Using the attached and the unit reading assignment, explore the capital budgeting techniques covered in the unit,
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Using the attached and the unit reading assignment, explore the capital budgeting techniques covered in the unit, NPV, PI, IRR, and Payback. Compare and contrast each of the techniques with an emphasis on comparative strengths and weaknesses. Be sure to show you understand how each is applied and used in capital budgeting decisions. Use Microsoft Word to complete your answer. Your paper on comparing techniques should be no less than two pages and any references should be cited using proper APA format.
Global Conference on Business and Finance Proceedings Volume 10 Number 1 2015 CAPITAL BUDGETING PRACTICES OF FIRMS: EMPIRICAL EVIDENCE FROM GHANA Paul Kofi Oppong-Boakye, Kwame Nkrumah University of Science and Technology Emmanuel Addai, Kwame Nkrumah University of Science and Technology ABSTRACT This study examines capital budgeting practices of firms in Ghana. The main aim of this study is to ascertain the capital budgeting techniques used by companies in Ghana. The study reveals that approximately 63% of companies in Ghana use more than one technique in capital budgeting analysis. 84% of the companies that adopt multiple techniques for the purpose of investment appraisal use the combination of net present value and the pay back period while the remaining 16% use the combination of net present value, internal rate of return and the pay back period. None of the companies in the study uses the accounting rate of return or the accounting rate of return in conjunction with other techniques. KEYWORDS: Capital Budgeting, Ghana INTRODUCTION Capital budgeting is a key issue in corporate finance. With limited credit and other sources of financing in today's uncertainties and challenging economic environment, the need to carefully evaluate the profitability of proposed capital investments is more important. Its importance is derived from the fact that the primary goal of every management of an organization is to maximize the wealth of its shareholders. According to Brigham and Ehrhardt (2008) capital budgeting is the decision process that managers use to identify those projects that add to the firm's value. Funds should therefore be made available for any project that promises returns in excess of an appropriate risk-adjusted required rate of return. (Denzil and Head, 2010). An appraisal system which leads to failure to apply resources to areas which provide a return less the cost of capital results in an opportunity loss (Arnold, 1998). To avoid such a situation, firms use a variety of capital budgeting techniques to evaluate investment projects. Popular among these techniques are payback periods (PBP), internal rate of return (IRR), net present value (NPV), discounted payback period (DPP), profitability index (PI), and accounting rate of return (ARR). Financial managers and academics have not been in full agreement as to the choice of the best capital budgeting method (Ryan and Ryan, 2002). Text books tend to emphasize the NPV rule, often arguing that it is theoretically superior to other methods (e.g. Zimmerman, 1997). On the contrary, surveys on capital budgeting practices across the globe especially in the U.S and the U.K have proved otherwise. Several research works have been done to determine the technique firms' use in evaluating capital investments in the developed economies such as the U.S and the U.K. However, much has not been done to determine which techniques firms in developing countries such as Ghana use in evaluating their capital investments. This study of capital budgeting practices of some selected manufacturing companies in the Kumasi Metropolis was therefore carried out to determine which techniques firms in Ghana use in evaluating capital investments as well as assessing the risk of major investments. LITERATURE REVIEW Brigham and Ehrhardt (2002) defined capital as the operating assets used in production. Whiles they defined a budget as a plan that details projected cash flows during some period. Capital budgeting is broadly defined as the systematic evaluation of how much capital to invest in a project or assets and the specific assets companies should use to meet their investment objectives (Cubbage and Redman, 1985). Capital budgeting GCBF Vol. 10 No. 1 2015 ISSN 1941-9589 ONLINE & ISSN 2168-0612 USB Flash Drive 213 Global Conference on Business and Finance Proceedings Volume 10 Number 1 2015 decisions are unavoidable if managers want to meet the primary goal of maximizing shareholders' wealth. There are several sequential stages in capital budgeting process. For most large firms, the investment process starts with the preparation of an annual capital budget (Brealey, Myers and Allen). Maccarrone (1996) argued that capital budgeting should be held in the wider context of strategic planning. Because capital investments are so important to the success of the organization, most companies have formal policies of guiding the decision process (Seitz and Ellison, 1999). Several methods or techniques are used to rank projects and to decide whether or not they should be accepted for inclusion in the capital budget. The payback period (PBP) method is described as the first formal method used to evaluate capital budgeting projects (Brigham and Ehrhardt 2002). Van Horne and Wachowicz (2005) defined payback period as the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflows. Many reasons have been cited for the use of payback method. Seitz and Ellison (1999) stated that simplicity was one reason for the popularity of the payback method since it could be easily established. They further argued that payback period was also used as a measure of risk. Managers often believe that the longer it takes to recover the original investment, the more chances there are for something to go wrong. One the contrary, the payback has been described as theoretically irrelevant and mistaken because it ignores the time value of money and cash flows beyond the cutoff point. Surveys such as that of Graham and Harvey (2001) found that 52% of firms in the U.S used PBP to evaluate capital investments whiles in the U.K, it was found that 63% of the firms also used PBP to evaluate capital investments (Drury and Tayles, 1996). Some firms use a variant of the regular payback , the discounted payback which is similar to the regular payback except that the expected cash flows are discounted by the by the project's cost of capital. According to Bhandari (1989), by accounting for the time value of money and objective decision rule the discounted payback period (DPP) overcomes the two serious limitations of the PBP. According to Drury and Tayles (1996), 42% of firms in the U.K used the DPP technique to evaluate their investments and Graham and Harvey (2001) also found that in evaluating investments in the U.S, 29.45% of firms also used the DPP technique. Ross, Westerfield and Jordan (2000) defined discounting as the process of valuing an investment by discounting its cash flows. The main discounting techniques are the net present value (NPV), internal rate of return (IRR) and the profitability index (PI). These methods incorporate the concept that money has an opportunity cost and time value of money. Van Horne and Wachowicz (2005) defined NPV of a project as a present value of an investment net cash flow minus the project's initial cash outflow. The NPV is seen by most researchers or authorities in finance as the most desirable capital budgeting technique. Under the NPV rule, it is expected that projects with net present value equal to or more than zero should be accepted; if not it should be rejected. The NPV approach assumes that a firm correctly estimates incremental cash flow from each of the available projects, discounts cash flow of each project using a discount rate that corresponds to the risk associated with each project, and accepts all projects with positive NPV (Mukherjee and Henderson, 1987). Unlike the PBP and the DPP criteria, the NPV considers the time value of money and all cash flows throughout the lifespan of the project. The NPV is considered the most desired technique because it is able to tell whether the investment will increase the firm's value and also considers the risk of future cash flows through the cost of capital. Notwithstanding the strength of the NPV criterion, it requires an estimate of the cost of capital in order to calculate the present value which might be very difficult exercise. Another discounting technique, IRR has been described as the most important alternative to the NPV. It is defined as the discount rate that results in a net present value of zero. The internal rate is the rate earned on money committed to a capital investment and is analogous to interest rates generally quoted in the financial market place (Seitz and Ellison, 1999). They pointed out that, IRR states the profitability of an investment in terms that are generally familiar to managers whether or not the managers have strong financial GCBF Vol. 10 No. 1 2015 ISSN 1941-9589 ONLINE & ISSN 2168-0612 USB Flash Drive 214 Global Conference on Business and Finance Proceedings Volume 10 Number 1 2015 background.According to the IRR rule, an investment should be accepted if its IRR is higher than its cost of capital and should be rejected if it is lower. Gitman and Forrester (1997)'s research based on a survey on 268 U.S firms, found that the IRR was the most popular technique at that time. His finding was supported by a similar survey conducted by Scott and Petty (1984) for large firms in the U.S A project's profitability index (PI), another discounting technique, is equal to the ratio of the present value of its expected cash flow stream. The profitability index is a benefit-to-cost ratio because it is the ratio of the benefit derived from the investment (the present value of its expected cash flow at the cost of capital) to its cost (the initial outlay). According to the profitability index rule, a project should be accepted if its profitability index is greater than one and rejected if it is less than one. The accounting rate of return (ARR), also known as Return on capital employed (ROCE) or return on investment (ROI) differs from other evaluation techniques in that, it focuses on accounting profit rather than cash flow. It is defined as the ratio of average accounting investment. The ARR indicates a company's efficiency in generating profit from its assets base. To make an investment decision, the accounting rate of return is compared to a standard, such as the existing average accounting return on the company's assets, or to the company's target accounting