUES 16

4.1 Suggested Study Areas 16

4.2 Conclusion 17

REFERENCES 18

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CHAPTER ONE

INTRODUCTION

1.1 Background

Gitman (2002) defines capital budgeting as the “process of evaluating and selecting long

term investments that are consistent with the business’s goal of maximizing owner

wealth”. Firms make a variety of long-term investments but the most common are those

in fixed assets commonly referred to as earning assets. Every organization that embarks

on this process must take all necessary steps to ensure that their decision making criteria

supports the business’s strategy and enhances its competitive advantage over its rivals.

The capital budgeting decision is an important decision for the firm since the firms’

survival and profitability hinges on capital expenditures, especially the major ones

Pandey (1995). Capital budgeting decisions are crucial to a firm's success for several

reasons. First, capital expenditures typically require large outlays of funds. Second, firms

must ascertain the best way to raise and repay these funds. Third, most capital budgeting

decisions require a long-term commitment finally, the timing of capital budgeting

decisions is important. When large amounts of funds are raised, firms must pay close

attention to the financial markets because the cost of capital is directly related to the

current interest rate.

A good capital budgeting process does more than just make accept-reject decisions on

individual projects. It must tie into the firm’s long range planning process that decides

what lines of business the firm should concentrate in and sets out plans for financing,

production and marketing etc. It must also tie into a procedure for measurement of

performance (Brealey & Myers, 2007).

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1.2 Historical Development in Capital Budgeting

1.2.1 The Period up to 1950

Earlier approaches to capital budgeting models were concerned mostly with the

economic evaluation of individual projects. For many years, most firms used Payback

period to evaluate investment project. In 1899, Irving Fisher first articulated the concept

of NPV as the market value of securities minus cost of resources. Fisher (1930) advanced

the Theory of Interest in which he suggested that NPV is the key part in theory of optimal

resource allocation. Fisher labeled his theory of interest the “impatience and opportunity”

theory. He put forward that Interest rates, were as a result of the interaction of two forces:

the “time preference” people have for capital now and the investment opportunity

principle (that income invested now will yield greater income in the future). The interest

rate, or what is called cost of Capital, forms the basis of the Internal Rate of Return (IRR)

defined as the discount rate that will equate the present value of future cash flows to the

resources employed now.

Fisher defined capital as any asset that produces a flow of income over time. A flow of

income is distinct from the stock of capital that generated it, although the two are linked

by the interest rate. Specifically, wrote Fisher, the value of capital is the present value of

the flow of (net) income that the asset generates.

In the period between 1930s and 1950s non owner managed firms put in place capital

budgeting control systems that identified planned capital investments going forward. The

size of non financial investments and the number of non owner managed firms increased

during the industrial revolution. These simultaneous changes created fertile ground for

use of more sophisticated evaluation techniques and for the capital budgeting processes in

use today (Chapman & Hopwood, 2007)

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1.2.2 1951 to date

During the 1950s, practicing financial controllers began to network with each other, with

consultants and with academicians to develop models for capital budgeting (Chapman &

Hopwood, 2007). Dean (1951), in his book Capital Budgeting, advanced the

implementation of Discounted Cash flows (DCF) methodology in its current form.

Managers are required to maximize return on investment at a given level of risk.

However capital budgeting models only consider the return on investment. As a result,

managers don’t usually have all the information to make the right decisions as far as risk

is concerned. To address this flaw, Hertz (1964) provided a discussion on how computer

simulation can be used to provide managers with a measure of risk on a capital

Investment Project.

Agency theory that developed in the late 1970s and early 1980s gave rise to analytical

models of capital investment process. These models suggest that current capital

budgeting procedures are a means of reducing agency costs that emanate from the

conflict of interest between owners of firms and management. The internal rate of return

(IRR) and the net present value (NPV) have long been the accepted capital budgeting

measures preferred by corporate management and financial theorists, respectively. While

corporate management prefers the relevancy of a yield-based capital budgeting method,

such as the IRR, financial theorists, based on Orthodox economic theory, endorse the

NPV method. The debate between NPV and IRR methods dates from the inception of

modern interest theory. The introduction of the NPV as amore superior model created the

impetus for conflict between the two methods. However, both methods suffer from

inconsistencies when ranking potential investment projects based on the assumption of

wealth maximization. Therefore, a consistent capital budgeting method must be robust

when correctly ranking and selecting superior investments in varying investment

environments, remain theoretically sound by maintaining the assumption of wealth

maximization, and be expressed as a yield based measure as preferred by corporate

management (Chapman & Hopwood, 2007).

