Capital budgeting articles pdf

Capital budgeting is the process of making planning decisions for long-term investments Horngren et al. There is a number of technique commonly used to evaluate capital budgeting projects, i.

According to Kester et al. Other techniques, such as real options valuation have been indicated as having potential to enhance the understanding of impacts by handling uncertainties directly Tyler and Chivaka, Studies have shown that companies are reluctant to use real options valuation Peel and Bridge, ; Sandahl and Sjogren, ; Block, ; Hermes et al. What happens is that decision makers often have to choose among several options, based on various criteria, without a prevailing option for all criteria.

This is because the decision maker must not only evaluate each option and each criterion but also weigh the relative importance of each criterion before making the final decision Carmona et al. According to Kalhoefer , discussions about the best method to be used in capital budgeting have been long and intensive. A number of surveys have been carried out in developed countries worldwide offering an interesting view on capital budgeting practices Hermes et al.

Brazil and Spain were chosen due to several factors. On the one hand, Brazil is an emerging country, even though with poor infrastructure and deficient port systems in many aspects. On the other hand, Spain is a typical example of developed country, member of the European community, with efficient port services, ranking fifth in Europe. Another important aspect is the lack of works in port companies relating to capital budgeting.

Studies on ports are justified on the grounds that the ineffective practice of the many activities performed in a port affects directly the goods distribution process, the environment, and society, with an impact on the international trade and zones of influence. In order for ports to improve the efficiency of their operations it is imperative to invest their resources appropriately in projects that generate sustained growth in the medium and long term. Given the above, it is important to examine which capital budgeting practices are used in the Brazilian port companies, compared to the Spanish ones.

To meet the objective of this study, which is to examine the capital budgeting practices in Brazilian and Spanish port companies from a comparative perspective, this study presents, in addition to this introduction, an overview of capital budgeting techniques.

The third section consists of an exposition of the methodological procedures used in the research. The fourth section presents the results, and the fifth section contains the discussions and conclusions this work. Capital budgeting is the process of making planning decisions and analysis of opportunities for long-term investments in assets to produce benefits for more than one year Horngren et al.

The decisions made during the process of development and evaluation of capital budgeting determine the future growth and productivity of the company, and it helps to achieve greatest profitability Olawale et al. A core feature of any investment assessment is the use of discounted cash flow — DCF, which takes into account the time value of money and theoretically is considered the most appropriate method, including at least four different discount models: net present value NPV , internal rate of return IRR , modified internal rate of return MIRR , and the profitability index PI Brigham and Ehrhardt, Net present value — NPV is the present value of the cash flows discounted at the cost of capital less the initial investment effort Olawale et al.

The calculation of NPV requires the comparison between the present value of all cash inflows related to the project with the present value of all cash outflows.

IRR differs from the net present value method because it determines the potential return of the investment. The internal rate of return is the rate that will make the present value of the proposed capital outlay equal to the present value of cash inflows Gitman, ; Jackson and Sawyers, NPV is a popular technique for investment decisions because it is a financial measure that determines the time value of money invested in a business Peel e Bridge, IRR is a percentage rate that equates the present value of future cash flows with the present value of its investment expenditures Bennouna et al.

The profitability index is the expression of the ratio between the present value of the future cash flows and their initial cost Ross, The profitability index is determined by dividing the present value of each proposal by its initial investment Olawale et al.

Various methods for investments evaluation do not consider discounted cash flows. In the payback period, the time required for the organization to recover the capital invested is estimated. And the accounting rate of return is the accounting measure of profits divided by the accounting measure of the investment Horngren et al.

Real options are options built into real assets Brealey and Myers, This technique can be used as a complement to NPV, which then assumes a new value, i. The cost of capital is a key parameter for the calculation of DCF. The companies should preferably use the weighted average cost of various funds and sources, including the cost of debt, preferred stocks, and common equity Brigham and Ehrhardt, The weighted average cost of capital WACC is the required rate of return on any proposal of investment that has the same level of risk as the assets of a company.

In general, it is recommended that the companies use different rates for the projects of investment or for the units or divisions. When examining the market return, the company can develop different rates for diverse new investments, including projects outside their core business. Simple techniques include the adjustment of the discount rates and payback, and the sophisticated methods. The sensitivity analysis is a behavioral approach that uses a number of possible values for a given variable in order to assess its impact on the return of the organization.

The scenario analysis is used to evaluate its impact on the return of the organization, resulting from simultaneous changes in a number of variables Gitman, The decision tree is a tool used to identify uncertain cash flows Ross et al.