return on investment A central aspect of capital budgeting theory is the concept of risk. Risk is generally defined as any possible deviation of cash flows from the expected or most likely estimate. In the context of investment appraisal, risk refers to the business risk of an investment, which increases with the variability of expected returns (Denzil and Head, 2010). There are several methods of assessing risk and of incorporating risk into the decision making process. A more common way of assessing the risk involved in a project is sensitivity analysis. This is a way of assessing the risk of an investment project by evaluating how responsive the NPV of the project is to changes in the variables from which it has been calculated (Denzil and Head, 2010). Sensitivity analysis can only provide an indication of what will happen if deviations from expectation occur; it does not provide an indication of the likelihood that such errors will occur Another way of considering the risk of a project is simulation analysis. Simulation analysis is a risk evaluation technique in which a large number of computer trials are taken to derive a distribution of the expected return of an investment project and a possible variability of that return. The overall objective of simulation is to obtain the expected return of a project and an indication of the variability of that project (Hertz, 1964). There is a very low level of the use of simulation analysis. Drury et al. (1993) found out that, more than 95% of companies rejected simulation analysis Another more sophisticated way that has been suggested to take risk and uncertainty into account is to specify distributions of possible outcomes for each variable, assign subjective probabilities as to the likelihood of these probabilities occurring and then calculate an 'expected' value from this distribution by multiplying each outcome by the probability of its occurrence. According to Denzil and Head (2010), the risk of an investment project can be examined in more detail by calculating the probability of worst case and the probability of failing to achieve a positive NPV. Another ways of assessing risk of an investment project is to raise the required rate of return or shorten the payback period. Other methods such as CAPM (also known as beta analysis) and subjective or managers' intuition are also used. The most important, but also difficult step in capital budgeting is estimating project cash flows. It is vital to identify the relevant cash flows, defined as the specific set of cash flows that should be considered in the decision at hand. Brigham and Ehrhardt (2008) identified two cardinal rules that can help one to minimize the mistakes that are likely to be made in the estimation of cash flows. They were of the view that capital budgeting decisions must be based on cash flows, not accounting income and only incremental cash flows should be seen as relevant. Poor estimation of cash flows will result in poor decision irrespective of the model being used. Included in the cash flow estimation is opportunity cost and interest expense. In a sophisticated capital budgeting exercise given unbiased estimates of cash flows, the only remaining task in computing the NPV is to choose an appropriate discount rate reflecting the project's risk. Using of the proper discount rate depends on whether the benefit and cost are measured in real or nominal cash flows. To be consistent, the cash flows should match with the discount rate. The cost of capital is the GCBF Vol. 10 No. 1 2015 ISSN 1941-9589 ONLINE & ISSN 2168-0612 USB Flash Drive 215 Global Conference on Business and Finance Proceedings Volume 10 Number 1 2015 required rate of return on the various types of financing. Both the cost of equity and the cost of debt depend on the firm's debt ratio. The higher the debt ratio, the higher the financial risk and the greater the returns required by shareholders and bondholders. Cost of debt and equity are used to estimate the project's cost of capital. In practice, however, it is assumed that the cost of debt is less sensitive to changes in financial leverage than is the cost of equity. DATA AND METHODOLOGY using semi-structured questionnaires. The initial sample size was 35, but 30 firms showed their interest in the study by filling the questionnaires .The questionnaires were pre-tested removing biases from the study to ensure validity. RESULTS AND DISCUSSIONS Profile of Respondents Table 4.1 below depicts the profile of the respondents in the study. Table 4:1 Profile of Respondents in the Study Industry Wood Processing Paper Products Food & Beverages Steel Processing Pharmaceuticals Rubber Products Agriculture TOTAL Frequency 7 2 4 7 4 3 3 30 Percentage 21 7 14 24 14 10 10 100 Annual Capital Budget Size The study asked the firms to indicate the average size of the firm's annual capital budget. Although all the firms are large, the size of the annual capital budget did vary among the respondents. The size of the annual budget is shown on table 4.2 below. Table 4: 2 Annual Capital Budget Annual Capital Budget Up to GH 1 Million GH 1 Million - 5 Million GH 5 Million - 10 Million GH 10 Million - 15 Million GH 15Million -20 Million GH 20 Million or more TOTAL Frequency 3 14 7 3 1 2 30 Percentage 10 47 23 10 3 7 100 The response to these questions which indicate that 17 companies (56%) spent less