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1.3 Capital Budgeting Techniques

Bringham and Besley (2000) identify several basic methods used by businesses to

evaluate projects and to decide whether they should be accepted for inclusion in the

capital budget. These methods are; Payback period, net present value and internal rate of

return. The payback period method is a non discounting technique since it does not

consider the time value of money. NPV and IRR are referred to as discounting techniques

since they take into account time value of money.

1.3.1 Pay Back Period

Bringham and Besley (2000) define payback period as the number of years required to

recover the original investment. It’s the simplest and the oldest formal method used to

evaluate capital budgeting method. Using the pay back to make capital budgeting

decisions is based on the concept that it’s better to recover the cost of a project sooner

rather than later. As a general rule a project is considered acceptable if its payback

period is less than the maximum cost recovery time established by the firm. The major

limitations of this method are the failure to recognize the time value of money and cash

flows beyond the payback period.

Pay back period =initial cash outlay

Annual cash inflows

1.3.2 Net present Value (NPV)

(Bringham & Besley, 2000), defines NPV as a method of evaluating capital investment

proposals by finding the present value of future net cash flows discounted at a rate of

return required by the firm. To implement this approach, we find the present value of all

future cash flows a project is expected to generate and then subtract its initial investment

to find the net benefit the firm will realize from investing in the project. If the net benefit

computed on a present value basis is positive, then the project is considered acceptable

investment. The advantage of this method is that it recognizes the the time value of

money.

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1.3.3 Internal Rate of Return (IRR)

IRR is the discount rate that equates the PV of the cash inflows with initial investment

associated with the project (Gitman 2002). As long as the project’s IRR, is greater than

the rate of return required by the firm for such an investment, the project is accepted. The

technique has two major limitations. First, when a project has unconventional cash flow

patterns, there is a likelihood of getting multiple IRRs. This is because there exists an

IRR solution for each time the direction of the cash flows associated with a project

changes. Secondly, in the case of mutually exclusive projects, the technique can result in

the acceptance of the lesser viable project. This is because the IRR method assumes that

the interim cash flows are reinvested at the projects’ discount rate. (Bringham & Besley,

2000)

1.3.4 Modified Internal Rate of Return (MIRR)

Bringham & Besley (2000) define MIRR as the discount rate at which the present value

of a project’s cost is equal to the present value of its terminal value, in which the terminal

value is found as the sum of the future values of the cash flows, compounded at the firm’s

required rate of return. The use of the technique helps overcome the IRRs limitation

resulting from the reinvestment rate assumption.

1.4 Theories in capital budgeting

1.4.1 MMs capital budgeting theory

MM pursues value maximization to increase the combined market values of debt and

equity. In mms theory the two sources of financing used are permanent and equity is a

form of permanent financing. Since permanent financing is employed, the payment of

principal is unnecessary so unlike in normal capital budgeting depreciation is set aside

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each year to replace the obsolete capital and investors do not recover the initial

investment at all. According to MM the cost of capital is the weighted average cost of

capital. To sum up MM theory, the value of a levered firm is the after –tax cash flows for

the stockholders discounted at the cost of equity plus the after tax flows from bond

holders discounted at the cost of debt or identically its value is the NOI discounted at the

Wacc. Therefore MM maximized the combined value of equity and debt or equivalently

the combined wealth of the stockholders and bond holders.

1.4.2 Contemporary capital budgeting theory

Contemporary capital budgeting theory is deeply rooted in MM's theory which was

discussed in the previous section. Slight differences abide, though, because, contrary to

MM's permanent cash flows, investment projects have limited useful lives in the real

world. In making capital budgeting decisions, five important elements are to be

considered: the initial investment, the operating cash flow, the useful life of the project,

the salvage value, and the cost of capital.

