CAPITAL BUDGETING ANALYSIS AND USES
Introduction
The present
business report of
capital budgeting includes
a brief literature review,
objectives of the
report, methodology and
the techniquies applied, a
detailed description of the
research process and
all other relevant
details for the
study of report
Introduction
The decision of
capital investment has
always been very
crucial as the future
performance of the organization depends
on the decision
made today. This report plays a greater role in
understanding the accounting related to the analysis of the organization to
prioritize the investments made by the organisations, which also helps the
decision makers to correctly make a decision of investments. The research
conducted here helps us understanding the concept of capital budgeting in
detail as well as practically. This research illustrates the use of capital
budgeting in Australia. Based on the extent of change that takes place in
business and the change in the uses of capital budgeting academically, we here
have tried to learn the concept of Capital Asset Pricing Model and the
developments that took place and which affected the Australian Prectise.
A Brief Literature Review
The study stated that 62% of
the companies used WACC to find out the hurdle rate while using the capital
budgeting technique. However, the other companies stated that they use
borrowing of cost to determine the hurdle rate while using capital budgeting
technique. It was confirmed from one international study that about 73% of the
companies used DCF and CAPM models while using the capital budgeting technique.
Many surveys that took place in Australia revealed that the use of techniques
like IRR and NPV which are based on DCF and the NPV techniques are becoming
more popular while estimating the cost of capital. ( Literature Review on Capital
Budgeting Studies, N.D. )
Objectives of the Study Conducted
The main objective
of capital budgeting
is to support
financing decision, dividend decision and
investment decision. In
investment decision the prime focus in on the long-term investment decision. NPV
contributes a lot in increasing the shareholder’s wealth; this was confirmed by
the research made. With the help of capital budgeting technique, we come to
know about the classification of the project for investment decision making. It
also helps us identifying the financial appraisals out of the project. The
research undertaken also helps us comparing the projects for the investment
required and the financial appraisal. This way, the study helps us making wise
decisions. The research undertaken helps us understanding the techniques deeply
like NPV, IRR, PVP, Payback method and other tools also.
Research Questions
The
research questions included in the study related to capital budgeting
techniques are as follows.
1.
The ways in which the capital budgeting techniques would be used to take
any decisions regarding the investments to be made in the project.
2.
Comparison of different projects which are based on the financial
appraisals and which are in turn based on the technique of capital budgeting.
3.
The use of the tools of capital budgeting like NPV, IRR, DCF and few
others.
4.
How WACC is used, the importance of WACC and use of WACC to compare the
return on investments.
5.
The use of capital budgeting technique to support the organisation in
managing the important projects and profitability of the organization.
6.
The use of capital budgeting techniques to analyse the projects and its
use to evaluate various aspects of the project. The use of simulation in while
applying capital budgeting technique.
Description of Research Process
Capital
budgeting is considerable as a key factor for evaluate the finance
of the company as it decision making process for the
organization and from
this organization can evaluate
the future projects which need to
begin or reject. The study showed the most often used
method by different companies in Australia was NPV method as NPV method is
useful to assess the benefits and costs of the project. However, it was also
noticed that pay back method was also widely used among the companies and for
the projects having life of 3-10 years. CAPM technique was used by many firms
but only when there was a risk factor in project. Many researches and studies
were conducted in order to have the idea about the most commonly used capital
budgeting method. The surveys revealed that discounted cash flow method was
highly used with NPV method more than IRR. Most
of the organizations
for the calculation
of cost of
capital uses CAPM
method but there is
an another popular
method used for
the same and
that is weight
average cost of
capital (WACC). It can be seen that there are many methods to analyze
and assess the project for viability of the same and to find out present value
of the cost of capital of the investments made. From the above study, we have
found out the most popular as well as most relevant method used by different
organizations in Australia. Many surveys conducted by different people in
Australia in previous years revealed that DCF technique of evaluating the
project was the most popular technique among different companies in Australia.
A questionnaire was prepared to analyze the capital budgeting techniques used
by different companies and 8 different methods were included in the
questionnaire. The questionnaire
was then offered
to the organization
to tick the
method the apply.
It was found by the analysis of the questionnaire received that no
company depended on only one method to analyze the project, while every company
used different technique to evaluate different projects.
