A Systematic Review on Capital Budgeting

Techniques

Date of Submission: 30th April,2024

A Systematic Review on Capital Budgeting Techniques

A Thesis
Submitted to:
Dr. Jesmin Akter
Assistant Professor
Department of Business Administration
ASA University Bangladesh (ASAUB)
In Partial Fulfillment of the Requirements for MBA

Submitted by:

Pavel Hassan

ID: 0502220004083003

Batch: 46th

Program: MBA

Department of Business Administration

ASA University Bangladesh (ASAUB)

 LETTER OF TRANSMITTAL

April 30, 2024

Dr. Jesmin Akter
Assistant Professor
Department of Business Administration,
ASA University Bangladesh,
Shyamoli, Dhaka-1207.

Dear Madam,
It is my pleasure to submit here with my dissertation, which has been prepared under the sound
and dynamic leadership of a personality like you.

This report is an integral part of my academic program in completion of the degree named
Masters of Business Administration, which has assigned me “A systematic review on Capital
Budgeting Techniques” as a part of MBA Program. I have tried my level best to collect the
relative information as comprehensive as possible in preparing the report. During preparation of
the report, I have experienced practically a lot that will help me a great in my career. It has
enlightened my practical knowledge regarding the present credit rating system. I will be able to
explain anything for more clarification if necessary.

I would like to thank you, for giving me the opportunity to do a report on the above-mentioned
topic.

Sincerely

___________________________
Pavel Hassan
Student ID: 0502220004083003
Spring Semester-2024
 CERTIFICATION

April 30,2024

This is to certify that Pavel Hassan, ID # 05022200004083003, a student of MBA 46th Batch,
Department of Business Administration, ASA University Bangladesh has completed his Master’s
Thesis under my supervision. His Thesis topic is “A systematic review on Capital Budgeting
Techniques”
I wish him success in his life.

________________________
Supervisor
Dr. Jesmin Akter
Assistant Professor
Department of Business Administration,
ASA University Bangladesh,
Shyamoli, Dhaka-1207, Bangladesh.
 Acknowledgement

My thesis journey would not have been possible without the help of Almighty God, the most
Merciful, the most compassionate that by His endless grace I have been able to complete this
thesis.

I am deeply indebted to my Thesis Supervisor Dr. Jesmin Akter, Assistant Professor, Department
of Business Administration, for her whole-hearted guidance and supervision. Her suggestions &
comments to make the report a good one was really a great source of spirit for me.

I am grateful to my parents who guided me though the entire studies and had helped me morally.

Finally, I would like to say that I have tried heart and soul to prepares this thesis paper
accurately. However, there might be some errors and mistake so I seek your kind consideration
as I am in the process of learning.

____________________

Pavel Hassan

Student ID: 0502220004083003

 Tables of content

No. Topic Page

Chapter One Introduction 1-6

1.1 Introduction 2-3
1.2 Significant of study 3
1.3 Objective of the study 3
1.4 Research problems in capital budgeting 4
1.5 Capital Budgeting Procedure 4-5
1.6 Capital Budgeting 6

Chapter Two Literature Review 7-12

2.1 Literature Review 8-12
2.2 Research Gap 12

Chapter Three Capital Budgeting Methods 13-25

3.1 Capital Budgeting Methods 14
3.1.1 Non-Discounted Cash Flow techniques 14-19
3.1.2 Discounted Cash Flow techniques 19-23
3.2 Comparison between NPV and IRR 23-24
3.3 Sensitivity analyses (SA) 24
3.4 Capital Budgeting Decision 25
Chapter Four Findings , Conclusion & Recommendations 26-28
4.1 Findings 27
4.2 Conclusion 27
4.3 Recommendations 28

Appendix 29-31

4.4 References
 Abstract

Each Business company might have a capital budgeting process in place regardless of whether it

is a private entity or a public sector entity. In this thesis I have done review of existing

Techniques of Capital Budgeting used in different companies or organizations. In general, it is

been said that the single decision or single most important determination taken by a company or

organization’s management team is the sorting of company investment decision which maximize

the company’s owner or shareholders current wealth. Many experts agree which decisions on

capital budgets are dichotomous to both the performance of the company’s activities. In the

business model of a company or organization capital budgeting plays a vital role. In such a

business environment where it needs the perfect decision might obtain a stronger strategic

advantage in everyone’s disputes. However, this is a generalization of investigation and

challenge that more sophisticated practices take place across all industries. I have reviewed

papers from over last two decade. Analytic techniques such as Net present value (NPV), Internal

rate of return (IRR), Payback, Discounted Payback, Accounting Rate of Return, Profitability

Index and Sensitivity analyses (SA) are reviewed here. More complicated methods such as IRR

and NPV are most favored by the large businesses as compared to the small businesses. The

study recommends the use of real options techniques because in the ever-increasingly complex

business environment they facilitate the linkage of financial objectives with corporate strategy.