Since the limited project life creates discrepancies between MM's and contemporary

theory, it is discussed before the other four components. In most major textbooks, a fixed

serviceable life is assumed, so the project will be in place for a few years, and, after that

period, it will be closed. See Block and Hirt (1994), Brigham and Gapenski (1993), Kolb

and Rodriguez (1992), Van Home (1992), and Weston and Brigham (1993). The

implication is that, upon the close of the project, the venture is to be dissolved, so the

company must pay back the par value of bonds to bondholders and the par value of

common shares to stockholders. Therefore, unlike in MM, depreciation is not

accumulated from year to year to replace the capital asset. Instead it is added back to the

NOI to increase the operating cash flow for the investors.

The initial investment is the amount of capital required upfront to start a project which

includes, but is not limited to, the purchase price of the capital asset, sales taxes,

transportation cost, installation cost, and the working capital needs. In MM, the investors

never recapture the initial investment because the project will go on forever; in current

theory this amount is recovered through the operating cash flows from the project.

The operating cash flow in current theory is the cash inflow to the investors from the

project. MM's cash flow is the NOI given by equation (1), but the operating cash flow in

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today's capital budgeting (OCF, hereafter) is MM's NOI less the tax shield benefit of

interest payment plus depreciation.

1.4.3 Real options theory

Black, Scholes, and Merton (1973) their work offers us a standard pricing model for

financial options. Together with Stewart Myers, they recognized that option-pricing

theory could be applied to real assets and non-financial investments. To differentiate the

options on real assets from the financial options traded in the market, Myers coined the

term “real options”, which has been widely accepted in academic and industry world.

Unlike the standard corporate resource allocation approaches, the real options approach

acknowledges the importance of managerial flexibility and strategic adaptability. Its

superiority over other capital budgeting methods like discounted cash flow analysis has

been widely recognized in analyzing the strategic investment decision under uncertainties

(Luehrman, 1998)

Traditional approaches to capital budgeting, such as discounted cash-flows (DCF), cannot

capture entirely the project value, for different reasons: it is assumed that investment

decision is irreversible, interactions between decisions today and future decisions are not

considered, and investment in assets seems to be a passive one i.e. management doesn’t

interfere during the life of the project. Managerial flexibility generates supplementary

value for an investment opportunity because of managerial capacity to respond when new

information arises, while the project is operated. Investment in real assets includes a set

of real options that management can exercise in order to increase assets value (under

favorable circumstances) or limit loses (under unfavorable situations). Managerial

flexibility in decision-making process introduces an asymmetry for probability

distribution of net present value (NPV) for a project. An investment opportunity value is

dependent on future uncertain events, so it will be greater than forecasted value in the

situation of passive management. From this perspective, a project has a standard value,

determined through traditional techniques (DCF, which does not capture adaptability and

strategic value), but also a supplementary value, coming from operational and strategic

real options held by an active management (Vintila, 2007).

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Real options are options to modify projects. If financial managers treat projects as black

boxes, they may be tempted to think only of the first accept–reject decision and to ignore

the subsequent investment decisions that may be tied to it. But if subsequent investment

decisions depend on those made today, then today’s decision may depend on what you

plan to do tomorrow. When you use discounted cash flow (DCF) to value a project, you

implicitly assume that the firm will hold the assets passively. After managers have

invested in a new project, they do not simply sit back and watch the future unfold. If

things go well, the project may be expanded; if they go badly, the project may be cut

back or abandoned altogether. Projects that can easily be modified in these ways are more

valuable than those that don’t provide such flexibility. The more uncertain the outlook,

the more valuable this flexibility becomes. The various real options in capital budgeting

decisions include;

Option to Wait (Option to Defer)

Management has an option to choose the timing of investment. This type of real option

usually occurs in natural-resource-extraction, real estate development, farming and

fishery industries.

Option to Abandon

If market conditions change unfavorably management has an option to abandon current

operation permanently and regain some of the initial investment cost by selling it. The

abandonment option is mainly important in new product introductions in uncertain

markets, capital-intensive industries, such as airlines, shipping lines and railroads.