Sampling and Sample Size:
Sampling
is selection of population for the purpose of conducting analysis. In sampling,
different companies based on specified criteria are selected and then analyzed
in order research a specific problem or specific behavior related to some
circumstances. Selection of different companies forms every field and analyzing
their preference or opinion or practices carried out by them would lead us to
proper conclusion of the problem we are searching for. Sample i.e
company are selected
in such a
way that companies
of all different types
are in the
sample i.e. companies possess
different patterns with regard to turnover, investment, capital and other
features related to the projects to be undertaken or any other area. Hence, it
can be said that different companies have different characteristics with regard
to the project to be undertaken. We know that if companies being researched are
similar in nature, the sampling would not be effective and we may not reach to
the conclusion we researched for.
Presentation of data
The
most important part of the research is the database. It
should be in
line with the
research and the
objective decided initially.
Questions
related to the preparation of database are highlighted below.
1. The
technique mostly used by the organizations regarding capital budget.
2. The
methods that reveal the results according to the actual gain from the capital
budgeting technique.
3. For
which industries the capital budgeting techniques are most useful.
4. The
means of improving the value of cost of capitals of the investments.
5. The
techniques that are most useful and relevant in capital budgeting.
6. The
projects the industries are interest to take over.
7. The
provision of effects of tax for calculation of capital budgeting.
8. The
importance of time value of money in the projects undertaken in future.
Data Collection and analysis:
Data
is like raw
material for research
so data should
be properly collected
as it serves
the purpose of
research and proper
analysis could be
made with the
use of such
data. As many of
the projects countinue
more then one
year and so
their earnings and
expenses , organizations are
increasingly using capital
budgeting technique for future
projects. To conduct the research, most of the data was collected from online
sources and after conducting the study, it was revealed that CAPM was the most
useful and mostly used technique. IRR and NPV were mostly used methods to
understand the project possibility. Most of the companies used more than one
technique to analyze the project feasibility and they used NPV or IRR method.
Conclusion
From the above research, it can be
concluded that there is increased use of the technique capital budgeting to
analyze the projects before starting with any project. It is concluded form the
survey that companies mostly use NV and IRR method with DCF technique to
evaluate the projects to be undertaken. Apart from the study conducted, it can
be said that there is no specific method which is applied by the companies to
evaluate the projects they plan to undertake. Timings of cash inflows and
outflows were also the important part to deal with as DCF technique takes into
consideration the time value of money factor.
Chapter 2-Literature Review
The study of the literature review
includes review of the business review literature, usage of capital budgeting
techniques in different ways, importance of WACC and break even analysis as
well as analysis of scenario and simulation. It also includes importance of
capital budgeting to manage the projects with profitability. Lastly, the study
includes the conclusion of the literature review.
Introduction to Literature Review:
Capital
budgeting is the topic related to managerial skills. The topic focuses on IRR,
NPV and the usage of payback period and other techniques. There were many
studies conducted on the capital budgeting topic and also many studies are
being conducted now to analyse the important as well as use of capital
budgeting methods. The different studies undertaken by different people were
Gitmen and Forresters(1977), the Porwal’s(1976), Graham and harvey’s(2001) and
many more. The wealth maximization
purpose of the depends upon many factors like the investments to be made in the
project. It holds importance and it needs to be evaluated keeping in mind other
factors.
Usage of Different Techniques in Capital Budgeting:
As per
Alan’s analysis in the year 2004, NPV is the amount we get at the end of the
project which is calculated by deduction the cost o the project form the
benefits we get over the life of the project. According to Pauline’s survey in
the year 2006, it was concluded that IRR is the rate at which company neither
earns nor loses which means there are no profit or losses, the investment made
by the company is fully recovered at this rate.