Key words: Capital Budgeting, Net Present Value, Internal Rate of Return, profitability Index

and Accounting Rate of Return.

Chapter One
Introduction

1
1.1 Introduction

Capital budgeting is usually done by the financial management of an organization. It is usually

said that, it is the most significant decision taken by financial management team(Batra & Verma,
2014). As a general definition capital budgeting is the process or decision taken by financial
management team of an company or organization to make the proper use of money in each sector
of the company or it can be said that it is the decision of the organization how to allocate the
resources on the company investment programmed (Al-Mutairi et al., 2018) by judging the
programs future outcomes. That means it decided on the programs or projects as per their
possible future outputs, how much benefits they may cause of over that particular year.

This capital budgeting is generally been used as the instrument for taking decision on where the
company shall make his investments and where to give more focus. It is been used for general
operational decisions like – equipment replacement, buying new or even such an expenditure like
building new office or factories (Leon et al., 2008. When there is a case like capital investment
decision it is very obvious that financial management team manager will go for best practice and
studies to make it sure that it is a good decision (Toit & Pienaar, 2005).This capital budgeting
also deals with Discounted Cash Flow (DFC), Net Present Value (NPV), and Internal Rate of
Return (IRR). And also, PB (Pay Back), ARR (Accounting Return Rate) also calculated with this
section(Leon et al., 2008).

This technique was used for long time but first time this thing was observed in the year of 1960.
That was the first time when researchers went interested about the process. How a company or
organization does this thing. We can get the proof 1960-1970 that there is pure trend towards too
slowly using models those were theoretically better based on DFC (Andrés et al., 2015).

Basis on Mao (1970) it is been found that from 1960 the application of capital budgeting has
been increased. He has categorized this analytical technique as per application. This budgeting
technique is applicable for investment decision making. But he has found that managers are not
willing to get used to with the modern techniques. But the companies which have been working
in a progressive and challenging weather might get change with time as the other rivals will
adopt them and will more accomplishments in market. They will get sustainability and increase
in market (Ghahremani, Aghaie&Abedzadeh, 2012).

2
Having decision of amount of money in consumptions or in investment is very crucial. Not only
for any individual sectors rather for every sectors of the economy. A company who tries to make
savings so that the certain rate of gain as money of upcoming costs given by the additional
amount of revenue exceeds the benefit of costs spending that day. The financial management
team might decide between paying out earnings in the form of dividends, which may be used for
present consumption, and retaining the earnings to invest in productive opportunities that are
expected to yield future consumption. Managers in charitable organizations, who provide
investment cash, aim to optimize the expected utility in investors. And government management
teams have also been looking to enhance one’s implementers' utility function. The investment
choices evaluated and analyzed here involve companies however, in any economic sector, the
decisional criteria for maximizing the present value of lifetime consumption that extend.

1.2 Significant of study

This thesis deals systematic review on capital budgeting techniques used by companies. Here we
will review literatures published in journal in the last some years section by section, in total
accountability and explanation on what has been accomplished, usually through some kind of
traditional research. In this study evaluating and comparing the present availability of new tools
with the approaches used in prior research on the knowledge on the capital budgeting methods
employed by firms. This study builds a solid knowledge of capital budgeting strategies and will
be a stepping stone for potential work to recognize.

1.3 Objective of the study

1. To understand budgeting techniques used by the companies in Bangladesh.

2. To find the research gap in capital budgeting techniques.

3. To understand different techniques in capital budgeting.

4. To extract the best possible technique in capital budgeting.

3
1.4 Research problems in capital budgeting

A paradigm shift in corporate investment practices over the last fifty years is seen in the capital
budgeting literature (Batra & Verma, 2017). Capital budget practices are defined as techniques
and methods that assist in assessing the feasibility of a project (Al-Mutairi et al., 2018).

Research suggests that the difference between theory and practice in capital budgeting is mainly
caused by the user of the practices: managers are unable to apply the practices that should be
used in the analysis of investment projects (Andrés et al., 2015). In fact, it seems that the
decision makers do not have familiarity or do not know the most appropriate methods (Lazaridis,
2004; Brijlal& Quesada, 2009; Hall & Millard, 2011).