Option to Switch

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Use (e.g., Inputs or Outputs): When output prices or the output demand changes

management can change the output mix (product flexibility) or produce the same output

using different types of inputs (process flexibility).

Growth Options

This type of option occurs when initial investment is chained to other subsequent

investment projects. Growth options are mostly expected in all infrastructure based or

strategic industries, hi-tech, R&D (computer, pharmaceuticals) and industries with

multinational operations and strategic acquisitions.

Time-to-Build Option (Staged Investment)

When investment costs occur in stages there is always an option to abandon the next

stage of the investment if expectations change unfavorably. Each stage is an option on the

value of the subsequent stages. This option is important in long-development capital-

intensive projects, all R&D-intensive industries, energy generating plants and

pharmaceutical industries.

Option to Alter Operating Scale (e.g. to Expand; to Contract; to Shut Down):

If market conditions are more favorable than expected, the firm can expand the scale of

production or accelerate resource utilization. Conversely, if conditions are less favorable

than expected, it can reduce the scale of the operations. Examples of this real option can

be found in natural-resource industries (mining), consumer goods and commercial real

estate.Among the above options, option to wait and option to abandon are recognized as the

most important real options which are embedded in most investment opportunities

1.5 Critique of the Capital Budgeting Techniques

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In Brealey & Myers (2007), NPV is professed as the more superior method to all others.

However, the NPV method also has deficiencies and is inconsistent in some investment

environments. Specifically, the NPV has been shown to be inconsistent in selecting

superior investments and ambiguous in maintaining the goal of wealth maximization in

environments when investments have different economic lives.

Alternative methods, such as the Payback method and the use of earnings multiples, are

also common. The payback is seen as possibly the most seriously flawed method,

because it ignores the time value of money and cash flows beyond an arbitrary cut-off

date. Weston and Bringham (1981) suggest that it may be rational for cash constrained

firms to use this method. Other suggested explanations for the use of the Payback method

are that it may be used by managers to approximate the riskiness of a project. That it can

approximate the option value of waiting to invest and that it can be explained by the lack

of sophistication of management (Graham & Harvey, 2002).

The traditional DCF methods are popular; however, financial economists have long

acknowledged that its universal application is not strictly appropriate. The problem arises

because the simple DCF approach ignores management’s ability to alter decisions and

outcomes once a project is undertaken. This managerial flexibility is referred to as “real

options” in the academic literature.

The idea that real options should be included in a capital budgeting analysis has recently

gained wider acceptance and is commonly promoted as the most appropriate method for

valuing strategic investment decisions.

CHAPTER TWO

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2.1 EMPIRICAL EVIDENCE

(Kadondi, 2002) A survey of Capital Budgeting Techniques used by companies listed at the Nairobi Stock Exchange (NSE)

In her study, Kadondi (2002) carried out a survey on capital budgeting techniques used

by companies listed at Nairobi Stock Exchange (NSE). The objectives were to document

the capital budgeting techniques used in investment appraisal by corporations in Kenya,

to determine whether the techniques used conform to theory and practices of

organizations in developed countries and to determine how firms and CEO characteristics

influence the use of a particular technique.

She intended to conduct the study on 54 Companies listed at the NSE but the analysis

included only 43 Companies whose annual reports and accounts were available. Of these,

only 28 Companies responded of which 50% were small companies and 50% large

companies. Data was collected through questionnaires.

Data was analyzed using SPSS and was put into frequency distribution tables. Chi-square

test was used to test relationships between techniques and firm characteristics. The

findings of the study were that 31% of the companies used Payback Period method, 27%

use NPV while 23% uses IRR. According 71% of respondents, their companies

considered capital budgeting process a strategy for achieving competitive edge

advantage. Another finding of the study was that small companies use IRR and Payback

Methods while large Companies with high net profit margins use NPV, IRR and Payback

Period methods.

This study is consistent with the survey done by (Graham & Harvey, 2002) who found

that large firms favored the sophisticated techniques of capital budgeting while the

smaller firms favored the traditional methods of payback and ARR. The issue of capital

budgeting techniques being used as a strategic tool for benchmarking and gaining

competitive edge was imminent in the study and we concur with the findings.