According to Kashyap’s analysis in the year 206, NPV is the comparison
between the amount invested now and the amount earned in future over the life of
the project. NPV and IRR are the methods used to evaluate the feasibility of
the project but in different ways. If there are more than one project analyses
based on the IRR technique, then the one having the highest IRR should be
selected to run the project. (Cost
of Capital Estimation and Capital Budgeting Practise in Australia, 2010)
Importance of Weighted Average Cost of Capital:
WACC is
the average rate of all the cost of capitals from where company have managed
funds. By calculating weighted average cost of capital, we learn that how much
interest is paid for 1$ of the investment made to the person who provided us
funds. Capitals can be derived from different sources like equity, preference,
debentures or any other kind of debts. WACC indicates total cost of obtaining
funds from outside. WACC makes us taking proper decisions. It’s easy to use and
analyse. The disadvantage of WACC method is the assumptions used to calculate
and apply the WACC method. The assumption made by WACC method is that the
capital structure of the company is never changed, but in reality the capital
structure of the company keeps on changing continuously. It is also assumed by
this method that there are no change in risk factor of the new project, the
risk level is same in new project which was there in old project. But this is
not true in any case. The risk level is always different in different projects.
Hence,
there are many advantages as well as disadvantages of using WACC method.
Importance of Breakeven Analysis, Scenario Analysis and Simulations in Capital Budgeting
In
some of the projects, the level of uncertainty is found to be very high. The
use of simulation, scenario and breakeven analysis are difficult in projects
where the level of uncertainty is very high. The advantage of using break even
analysis is that the projects can be analysed by considering different options
available with the company. It can also be analysed by making changes in
different level of costs, may it be variable or fixed cost, the impact on the
level f profit and with the help of making changes in the production volume,
the impacts on the level of costs can also be determined with ease with the
help this methods.
The
efficiency of the firm with regard to financial management is reviewed on the
basis of how the firm can maximize its goal and how far it can fulfil its
objectives in every project. Different
types of risks are associated with different projects like, risks related to
corporate, international risks, risks related to market, risks related to
competition. The analysis of risks help us to identify its effects on the
project being undertaken. Various risk analysis techniques are used to analyse
the risk factor in project. Major techniques used to analyse the risk analysis
are sensitivity analysis, decision tree analysis, corporate risk analysis.
Importance of Capital Budgeting to Manage Projects with Profitability
Capital
budgeting is the techniques used to evaluate the projects of the company. Every
organisation would analyse the situations properly in order to secure the
investment made by them. Therefore, the cost and benefit of the project is
undertaken in order to evaluate the viability of the project. Capital budgeting
is mainly used to analyse and manage the finance of the company. capital
budgeting is considered to be the useful and important tool to manage the
business of the company. It’s a crucial decision to be undertaken by every
decision maker. Every organisation wants the perfect analyses of its project so
that they don’t have to incur any cost in future. The capital budgeting
decisions are irreversible in nature therefore, any wrong decision may prove to
be costly to the organisation. Hence, it’s important for the organisation to
take capital budgeting decisions in advance to secure the future of the
company. (Capital Budgeting Decisions,
N.D.)
Conclusion
Successful
analysis of the capital budgeting technique requires classification of
different types of projects. Three different and important types of projects
are independent projects, mutually exclusive projects and projects having
contingent nature. Independent projects are kind of projects were decision
making about the project is very easy. The analysis is conducted to find out
the best possible options and most of the techniques used by the decision
makers. However, the analysis can only suggest us the best course of
alternative to work with any project but in different situations the results of
the project may differ. Different techniques in capital budgeting like NPV,
IRR, PVP, DCF have major role to play in analysis. The analysis is made with a
view to understand the applicability of capital budgeting technique in
practise. The study teaches us how the theoretical studies can be implemented
to the projects being undertaken. The analysis made in chapter 1 showed that
major firms used DCF method to analyse the viability of the project. The study
made of Pandey and Kurfi had strongly supported this conclusion.
Chapter 3-Data Collection & Analysis:-
Capital
budgeting process involves detailed study of the project as well as the
situations that affect the project. Environmental factors, social factors and
economic factors also affect the decision to be taken related to the project
analysis. The capital budgeting process is divided into four most important
stages.
1. Identification
and development of the investment proposals.
2. Evaluation
of the projects financially.
3. Project
implementation.
4. Project
review.
Analysis
of the project should be done very carefully as any carelessness in the project
evaluation may cost the company a higher cost. Analysis of the project involve
many different decisions like the project amount, technique to be used to
analyse the project, factor to be considered, qualitative as well as
quantitative factors.
Objective of Research
The
objective of this research is to give an overview of the process of capital
budgeting. Firstly, the overview of the literature is sketched and then the
empirical study studies a number of aspects of capital budgeting procedure
adopted by different companies to evaluate the capital investment projects.
