It provides flexibility to management — i. Using this model, managers have many choices of how to increase future cash inflows, or to decrease future cash outflows. The analysis has shown that managers can use models such as the CAP or the APT to estimate a discount rate appropriate for each particular project, and use the weighted average cost of capital WACC to reflect the financing mix selected. A common practice in choosing a discount rate for a project is to apply a WACC that applies to the entire firm.
However, a higher discount rate is more appropriate when a project's risk is higher than the risk of the firm as a whole. Hypotheses The hypothesis have been confirmed for the most general methods and criteria. These methods and criteria are that companies prefer the use of the pay back method when they evaluate investment opportunities because of its simplicity and that the companies have to do with financial flexibility.
The method chosen are related to the pecking order theory and budget. This confirms that companies apply both financial evaluation criteria and non-financial. In addition, the article reveals that both risk and uncertainty are considered when evaluating investment projects and that well-defined investment decision processes are employed when appraising projects. Data Source and Method of Collection The author used theories on payback period method and past research work which companies used in appraising investment and he has used it as secondary data in order to be able to answer the questions raised in the research hypothesis.
The author used empirical studies and personal judgment to analyze data from the selected countries on how often the countries use the payback and other methods to reach a conclusion on why the country or the continent used the method in question. Furthermore the analyzed data has shown how each continent has favored the use of the payback method. To agree with the above statement, the author analyzed secondary data from the result of the survey conducted among firms in Africa, Europe and America.
Due to the number of expected results from the hypothesis, the author used a combination of quantitative and qualitative methods to provide the best possible result from the analysis. This process and its application reflect the level of quality both companies want to be perceived with not only internally, but also by external stakeholders such as customers, suppliers and investors though the result of the research benefited mostly financial managers.
The author has managed to establish why payback method is often used indifferent continents and he managed to trace the reason why some particular continents prefer payback method, which is primarily based on the kind of industry that run the economy of such countries, a common example is the manufacturing industry.
The author noted that companies in advanced countries often use the payback method because of the capital structure while companies in Africa mostly tend to use the payback method mainly because of the availability of the internal funding Further analysis of the research shows that the prevalent use of the payback period is more pronounced in the Europe, followed by North America and then Africa. The results show that European companies most often use the payback method followed by American companies and lastly the African companies.
There as on the African companies were rated last is due to the fact that one of the African countries i. Nigeria showed a high rate in the use of the payback method while the other African country i.
South Africa showed a very low rate in the use of the payback method. The article has revealed that from the past reports how is that manufacturing companies in Europe and American companies often used the payback period, compared to other sector of the economy. The author concluded that the issue of the relevance of the use of the payback method is motivated by the importance of the payback method which includes the size of the business, the goal function, the management attitude to the pecking order theory and the simplicity of using the method.
Also from the data obtained, the simplicity of the payback period has motivated the use of the method. Managers normally will want to use a very simple formula to make their investment decision. Although developed countries are now more interested in using some complicated formulas like real option, NPV, IRR but the conclusion is that the simplicity of the payback method made it to be easily understood and this has motivated the general use of the payback method.
The risk taking of the finance manager also indicate why the payback method is often used. The above observation by the author confirms what T.
Lucy, on page where he noted that payback method favors quick return projects which may produce faster growth for the company and enhance liquidity. He further observed that choosing projects which payback quickest will tend to minimize those risks facing the company which are related to time. However, not all risks are related to time. The author also pointed out that the size of company also motivated the use of the payback 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.
Data were collected with a structured questionnaire survey taking from the chief financial officers CFOs of companies listed in the Dhaka Stock Exchange in Bangladesh. Garnered data were then analyzed using descriptive and inferential statistical techniques. The results found that net present value was the most prevalent capital budgeting method, followed closely by internal rate of return and payback period.
Similarly, the weighted average cost of capital was found to be the widely used method for calculating cost of capital. Further, results also revealed that CFOs adjust their risk factor using discount rate. The findings of this study might help the firms, policymakers and practitioners to take a wise decision while evaluating investment projects. Mollah, M. Anhar Sharif Mollah, Md.
Abdur Rouf and S. Sohel Rana. Published by Emerald Publishing Limited. Anyone may reproduce, distribute, translate and create derivative works of this article for both commercial and non-commercial purposes , subject to full attribution to the original publication and authors. Most of the scholar and practitioner opine that although three decisions are important, firm success and survival ultimately depend on a right investment decision because a good investment decision remains good business even though bad finance taken; on the contrary, a bad investment decision will be a wrong decision even with best finance policy Brealey et al.