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(Njiru, 2008): A survey of capital investment appraisal techniques used by commercial parastatal in Nairobi.

The study’s objective was to identify the most commonly used capital investment

appraisal technique by commercial parastatals and determine the factors that influence

the choice of capital investment appraisal technique used by commercial parastatals. It

covered all commercial parastatals with headquarters in Nairobi and was for the period of

5 years between 2003 and 2008. The researcher used the survey method. He asked

questions about capital investment appraisal technique used in the organizations and

explored factors considered by the parastatals in making these decisions. He used

questionnaires consisting of both closed and open-ended questions.

Interpretation and analysis of data was done using the statistical package for social

science (SPSS). Out of the 30 parastatals targeted, only 20 responded which was a

response rate of 67%. Descriptive statistics, in particular, arithmetic mean and standard

deviation were used to interpret responses to the questionnaires.

The analysis revealed that on average, the annual size of capital budget is 1.4% of the

total asset base of the organizations studied. This implies a low intensive capital

investment during the study period (2003-2008). The study also found that all the

parastatals had a capital investment policy.

The results showed that incorporating risk, determination of the appropriate discount rate

and incorporating inflation in the capital investment analysis were the three main

challenges that parastatals faced in the capital investment appraisal process.

According to the study, the three main capital investment appraisal techniques used by

commercial parastatals are IRR (65%), NPV (25%) and pay-back period technique

(10%). The amount of funds required for the capital investment, size of the organization,

government policy and industrial practices are the main factors that influence the choice

of the capital investment appraisal technique. Further the study found that 75% of the

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respondents preferred discounted cashflow (DCF), 10% non-discounted cashflow (DCF)

technique whereas 15% did not respond.

(Grinstein & Tolkowsky, 2004)): The Role of the Board of Directors in the Capital

Budgeting Process - Evidence from S&P 500 Firms

Grinstein and Tolkowsky (2004) carried out a Survey to determine the role of the board

of directors in capital budgeting process. The study was carried out in the United States

of America. The sample consisted of “S&P 500” firms and covered the period from 1995

to 2000. Their final sample consisted of 2,262 firms after excluding financial institutions

due to their special governance regulations and requirements and a further 292 firms for

whose proxy statement information was not obtained.

They used several financial and governance variables to characterize what determines the

establishment of the capital budgeting committees which included firm size, board

structure and the ratio of number of independent directors to total number of directors.

They used both univariate and multivariate data analysis methods in their survey. The

findings were that 17% of the boards of directors of the sampled firms disclosed that they

establish committees that have a capital budgeting role. The study revealed that boards of

directors have four main roles in capital budgeting. These roles include reviewing of;

annual budgets, large capital expenditure requests, merger and acquisition proposals and

performance of approved projects. They found that committees that review budgets and

capital expenditure requests perform a monitoring role which is consistent with existing

theories.

They also found that boards are more likely to establish special committees to perform

these tasks where the auditing costs are low and when the overinvestment problem is

severe. Some committees have an advisory role in capital budgeting process. The main

finding of the study was that boards of directors have a dual role in capital budgeting

process, that is the disciplinary role and the advisory role.

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In our opinion, the findings of this study are very relevant, and the role of the board and

that of management should be clearly spelt out in the capital budgeting process of most

firms. It is evident that to reduce agency conflict, the board needs to play a more active

role in the approval of major capital projects.

(Pradeep & Quesada, 2008): The use of Capital Budgeting Techniques in Business: a perspective from the Western Cape.

Pradeep and Quesada (2008), in a study on the use of capital budgeting techniques in

businesses in the Western Cape Province of South Africa, investigated a number of

variables and associations relating to capital budgeting practices. The sample consisted of

600 firms but only 211 interviews were conducted successfully giving a response rate of

35%.

A descriptive approach to the research finding was adopted. Chi-square test technique

was used to measure association between variables. Data analysis was carried out using

SPSS software.