Hypothesises Tested
Hypothesis
1 is about testing the most important stage in the capital budgeting process in
financial analysis and selection of the project.
Hypothesis
2 forecasting methods on cash flow are based quantitative methods.
Hypothesis
3 is about the important techniques of capital budgeting which are applied by
the decision makers based on the percentage they derive from the IRR and ROI.
Hypothesis
4 is conducted to analyse that the capital budgeting method should not be
influenced by the annual capital budget size.
Hypothesis
5 is conducted to prove that decisions on investment are mostly accepted on
financial criteria. (Hypothesis
Development, N.D.)
Research Methods
Population Description
The
population selected was companies listed on specific stock exchange. The reason
behind choosing these companies for hypothesis was due to the fact that
The
capital investment decision features more prominently in these companies because
the activities relate to capacities of production.
Data Sources
The
data used in this study was obtained from Bureau of Financial Analysis. A
questionnaire was sent to the selected sample.
Selection of Samples
Selection
of samples will be made by selecting first 300 companies listed on stock
exchange who owe to time and financial constraints.
Questionnaires
The
questionnaire will include different questions divided into three or four
different sections. The first section would be related to the profile of the
company. This information will be required in order to properly categorise the
information obtained and to give an indication of the seniority of the decision
maker and background of his/her company. it will include questions about
investment in capital projects as well as the operations of company. Second
section of the questionnaire would be on the capital budgeting techniques which
they would prefer to use to analyse a specific project given to them. The last
section would deal with the amount of risk they would bear into capital
budgeting decision.
Collection of Data and Analysis
The
data used in this analysis was made available by the Bureau of Financial
Analysis.
Empirical Results
It
was found by the study that although the questions included in the
questionnaire had only one logical answer, many of the respondents chose more
than one answer. To apply a consistent approach to capture data, the first
answer given by the respondent was considered as the answer in order to
properly catch the data for analysis purpose.
Total
70 questionnaires out of total 300 were properly responded and out of 70
questionnaires 65 questionnaires were usable. Total 13.8% of the respondents
were from Stores Sector, while 12.3% were from Industrial Holdings Sector and
further 12.3% were from the Food sector. Analysis of the amount of total assets
of the selected companies and size of their annual capital budget was made.
Analysis showed that main respondents fell into main two categories, 35.4% were
with assets between 100$ million and 500$ million and 32.3% were with assets of
more than 1$ billion.
Annual
sales were more than 100$ million for 83.1% of the respondents while capital
budget of 41.5% of the respondents was more than 50$ million. The importance of
the capital investment decisions can be clearly seen when we analyse the amount
spent on the capital investment project. Suppose, if the 24.5% of the total 65
respondents spend more than 100$ million on their annual capital budget, this
will amount to more than 1.6$ billion in capital investments per annum.
Chapter 4-Discussion
Stages in Capital Budgeting Process
Different
stages of capital budgeting processes were project definitions and cash flow
estimation, financial analysis and selection of the project, project
implementation and project review.
The
analyses showed that most of the respondents found project definition and cash
flow estimation as the most important as well as most difficult stage. From the
data collected with the help of questionnaire, it was found that selection of
the project and financial analyses were the second most difficult parts. These
showed that the decision makers have proper understanding of the care that
should be taken while the investment decisions are evaluated as the project
succeeds only when the estimations of cash flows or financial analysis is
conducted carefully. Project
implementation stage was found more important than the project review stage and
project review stage was found to be more difficult than project implementation
stage. (Capital Budgeting Evaluation
Practises, N.D)
About Cash Flow Forecast Methods Used
Different
methods included in questionnaire used to analyses the cash flow estimates were
management Subjective Estimates, Consensus of Expert Opinion and Quantitative
Methods. Other methods were combinations of the above methods.
Different
cash flow forecasting methods were stated in the questionnaire. Most of the
respondents used combinations of methods to estimate cash flows. The important
method from the analysis was Management Subjective Estimates in conjunction
with Expert Opinion and Quantitative Methods. The second highest method was
Management Subjective Estimates in conjunction with Quantitative Methods. The study revealed that decision makers use
combinations of different cash flow estimation techniques to estimate cash
flows. And 20% of the respondents use Management Subjective Estimates to
estimate cash flows.
