Evaluation of Capital Budgeting Techniques in Enterprises

Introduction,
Capital budgeting is the process by which investors determine the value of a potential
investment project. The three most common approaches to project selection are payback
period (PB), internal rate of return (IRR), and net present value (NPV).
Capital budgeting is a process of evaluating investments and huge expenses in order to obtain
the best return and investment.
A capital budgeting decision is both a financial commitment and an investment. By taking on
a project, the business is also investing in its longer-term direction that will likely have an
influence on future projects.
An organization is often faced with the challenges of selecting between 2
projects/investments or the buy vs replace decision. Ideally, an organization would like to
invest in all profitable projects but due to the limitation on the availability of capital an
organization has to choose between different projects/investments.

Summary,
Trends in Indian capital budgeting techniques
In India, regarding non-DCF techniques, the use of both PBP and ARR is decreasing. The
decrease is more pronounced in ARR than in PBP. the trends of CBT preferences in India. By
increasing their use of DCF methods, firms in India are aligning their practices with the
theory.
The theory supports the increased use of NPV compared to other CBTs, but firms in India and
South Africa increasingly use only NPV. There has been a significant decrease in the use of
both PBP and ARR by South African and Indian firms. However, firms in the USA and UK
have only decreased their use of ARR.
India and South Africa firms increasingly use only NPV, thereby limiting the scope of
information available for evaluating capital projects. There has been a significant decrease in
the use of both PBP and ARR by South African and Indian firms. However, firms in the USA
and UK have only decreased their use of ARR.
Firms in India and South Africa have significantly decreased their use of non-DCF methods.
Their use of DCF methods diverges, with Indian firms increasingly using NPV. Although the
use of NPV is encouraged, South African firms rely on limited information to evaluate
investment projects.
India firms underuse all non-DCF methods compared to UK firms, but they do use the PBP
method more than US firms. While firms in India are conforming to theoretical principles,
there is a likelihood that excessive dependence on DCF methods may limit the scope of
information available for decision making.
Capital budgeting techniques in South Africa
In South Africa, firms tend to use DCF methods (particularly NPV and IRR) rather than
alternative techniques (alternatives or non-DCF) when making such decisions.
Alternative Capital Budgeting Techniques (CBTs) are not often used in practice. They include
Monte Carlo simulations, decision trees, the Capital Asset Pricing Model (CAPM) and
Economic Value Added (EVA). These methods have been extensively discussed in the
literature (Hull, 2014; McDonald, 2006; Verbeeten, 2006).
the use of longitudinal analysis to understand the evolution of CBT preferences. Rigopoulos
(2014) argues that management attitudes towards different CBTs change over time. Changes
in survey response rates or sample sizes as well as company closures, restructuring and
management changes are also mentioned.
Data similarity does not imply that exactly the same firms must be surveyed, because firms
are not static. Trend analysis was deemed to be a suitable research methodology for gaining
an understanding of the evolution of CBTs. The populations identified were firms in the UK
and USA (developed countries) and India and South Africa (developing countries).

Trends in UK capital budgeting techniques

The preference for the PBP technique appears to be stable, fluctuating around a mean use
level of 74%. The Mann-Kendall test was used to evaluate whether these trends are
significant. An important debate topic is whether the increased use of DCF methods is
gradually leading to the phasing out of non-DCF methods.

Trends in US capital budgeting techniques

The preference for PBP is increasing in the USA, unlike the UK, where it was observed to be
relatively stable. The decreased use of ARR can arguably be attributed to the increased
prominence of private equity firms. Risk management tools, such as PBP, are likely to play a
key role in guiding corporate decision making.
The Mann-Kendall trend test results and shows how CBT preferences have developed in the
UK and USA over the last five decades. Using the strength of Tau factors, this study shows
that UK firms are significantly increasing their use of NPV, followed closely by IRR and then
PBP.

Trends in capital budgeting technique preferences

Firms in the USA, UK, India and South Africa have evolved uniquely in the ways in which
they align practice with the theory. It may be expected that IRR and NPV will continue to be
the primary techniques used by UK firms when evaluating capital investments. The increased
use of IRR is expected to crowd out other CBT’s.
Capital Budgeting Techniques
In today's business environment making sound capital budgeting decisions is a critical factor
for survival and success (Bukvic, 2016; Hayward, Caldwell, Steen, Gow, & Liesch, 2017).
Due to the competitive nature of business, companies increasingly find themselves faced with
many (and sometimes competing) capital investment choices. To assist an organization in
selecting the best investment there are various techniques available based on the comparison
of cash inflows and outflows.
1. Traditional methods
2. Discounted Cash flow methods

1. Traditional Methods Covers:

Based on the principles to determine the desirability of an investment project on the
basis of its useful life and expected returns. These methods depend upon the
accounting information available from the books of accounts of the company. They
will not take into account the concept of 'time value of money', which is a significant
factor.

1. Payback period method

The payback period is the number of years it takes a firm to recover its original investment by
net returns before depreciation, but after taxes. According to James. C. Vanhorne, "The
Payback Period is one of the earliest methods of evaluating the investment projects".
1. It is one of the earliest methods of evaluating the investment projects.
2. It is simple to understand and to compute.

2. Accounting Rate of Return

Accounting rate of return on an investment can be calculated as the ratio of accounting net
income to the initial investment, i.e., 1.2. It is very simple to understand and calculate and is
not based on cash flows generated by a project. Soloman: 'Accounting Rate of Return on an
Investment - A Technique for Analysing Project Performance'.
1. It is very simple to understand and calculate.
2. It is not based on cash flows generated by a project.
2: Discounted cash flow methods Covers:
Discounted cash flow (DCF) methods are an alternative to the traditional method of
calculating the value of money. They give equal weightage to the present and future flow of
incomes. DCF methods are based on the concept that a rupee earned today is more worth than
one earned tomorrow. As follows two methods:

1. Net Present value

The net present value (NPV) is the difference between the present value of cash inflows and
cash outflows over a period of time. In case there are multiple projects to choose from, the
project with a higher NPV will be more likely to be selected.

2. Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is the rate at which an investment project's net present
value (NPV) becomes zero. The IRR is also known as cut off or handle rate - it is the
concern's cost of capital minus its cost of issuing shares.

Conclusion,
Although a number of CBTs are detailed in the theory, only selected techniques are
commonly used in practice. A longitudinal analysis of the developments in CBTs was
undertaken to identify CBT evolution trends. Although ROI is the second least preferred
CBT, it is of growing significance in the UK followed by the USA, South Africa and India.
More research is needed to understand the use of real option techniques in capital budgeting
by firms in both developed and developing countries.
The increased use of DCF methods is congruent with finance theory, which stresses the need
to incorporate the time value of money in financial decision making. Firms in developing
countries are increasingly using DCF methods rather than non-DCF methods (such as ARR
and PBP) in making capital investment decisions. While there is limited information
regarding the use of alternative CBT methods, it is possible to say that there has been a
general increase in the used in both developed and developing countries.
More research is required to explore the continuing importance of IRR over NPV in private
equity firms' capital budgeting processes. Further research is needed to ascertain the relative
performance of companies that have adopted DCF methods compared to companies that use
non-DCF methods. Future areas of research should focus on CBT practices in high-risk
environments and sectors, such as technology companies.