This technique consists of a diagram of sequential decisions and possible outcomes Brealey and Myers, The Monte Carlo simulation is a statistical method used in stochastic simulations with various applications and areas Hromkovic, According to Moore and Weatherford , the Monte Carlo simulation is one of the various methods designed to evaluate uncertainty propagation, and its advantage is to determine how an already known randomized variation, or error, affects the performance or feasibility of a project that is being modeled.

In addition to the correct use of the financial techniques, literature provides many recommendations for its management and other supports for decisions on capital budgeting. Preferably there should be a manual for capital budgeting Pike, , full-time people working on capital budgeting Klammer and Walker, ; Pike, , the use of standard model to determine NPV or IRR e. Table 1 shows a summary of the most usual methods and techniques of capital budgeting used by the companies and presented in studies analyzed in this research.

Among the works comprising budgeting in ports, we can cite the study performed by Lin and Yahalom in the Keelung Harbor about the integration between activities-based budgets and the balanced scorecard. This lack of studies, particularly in ports in developing countries, shows the importance of carrying out studies on capital budgeting in sea port companies.

In this section we present the methodological procedures used to build the theoretical framework, procedures for preparation of the questionnaire, and the selection process.

Process for construction of the Theoretical Framework — Proknow-C. The Proknow-C process, used for selecting and analyzing references, is divided into three phases: choice of databases, selection of articles, and systemic analysis Ensslin et al. The first phase provides the basis for the choice of databases; the second obtains a portfolio of articles from a structured process, and, the third provides the systemic analysis of the articles portfolio.

Based on this structure, we selected articles addressing the budget subject and published in the period of to To achieve such amount of papers, the phases and steps were performed sequentially. From this initial sampling, we read all abstracts in order to select the studies relating to the capital budgeting practices. The selected articles comprise the basis of the theoretical framework.

The questionnaire was developed based on the main features indicated in the literature review Segelod, ; Peel and Bridge, ; Graham and Harvey, ; Akalu, ; Brounen et al. Such main features mentioned in the literature are shown in Table 2. Based on the characteristics described in Table 2, we developed the questionnaire described below. The questionnaire has 11 questions which verified the use of the Capital Budget for the decision making processes at the port.

Initially, it identifies the utilization frequency of the capital budget assessment techniques, using the Likert scale of 05 levels between never and always. The next question is on the techniques used by the port to define the minimum expected rate of return for a new investment, using a list of possible techniques in which the respondent has multiple answer options.

The third question identifies if the port uses the same rate for all of its investments with dichotomous answer option yes or no. The forth question aims to identify the technique used for holding risk analysis using a list of possible techniques, by Likert scale of 05 levels between never and always. The fifth question aims at investigating the relevance of the used measure s by the port manager in the investment process in which the respondent has multiple answer options.

The sixth question identifies the investment percentages for three categories: port maintenance, existing application, and expansion. The seventh answer is dichotomous yes or no , and aims at identifying the direct participation of the members in charge of the analysis and decisions about investment. Pike and Neale and Arnold now provide diagrams that illustrate the multistage nature of investment decision-making in firms.

Kester and Robbins conducted a survey of CFOs of listed companies on Irish Stock Exchange on capital budgeting techniques used by Irish listed companies.

The results found that they use DCF methods, and NPV was the most popular measure for capital budgeting decision, followed closely by PB, and IRR was ranked third, also mentioned that ARR was the least important technique according to the respondents.

Scenario analysis and sensitivity analyses were perceived to be the most prevalent tools for incorporating risk. The respondent executives also indicated that they use a single discount rate based on weighted average cost of capital WACC that was the most widely accepted method used for calculating discount rate.

On the other hand, Lazaridis studied capital budgeting practices in Cyprus, and PB was found to be the most prevalent method, but not NPV. Shinoda conducted a survey focusing on capital budgeting practices in Japan taking sample data from companies listed on the Tokyo Stock Exchange.

The results found that Japanese firms manage their capital budgeting decisions by a combination of PB and NPV methods. The capital budgeting techniques used depend on the subject and situation. Effective decision-making with regard to capital budgeting requires a more multifaceted approach to the issue of capital budgeting methods rather than rigorous academic theory. Over the past two decades, very few studies have been conducted on the capital budgeting practices in the developing countries.

Compared to developed countries, the results of most studies show inconsistencies. In most developing countries, the PB method was the most popular method in evaluating investment projects. Kester et al. The rate of capital asset pricing model CAPM is more used in Australia compared with other countries considered for the adjustment of risk. Hermes et al. In total Small firms used cost of debt CD most often In contrast, However, Primarily payback was the most widely used tool, while real options were used relatively little.

Finally, they found that the relevance of growth opportunities and flexibility was an important factor in explaining the use of real options. Similarly, WACC is estimated using target value weights, and capital asset pricing model with extra risk factors is used to determine the cost of equity capital.