Techniques used in Capital Budgeting Process
Different
capital budgeting techniques quoted in questionnaire were Return on Investment,
Internal Rate of Return, Net Present value, Present Value Payback,
Profitability Index, Accounting payback.
Another
study conducted to find out the most used capital budgeting technique suggested
that IRR was the most popular technique followed by the IRR method. NPV was a
less used method holding only 10% weight age. A study conducted in UK suggested
similar results as above showing IRR the most used technique than NPV. The
reason behind choosing IRR was being good device to rank the projects and it’s
easiness to understand as the results were based on percentage rate of return
and non requirement of the discounted rate of return. NPV was found to be the difficult
technique to analyse projects and it was found unnecessary for short-lived
projects. It was also found difficult because of the changing hurdle rates and
ineffective due to non consideration of inflation.
A
study conducted in USA showed that Discounted Cash Flow technique was more used
in USA than UK. The analyses showed that 84% of the companies selected in
samples used DCF technique as against only 54% in UK. If the capital budgeting methods used are
analysed according to the annual capital budget size as per the next analysis,
it was found that companies having annual budget in excess of 100$ million
considered IRR as the most important tool to analyse the projects. ROI is
regarded as the second most effective and used technique to evaluate the
project.
But,
if we look at the methods used without considering the capital budget amount of
companies, we found that ROI was the most used technique of capital budgeting
followed by IRR having 33.8% and 32.3% weight age respectively.
Next
analysis made was about most important capital budgeting technique used in
terms of annual capital budget. The same methods used above to analyse the most
used method were included here to analyse the most used method in terms of
annual capital budget. Different ranges of annual capital budgets were defined
and different methods were quoted on the other side. It was found that
companies having annual capital budget of 50-100$ million consider IRR most
important. Present vale Payback was the second most important technique
according to the data received. The
weight ages of both the methods in terms of percentage were 45.5% and 27.2%
respectively. Companies having an annual capital budget of 25-50$ million
consider NPV as the most important technique to analyse the projects. ROI was
the second most important technique after NPV. The percentages held by both the
methods were 42.9% and 37.5% respectively. Present value Payback and Internal
Rate of Return in conjunction with the Net Present Value were found to be the
second most important methods in capital investments decisions. (Capital Investment Practises,N.D.)
When
the annual capital budget was 5-10$ million, companies regarded Present Value
Payback method as the most important method and Return on Investment in
conjunction with the Net Present value method was considered as the second most
important technique. It was also found that companies having an annual budget
of 2-5$ million and companies having an annual budget of less than 2$ million
considered Return on Investment as the most important method with 75% and 57.2%
respectively. These companies considered Net Present value and Present value
payback as the second most important techniques with 25% and 28.5% respectively.
The important fact found out from the analysis was that Profitability Index and
Accounting Payback was not considered as important by any of the companies to
be used in the process of capital budgeting. It can be concluded here that this
two methods hold no importance in the capital budgeting process.
The
study by parry and Firer found that there was a difference between the
techniques used by low and high intensity firms in order to evaluate the
projects. According to the study conducted by them, it was found that high
capital intensity firms holding 65% of the weight age considered IRR as the
important technique compared to 24% of the low intensity firms. Low intensity
firms found ROI to be the most important technique with 47% which indicates the
lower sophistication in capital budgeting technique by companies shaving lower
budget. The above finding was supported by several studies which stated that
DCF technique was more useful for larger projects and the larger companies
preferred DCF technique compared to others.
Different
techniques used by different companies in assessing the viability of different
operations were also conducted here. Six different operation were quoted which
were Capital Investments Project, Expansion in Existing Operations, Expansion
in New Operations, Foreign Operations Abandonment, General/Administrative
Projects and Social Projects. Social projects are the projects which do not
generate any income to the firm but which are only beneficial to the society.
It
was found form the study conducted that 21.5 of the respondents did not deal
with the foreign operations. 9.2% of the respondents did not have abandonment
activities. 6.2% of the respondents did not deal with general/administrative
projects. The study stated that IRR and ROI was the most often used technique
at every stage of capital budgeting with the percentage of 27.7% each followed
by NPV and PVV holding percentage of 21.5% and 15.4%. The most often used
technique with regard to different operations wherever applicable, were ROI and
IRR respectively.
38.5%
of the total respondents stated that they use different other techniques to
assess the viability of social projects.
