Capital budgeting techniques

Researches show that investment decisions which are made, no matter in large or small businesses are mostly dependant on Capital Budgeting techniques. According to Jones and Smith (1982), one of the first published works dealing with the use of present value calculations to assess nonfinancial investments was in 1887 by an American civil engineer concerned with the economics of railway construction (Jones and Smith, 1982). It is also seen that Fisher’s (1907) seminal work called ‘The Rate of Interest’ was the first work in the American economic literature to discuss net present value as a criterion for appraisal of alternative investments (Fisher, 1907). Capital Budgeting, frankly speaking is “the process of generating, evaluating, selecting and following up on capital expenditures” (Study Finance, 2007), or in other words “the planning process used to determine a firm’s long term investment”.

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According to Maccarrone (1996), capital budgeting has received an increasing attention over the last few years and further believes that most studies have focused either on the relationships between investment decisions and financial theory or on behavioural aspects of Capital Budgeting (Maccarrone, 1996). Also looking at the research paper by Fourcans (1987), where he says that the capital budgeting process is of critical importance to the success of all multinational companies, it can be judged that capital budgeting plays a vital role for any management decision that takes place amongst the organization. There are also glimpses of risk and uncertainty involved while using the capital budgeting techniques in the research by Fourcans (1987) which shows an understanding that businesses while using these techniques do take certain amount of risks for the answers to turn out to be in-accurate in nature (Fourcans, 1987).

As mentioned before, majority of investment decision which take place are mostly backed up by capital budgeting techniques, but in real life, not all companies follow the same type of techniques. The type of techniques they use sometimes depends on their size or on the position of the business in the market. In this report we will be looking at different business positions and list the type of techniques they use based on research. Also we will be looking at the risks and uncertainty involved in capital budgeting techniques because theories and researches suggest that quite a lot of time the results from capital budgeting are inefficient and in-accurate.

Technically speaking, every investment project is worth the go if the net present value (NPV) is positive, but according to Holmn (2005) this is not always the case. The NPV is computed by forecasting the project’s cash flow and discounting them at a discount rate that reflects the price charged by the capital markets for the risk of the cash flow. For investors with well-diversified portfolios, it is only the project’s systematic risk that affects its value: the project’s idiosyncratic risk should not be considered

Capital markets imperfections such as costly external financing and bankruptcy costs are mostly ignored when it comes to the way capital budgeting techniques are used (Holm�n, 2005). This reason is also backed up by Stulz (1999) who believes that there are certain aspects which are neglected while making decisions based on NPV (Stulz 1999). There is no doubt that NPV is the most commonly used technique, but there are also other alternates like payback period and use of earnings multiples that are used.

The payback is seen as perhaps the most seriously flawed method, because it ignores the time value of money and cash flows beyond an arbitrary cut-off date. Surprisingly, Graham and Harvey (2001) report that 57% of the CFOs (Corporate Finance Organizations) in their survey of US firms always or almost always use the payback method in capital budgeting decisions, compared to the 76% that use the NPV method (Graham and Harvey, 2001). The use of the payback method seems even more popular in Europe, as reported by Brounen, de Jong, and Koedjik (2004). They found out that the payback method is the most frequently used method among firms in UK, Germany, and France, and it is also very common in the Netherlands, where it is the second most popular method after the NPV (Brounen, de Jong, and Koedjik, 2004, pg 71-101).

As we saw previously in the report, different companies have different methods of using capital budgeting. If a company is large and is in a very stable position then they might consider using more complex techniques with higher expectancy rates. This is because they have the time to achieve what they budgeted for as they have more share in the market and can afford taking risk to a certain level. As mentioned in the research done by Holm�n (2005), it has been found out that mostly large companies prefer using the NPV method of capital budgeting rather than the other available methods (Holm�n, 2005)

Even the survey done by Ryan and Ryan (2002) proves that vast majority of large companies with more capital investments prefer using NPV and IRR (Internal rate of return) techniques. Patricia and Glenn’s research was done on the Fortune 1000 companies and amongst their research it was judged that 49.8% of large firms use NPV and 44.6% use IRR with the probability of using each more frequently being 85.1% and 76.7% respectively (Ryan and Ryan, 2002).

In the research paper by Ekanem (2005), it is said that small firms normally use the technique called ‘bootstrapping’ in making their capital investment decisions. Bootstrapping represents an approach to decision-making that is grounded in the previous experience of key decision-makers and their organisations and the largely informal routines that they develop from this. The concept of bootstrapping is not simply away of owner-managers finding a solution to a problem or a sort of ‘fire fighting’, it is a notion of what they are bringing to solve the problem, i.e. reliance on past experience (Ekanem, 2005).