For risk assessment, sensitivity analysis and scenario analysis are the dominant approaches; however, despite the theoretical superiority, the use of real options is very low. Baker et al. Few of the responding firms use real options when making capital budgeting decisions. They tend to use less sophisticated techniques to evaluate investment opportunities and calculate the cost of capital than their counterparts in developed countries.

The most frequently used techniques by Chittagong Stock Exchange-listed companies to estimate the cost of equity capital are the CD plus equity risk premium and the accounting return on equity. Alleyne et al. The study suggested that firms in Barbados are not likely to use capital budgeting practices in project selection. Majority of respondents list the PBM as the preferred capital budgeting method to be used owing to simplicity, ease of calculation, possibility of less effort and agility of the methods.

While there are no statistically significant differences in the capital budgeting practices used in different sectors, professional accountants are more likely to use NPV and sensitivity analysis than nonprofessional accountants. Nurullah and Kengatharan a conducted a comprehensive primary survey of 32 out of 46 CFOs of manufacturing and trading companies listed on the Colombo Stock Exchange in Sri Lanka.

Similarly, for incorporating risk, sensitivity analysis was considered as the dominant capital budgeting tool, and the most preferred method for calculating cost of capital was the WACC. Moreover, results stated that the use of the capital budgeting methods NPV, IRR and PB and incorporating risk tool were sensitivity analysis and simulation influenced by size of the capital budget. Andor et al. The same is true for calculating the cost of capital and the use of CAPM.

Surprisingly, study revealed that even though advanced capital budgeting practices including DCF, sensitivity analysis and real options are available, still top management can reject a handsome project that was once chosen based on DCF methods owing to several other factors such as ethical and moral considerations, financial resources scarcity, strategic fit, trust in the analysts or reliable sources of data.

Bennouna et al. The result shows a theory-practice gap remains in the detailed elements of DCF capital budgeting decision techniques and in real options. Khamees et al. The results revealed that respondents do not depend on a single technique. De Souza and Lunkes investigated the use of capital budgeting practices by large Brazilian publicly traded companies.

Batra and Verma examined responses from 77 Indian companies listed on the Bombay Stock Exchange. Their evidence reveals that corporate managers largely follow the capital budgeting practices proposed by academic theory. Managers also favor WACC as the cost of capital. Yet, the theory-practice gap exists in adopting specialized techniques of real options, modified internal rate of return MIRR and Nurullah and Kengatharan b simulation. Managers also consider nonfinancial criteria in selecting projects.

The nature of this study allowed for the use of an explanatory sequential mixed method design, by collecting quantitative data and to further explain it using qualitative research.

This allowed for the researchers and end users of the final report to be provided with general data and also enabled them to develop a greater understanding of the reasons for the decisions Creswell, For this reason, open-ended questions were also included within the survey instrument.

The reliability of the responses from the survey phase was tested with follow-up interviews. These interviews were scheduled and used to clarify issues and gather additional information regarding the reasons why the techniques practices documented within the questionnaire are not used and determine what techniques are being used.

This is an exploratory study using survey methodology to collect data regarding current practices of capital budgeting in Bangladesh. The questionnaire used to collect data was adopted from previous seminal studies Nurullah and Kengatharan, b. The questionnaires were sent to the top DSE companies in terms of market capitalization. The changes in capital budgeting procedures over the decades have been well documented in prior studies. The research of Canada and Miller, Fremgen, Gitman and Forrester, Kim and Farragher, Stanley Block all indicate that increasingly sophisticated capital budgeting procedures have been put in practice.

However, a generalization that more sophisticated practices take place across all industries is subject to investigation and challenge. This consideration is important because an analyst within a given industry may be intending on following industry norms but misled by general observation that relate to the studies cited above.

Just as there are different valuation procedures or financing norms between industries, there may also be different capital budgeting procedures.

Rosenblatt and Jucker and Scott and Petty summarize several of these surveys. They show that from to the use of techniques which recognize the time value of money i. A number of textbooks have similar concerns. Traditional capital budgeting techniques; The traditional capital budgeting techniques consists of payback period and accounting rate of return.

These two are the most common that many company uses The Payback Period Method: The payback can be defines as the time required for the cash inflows from capital investment project to equal the cash out flow. When deciding between two or more projects, the usual decision is to accept the one with the shortest payback. Payback is commonly used as a first screening method.

The specific approach to be adopted in the process of identifying the actual payback period will depend on the nature of the cash flow; i. Where the cash flow is evenly, the formula approach for payback period is appropriated, and it is defined as; Adeniyi i asserted that in spite of the theoretical limitations of the payback period method, it is the one that is most widely used in practice. He offered the following reasons for its usage: it is easily understood by all levels of management; it provides an insight on how quickly the initial can be recouped; most managers see risk as time-related i.