Gh5million per annum on capital investment provides a good spread of the different size of the firms' annual capital budget. Estimation of Cash flows Regarding the estimation of cash flows, the respondents were asked to indicate whether they made an estimate of the cash flow they intend to generate from their capital investments. Unfortunately, this study does not query firms as to which methods they use to arrive at cash flows. Results on whether they estimate the cash flows of their projects are shown in figure 4.1. GCBF Vol. 10 No. 1 2015 ISSN 1941-9589 ONLINE & ISSN 2168-0612 USB Flash Drive 216 Global Conference on Business and Finance Proceedings Volume 10 Number 1 2015 Figure 4:1 Estimation of Cash Flows Estimation of cash flows 13% 10% YES 77% NO This study reveals that 23 firms representing 77 percent of respondents make an estimate of future cash flows while 4 firms representing 13 percent reported that they do not forecast cash flows. Three (3) firms representing 10 percent of respondents did not answer this question at all. Cash flows and Opportunity cost Opportunity costs are cash flows that could be generated from an asset the firm already owns, provided the asset is not used for the project in question (Brigham and Ehrhardt, 2008). Figure 4.2 gives a summary of the response given by respondents. According to the study, whereas 63 percent of respondents include opportunity cost in the project cash flow, 17% do not and 20% have no idea. Figure 4:2 Opportunity Cost Opportunity Cost 17% 20% 63% YES NO NO RESPONSE Cash flow and Interest expense One common mistake that firms make is to subtract interest expense when estimating project cash flow. This study attempts to find out whether firms in Ghana include or subtract interest expense from projects' cash flow. The study reveals that 70 percent of respondents included interest expense in the project cash flow. They opined that subtracting the interest expense from a project's cash flow amount to double counting interest cost since cost of debt is always embedded in the cost of capital used to discount the GCBF Vol. 10 No. 1 2015 ISSN 1941-9589 ONLINE & ISSN 2168-0612 USB Flash Drive 217 Global Conference on Business and Finance Proceedings Volume 10 Number 1 2015 project's cash flow. Contrary to the above, 10 percent do not include interest expense and 20 percent had no idea about this and therefore provided no answer to this question. Figure 4:3 Interest Expense Interest Expense 20% 10% YES 70% NO NO RESPONSE Capital Budgeting Techniques One of the main goals of this survey was to determine the capital budgeting technique(s) used by firms in Ghana. Several techniques are available to assist a firm in evaluating a capital budgeting project. The four most commonly cited methods are PBP, ARR, IRR and NPV. The respondents were asked to indicate the capital budgeting technique(s) normally used, including multiple techniques. Their response are summarized in table 4.3 Table 4: 3 Capital Budgeting Techniques Techniques Used ARR IRR NPV PBP ARR, IRR ARR, NPV ARR,PBK IRR, NPV IRR, PBK NPV,PBP ARR, IRR, NPV IRR, NPV, PBP ARR,NPV,PBP ARR, IRR, PBP ARR, IRR, NPV, PBP TOTAL No. of Firms 0 0 7 4 0 0 0 0 0 16 0 3 0 0 0 30 Percentage (%) 0 0 23.3 13.3 0 0 0 0 0 53.3 0 10 0 0 0 100 As summarized in the table above, approximately 63 percent (19 out of 30) of respondents said that they use more than one capital budgeting technique for evaluating their capital investment proposals. 84 percent of companies that use multiple techniques representing 53 percent (16 out of 30) of total respondents used both NPV and PBP to evaluate their investments. The other 16 percent of companies that use multiple GCBF Vol. 10 No. 1 2015 ISSN 1941-9589 ONLINE & ISSN 2168-0612 USB Flash Drive 218 2015 Global Conference on Business and Finance Proceedings Volume 10 Number 1 techniques representing 10 percent of total respondents relied on NPV, PBP and IRR. This result is consistent with the results of Verma, Gupta and Batra (2009) which reported that 90 percent of companies they studied were using more than one method for evaluating investment proposals. A survey by Farragher, Weiman and Sahu (1999) concluded that 78 percent of America companies used NPV while Graham and Harvey (2001) gave a similar result, reporting that approximately 75 percent of U.S companies also used NPV. This study on the other hand, reveals that approximately 23 percent (7 out of 30) of companies' surveyed use the NPV to evaluate projects. This result is also in conformity with theory which considers NPV as the superior capital budgeting technique. The study further reveals that 13 percent of respondent companies use the PBP as against 63 percent in Great Britain as reported by Drury and Tayles (1996). Surprisingly, none of the respondents used ARR or IRR or both as single or multiple capital budgeting technique(s) to evaluate their investments. But interestedly, three (3) companies representing 10 percent of respondents used IRR as supplementary technique to PBP and NPV when multiple techniques are used to evaluate projects. Use of Capital Budgeting Techniques Respondents were asked how frequently they use four capital budgeting techniques: PBP, NPV, IRR and ARR. The responses were on a four point Likert scale with the following alternatives: \"sometimes\
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