The other techniques used to assess the viability of social projects
were Derived Benefits, Social responsibilities and moral issues,
Subjectiveness, Not seen as capital and Legal requirements.
The
analysis of the above data was conducted and it stated that social projects are
evaluated on the subjective basis where the future benefits are compared with
amount invested in the project. These benefits from these projects can be goodwill
earned from it as social projects do not give financial benefit to the company.
Legal requirement were quoted quite low importance wise but it should be given
consideration that legal requirements are the most important part while
evaluating social projects.
Next
analysis made was of non financial criteria used in major investments
decisions. The items considered in this analysis were investments that were
never accepted on no-financial grounds, safety of employees or other public,
necessity of maintaining existing programmes or product lines and others. This
analyses shows qualitative criteria that respondents use in most of the
investment decisions. It was clear from the analyses that investors never
accept the investments on non-financial grounds. 21.5% of the investors were
found to be concerned with safety of their employees or the public which
influenced their decision about the acceptance of the project. 20% of the
respondents showed that there investment decisions were affected by necessity of
maintaining existing programmes or product line. Other studies related to
capital budgeting techniques also supported the above findings. It stated that
qualitative or non-financial criteria also affect the capital budget investment
decision. It was found in a USA survey that 97% of the respondent companies
admitted to have approved investment projects for which the quantitative
appraisal techniques
had
advised rejection. It was also found that one third of the respondents
considered judgement as the most important appraisal technique.
Highest
risk stage according to the respondents were also analysed in this process. The
stages were project definition and cash flow estimation, financial analysis and
project selection, project implementation and project review. The study
revealed that there is lack of evaluation of risk at stages as the focus is
mainly on the ability to manage the stage of implementation of project. It
seemed form the analysis that as soon as the project had been defined and the
cash flows related to the project was estimated, the tendency was to do the
financial analysis. Then selection of a project and then to implement with a
risk focus at a letter stage.
Next
analysis conducted was about risky stage according to annual capital budget.
Ranges of different annual capital budget were defined and every stage of the project
was stated. Project implementation was given the second rank according to the
risk involved in that stage. Companies having annual capital budget of 25-50$
million considered financial analysis and project selection with same risk
level with that of the project implementation stage. These investors do not
consider the project definition and cash flow estimation stages as high
riskiest stages. Companies having annual capital budget of 25-50$ million
prefer same stages as risky stages compared to those companies having annual
capital budget of more than 50$ million. Companies with an annual capital
budget of less than 54 million found the financial analysis and project selection
stage as the highest risky stages. (Simon
Gervais, Capital Budgeting and Other Investment Decisions, N.D.)
Chapter 5-Conclusion
From
the hypothesis tested above, following results were obtained.
Hypothesis
1 was proved negative as the most important stages of project in capital
budgeting process were project definition and cash flow estimation and not the
stage of financial analysis.
Hypothesis
2 proved difficult to assess the results as most of the cash flow forecasting
depended on the combination of different methods to evaluate the cash flow
estimations. Quantitative methods were appeared to be of least value.
Hypothesis
3 stated that the most widely used capital budgeting techniques in capital
budgeting process were ROI and IRR. This finding cleared that NPV is not the
most important technique and widely used technique to evaluate the projects.
Hypothesis
4 proved negative, as companies having smaller annual capital budget preferred
PVP while medium capital budget companies preferred NPV as the important tool
and companies having higher annual capital budget found IRR the best and most
useful as well as important tool to evaluate the project.
Hypothesis
5 was also proved negative as 64% of the decision makers used the non-financial
criteria while assessing the project.
The
important thing found out in this research was that most of the companies
listed on stock exchange and selected for the study preferred ROI and IRR as
the tools to analyse the project. The use of these methods varied depending on
the size of the company’s annual capital budget as there is correlation between
the size of the annual capital budget and preference for ROI and IRR. As the
budget increases, more extensively these methods are analysed to apply to the
project.[1]
[1] ANON, N.D., “Investigating Aspects of the Capital
Budgeting Process Used in the Evaluation of Investment Project”,
Accessed on 9th September 2015, <http://repository.up.ac.za/bitstream/handle/2263/11583/Hall_Investigating(2000).pdf?sequence=1>
Comments
Post a Comment