Accounting Rate of Returns: The accounting rate of returns technique for capital project is to estimate the return on investment that the project should yield. If the computed value of return on investment exceeds a target rate of return for a single project, it is advisable to undertake the project otherwise the project should be rejected.

But where multiple project proposals are being considered, the project proposal with the highest return on investment is the most viable. The accounting rate of returns ARR is defined as: Discounted cash flow: The discounted cash flow consist net present value, internal rate of return and profitability index. The modified internal rate of return also which is some companies use depending on certain circumstances. This technique ignores the impact of risk on project evaluation; divisional manager may not be comfortable by relying on the method for performance evaluation, because it is not a rate of return method; it may mislead the investor or firm because it does not represent the actual returns associated with the project; it over-relies on the accurate estimation of the market determined cost of capital.

The Internal Rate of Returns IRR technique: This is the discount rate or the cost of capital that will equate the sum of present values of a project to zero. It is the rate of discount in which discounted cash inflows and outflows of a project are balanced.

In other words, internal rate of returns is the maximum rate of interest a firm can afford to pay if a project is financed with borrowed funds and the project cash inflows are to be used to liquidate the loan.

It is equally the minimum rate of interest a lender is willing to accept for releasing fund to the borrower. Conventionally, if the internal rate of returns exceeds the prevailing rate i. These are the formula method and the present value profile method.

The companies that are small survive mainly on investment that can generate immediate liquidity and the major investment method that supports this idea is the payback method which also confirms T.

Lucy, observations. The valuation of managers has also motivated the use of payback method. From the article and personal judgment, managers are biased on the investments that generate immediate cash flows, because this is what their bonuses are attached to. The major reason for this kind of attitude is that most businesses are run on loan and overdraft. The exorbitant interest rate most especially in African Nigeria will make managers use appraisal method that consider liquidity first before profit.

The surveys indicated a clear trend towards the application of the more sophisticated discounted cash flow methods such as the NPV and the IRR. However, Shapiro, observed that the payback period still remains popular, especially as a secondary method to evaluate a potential investment project and this confirms the findings of this article.

The observation of Shapiro, confirms T. Luncy, on page that in spite of any theoretical disadvantages, payback is undoubtedly the most popular appraisal criterion in practice. In his article Kayali, argues that the pure usage of the traditional investment project evaluation metrics payback period, ARR, IRR, NPV assume that the management of a firm is passive, not reacting to any changes that may occur.

As more information about an investment project becomes available, management could revise the investment project. The above statement by Kayali suggest that the choice of investment project evaluation techniques depends on a number of factors, for example, the survey conducted in Nigeria shows how investment methods are combined together, it was observed that the payback method was often used, which accounted for The author failed to generalize the conclusion on how the methods are being usedintheAfricancountriessincebothsurveyconductedinAfricarevealedcontradictory rates i.

We can draw lessons from Kayali that some project evaluation requires combination of a number of methods to avoid conflicting results. Lucy, page acknowledged that numerous survey have shown that payback is a popular technique for appraising projects either on its or in conjunction with other methods.

The evidence o f the data from the South Africa survey has only shown when the payback period is used only as an investment appraisal and the author could not conclude based on that because if the payback period is considered as additional method the percentages would have been higher. In addition to financial evaluation methods for project appraisal discussed by the author in this article, the evaluation of investment projects should also consider criteria of a nonfinancial nature.

However, as these criteria are mainly intangible, it is hard to value them in financial terms making it difficult to determine their effect on the success or failure of investment projects.

These criteria are difficult to quantify and to measure Ansari, It is apparent from the surveys shown in Exhibit 9. The study of Pike indicates a trend in the increasing usage of discount rates.

The Drury et al, study suggests that larger organizations use net present value and internal rate of return to greater extent than the smaller organizations. The Dry et al. The lager organizations ranked internal rate of return first followed by payback and net present value where the smaller organization ranked payback first, internal rate of return second and intuitive management judgment third.

Based on these past research findings, managers should complement payback method with other methods in order to make a sound investment decisions. This suggests that there are areas in which work presented here can be advanced and improved upon.

One such area is to extend the sample size as only two countries were tested in each of the three continents. This thesis has focused on only corporate manufacturing firms and ignored the small firms and other industries. This suggests several areas for additional work. One such area is investigating of other firms rather than manufacturing with a bigger sample size. Though this is a limitation of this study but it is not thought to colour the results presented.

Conclusion In conclusion, putting all these analyses together, it is evident that companies prefer the use ofpaybackmethodandalsotheempiricalanalysesindicatehowthismethodhasgained patronage among other investment methods in the industry.

The analysis show that the payback method is preferred in appraising capital budget decisions in various organizations because of its simplicity, liquidity and risk assessment among many other advantages.