The results revealed that payback period followed by NPV appear to be the most used

method across the different sizes and sectors of businesses. 39% of respondents used

Payback period technique while 36% used NPV. 28% of respondents used internal rate of

return and profitability index. 22% of respondents used Accounting rate of return while

10% did not use any capital budgeting technique. The study also revealed that 64% of the

business surveyed used only one method of capital budgeting while 32% used between

two and three different techniques to evaluate capital budgeting decisions. The more

complicated methods such as NPV and IRR were favored by large businesses compared

to small businesses.

The findings of this study are contrary to earlier studies by (Graham and Harvey, 2001).

The finding that most firms prefer Payback period to NPV is a pointer to other behavioral

factors like use of intuition, fear of failure and resistant to change.

CHAPTER THREE

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3.1 RESEARCH METHODOLOGY

3.1.1 Hypothesis

We will formulate a hypothesis based on the relationship between use of capital

budgeting techniques in investment and profitability of the firm.

3.1.2 Research design

The study will use a cross sectional design. This is a study done at a particular point in

time.

3.1.3 Population

The study will focus on all the energy parastals in Kenya. The study will cover a period

of 5 years from 2004-2008.

3.1.4 Sample selection

Sample is the energy parastals in Kenya. The study will use probabilistic

techinique.Total no of company’s to be analyzed will be 4 firms.

3.1.5 Data collection.

The study will use primary sources of data namely interviews but incase of unavailability

of interviewees, questionnaires shall be used. It shall focus on 4 main energy parasatals in

Kenya. The information will be got from CFOS and staff from the finance department.

3.1.6 Data analysis

Questionnaires will be edited and relevant questions coded for ease of analysis. Statistical

package for social sciences (SPSS) will be used to analyse the data.

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CONCLUSIONS AND UNRESOLVED ISSUES

4.1 Suggested Study Areas

Although the area of capital budgeting has been studied widely and various

recommendations made on the most preferable methods, there is still a lot that needs to

be done. The area of real options in capital budgeting, though explored quite widely, has

not been studied locally and this will form very good grounds for a local study.

In their study, Li and Johnson (2002) concluded that although some recent studies

recognized the potential of real options theory in evaluating strategic IT investment

opportunities, they believed that the applicability of various real options models should

be scrutinized under different scenarios. Standard real options models assuming

symmetric uncertainty in future investment payoffs cannot be directly applied to the

shared opportunities because of the competitive erosion. With the presence of potential

competitive entry, real options analysis should balance the strategic benefit of preemptive

investment and the value of the option to wait. IT switching cost is another important

factor that must be considered when conducting real option analysis.

As high IT switching cost or technology locking is very common in the digital economy,

decision makers should pay more attention to the technology uncertainties. Since the

dynamics of the technology competition and standardization play an important role in IT

investment decision, more studies should be done to incorporate it into the real options

based decision-making process. Further real options analyses should be conducted to

explore the functions of open standard and technology interoperability in fostering IT

investment.

According to Grinstein & Tolkowsky (2004) most studies on the role of the board of

directors in capital budgeting have focused on the disciplinary or monitory role of the

board of directors. The advisory role of the board of directors is under explored. Studying

capital budgeting mechanisms that have both features is an important topic for future

research.

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The relation between firms’ investment risk characteristics and the choice of capital

budgeting method has also not been previously explored. There is also need to conduct

research on an evaluation of project success against capital investment appraisal

technique used. Studies to determine if a relationship exists between capital budgeting

practices adopted by firms and profitability also need to be conducted.

4.2 Conclusion

Despite a strong academic preference for NPV, surveys indicate that managers prefer

IRR over NPV. Volkman (1997) found that most companies apparently find it easier to

compare investments of different sizes in terms of percentage rates of return than by

amount of NPV. However NPV remains the more reliable reflection of long-term

investments value to the business. IRR, as a measure of efficiency may give better

insights in capital constrained situations though when comparing mutually exclusive

projects, NPV is appropriate. Other techniques such as Payback, Profitability Index and

Accounting Rate of Return(ARR) though not so robust as compared to both IRR and

NPV may find some meaning in context of simple evaluation of capital budgeting.

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