Once the decision has been made, the process cannot be manipulated without incurring losses Hall and Millard, Capital budgeting is a major terrain of the sphere of financial management.
Gitman et al. Universally accepted definition yet to exist, because it is involved with multifaceted activities and influenced by many changing factors in the organizational environment.
Capital budgeting practices are the most vital component of financial management Bunch, and one of the most widely investigated topic in corporate finance literature.
Majority of the studies investigating the capital budgeting practices among surveyed firms are from developed economies followed by emerging economies [e. However, in contrast to the developed world, this area is less investigated in emerging economies.
Bangladesh is a rapidly growing emerging economy. Till date and as per best of our knowledge, there is no comprehensive study exploring the key aspects of capital budgeting practices by listed firms in Bangladesh. This presents an opportunity to investigate the topic under discussion for an emerging economy like Bangladesh. Therefore, the aim of this study is to fill this gap in the empirical literature by providing first-time comprehensive empirical evidence from Bangladesh.
Currently, research on capital budgeting practice has attracted scholars because of its importance and insight gained. However, in comparison with developed countries, this area is less studied in emerging economies like Bangladesh.
Therefore, the purpose of this study is to investigate the current scenario of capital budgeting practices in Bangladesh and to identify the pitfalls of capital budgeting practices of listed companies in Bangladesh. The capital budgeting process is a multifaceted activity designed to help in the selection of investment projects that are viable and worthy of pursuing.
It is dynamic, not static. No all-around acknowledged agreement exists, and it is affected by many changing factors in the organizational environment. Mainly, capital budgeting process deals with planning, reviewing, analyzing, selecting, implementing and following up activities.
Leon et al. The authors also stated that evaluation must involve the cash flows from the proposed project considering the risk and uncertainty. Thus, care must be taken in project selection to ensure a greater probability that positive results will be made in the long run to the firm.
Capital budgeting is considered an important element in the firm managerial decisions Garrison et al. Ross et al. Capital budgeting method can be categorized into two groups: discounted cash flow DCF method and non-discounted cash flow non-DCF methods. While DCFs take into account the time value of money, the non-discounted methods are not considered time value of money Alleyne et al.
Haka et al. Sophisticated techniques consider risk adjusted net cash flows, time value of money and inflation. According to Baker and Powell , the capital budgeting process involves six stages: identifying project proposals, estimating project cash flows, evaluating projects, selecting projects, implementing projects and performing a post-completion audit.
A clear explanation of capital budgeting was set forth by Segelod , who said:. According to Alles et al. The nonfinancial factors include demographic variables of the decision-maker. But Katabi and Dimoso conducted a study in Tanzania and found that business-related factors like industry of the business, sales growth, business establishment, number of employees and form of business play a vital role for selecting capital budgeting methods.
In addition, Brunzell et al. Daunfeldt and Hartwig conducted a study on Swedish listed companies and found few new factors such as dividend payout ratio, potentiality of firm growth and foreign sales amount.
Nonetheless, a transformation was witnessed by the end of the s wherein surveys stated that popularity of DCF methods of IRR and NPV was increasing day by day and decreasing the usage of payback period PBP as a primary method, while it was highly popular method as secondary criteria Blazouske et al.
A review of the past research, of the s and beginning of s, stated the dominance of non-discounted techniques like PBP Graham and Harvey , after that by ARR. During this time most of the researchers found that the DCF model was the least popular method for capital investment decision Baker and Beardsley, 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. Do firms use methods that help to maximize the firm value? The review of empirical surveys and studies help to find answers to these questions. 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 Profitability Index: This is also a discounted cash flow method, which is determined by the ratio of the sum of present values of cash inflows to the capital outlay. As we can see from figure 1 the capital budgeting techniques broadly classified into traditional and modern or sophisticated technique which many company are using whether their objective is expansion of existing plan machinery, maintenance, adding line of production or research and development in manufacturing companies.
Figure 1: Capital budgeting techniques Capital budgeting techniques Traditional Discounted cash flow Accounting rate of Payback period Net present Internal rate Profitability return value of return index Source: Adeniyi A. We can classify the determinants of the technique selection into financial and non-financial factors.
The financial factors include the size of the organization measured by the value of assets , rate of growth in revenues, profitability, leverage level, capital expenditure of the investment opportunity, and availability of cash.
On the other side, the nonfinancial factors include: the age of the company, life of the project, management experience and educational background, quality of the project, familiarity with investment, and other external factors. Many literatures show that companies with higher growth rates use PB and NPV more often and use other techniques such as adjusted present value APV less often when compared to companies with lower growth rates.
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