There is, however, some limited evidence that company-specific conditions will influence the
effectiveness of using sophisticated capital budget practices (Chatterjee et al., 2003). In this
context, together with the characteristics of the company, the managers’ profile is also
considered to be impacting in capital budgeting practices (Graham & Harvey, 2002; Brounen et
al., 2004) and in the decision-making process (Rayo et al., 2007). In addition, factors such as
cognitive ability, preferences, profile, experience function, and managerial training also affect
capital budgeting decisions (Brijlal& Quesada, 2009; Egbide et al., 2013). From the theoretical
problem of the use of capital budgeting practices by managers, we intend to analyze two lenses
in the systemic analysis: from the perspective of managers and from the perspective of practices.

1.5 Capital Budgeting Procedure

What type of capital budgeting procedure should be used for an organization depends on the
manager’s level in the organization, the size of the organization, the size and complexity of the
project which being evaluated. The success of the project depends on how potentially they have
selected the best or the most profitable investment project by using a carefully designed process
and avoid negative strategy and consequences which could follow from poor investment
projects. They can maximize their shareholders returns by doing this. But capital budgeting
process could be influenced by many changing factors in an organizational environment.

4
The typical steps in the capital budgeting process highlighted by Stowe and Gagne (2018) are
shown in the Figure.

Generating
Ideas

Analysing Capital Monitoring

Induividual Budgeting and post
Proposals auditing
Technique

Planning
the Capital
Budget

Figure1: Capital Budgeting Process adopted from Stowe and Gagne (2018)

This process starts with generating ideas; generate ideas from inside and outside of the company
for proposal of the investment. The second step is analyzing individual proposals to collect
information and to evaluate all possible alternative projects to judge the advantages of the
proposals. Criteria should be matches to the objective of the firm to maximize its market value.
The third step is to plan the capital budget; select analyzed proposal that fits with the company’s
overall strategies. Finally monitoring and auditing; comparing the actual results with the planned
one and explain any deviations. This will help for future selection of any proposals.

5
1.6 Capital Budgeting

The systems and processes employed for evaluating an infrastructure plan and investment plan
for a company is called capital budgeting. It supports managers when identifying the other most
profitable projects at such an acceptable level of risk (Verbeeten, 2006). Total assets may not
utilize simple techniques of financial analysis as payback times so the accounting return rate and
the period value of property may not take into account. Active forms of capital budgeting
including such present values and operational return bring ambiguity, working capital and the
quality of opportunity for money under consideration.

Management teams can use a variety of methods and approaches to facilitate procedures of
financial analysis (Horngren, Foster and Datar, 1997; Ross, 1995). In concrete terms the methods
of working capital show difference among business and business or in some instances for both
management team companies? Management teams in the decision-making process often seem to
reject ideas (McDonald, 1998).

The assessment of the plans for capital budgeting is part of an expenditure judgment (Arnold
&Hatzopoulos, 2000). Throughout this frame of reference, the decision-making of efficient
financial management consulting will be critical for the company's long-term development and
growth (Bennouna et al., 2010). In addition, the financial planning covers the institution's most
basic economic consideration, small, medium-sized or massive-sized, since its productivity and
efficiency are determined (Egbide et al., 2013).

Such significance justifies the use of different working capital practices and procedures by
particular companies and the way they function dynamic interdependence systems across budget
variables (Pike 1986).

The conceptual and analytical work in finance research was mainly based on financial decisions
(Al-Mutairi et al., 2018). The central problem is to examine more than others the most widely
used activities and the cause motivating eachother (Block, 1997; Ryan & Ryan, 2002;
Markovics, 2016).

6
 Chapter Two

Literature Review

7
2.1 Literature Review

Capital budgeting is the methods and techniques used to evaluate and select an investment
project. It helps managers to select projects which are highest profitable with an acceptable risk
(Verbeeten, 2006). Simple capital budgeting techniques such as payback period and accounting
rate of return do not use cash flows and do not consider the time value of money. Sophisticated
capital budgeting techniques such as the net present value and the internal rate of return
considers risk, cash flows and the time value of money.

Many scholars and researchers agree that capital budgeting decisions are diametrical to a
business’s performance (Arya, Fellingham& Glover, 1998). Capital budgeting plays a
diametrical role in a business’s competitive model. A business whose ability to effectively
develop a feasible mechanism for capital budgeting may gain a better competitive advantage to
its conflicts in an environment characterized by change and volatility (Lazaridis, 2004).

In the last three decades, empirical research involving both large and small sized businesses have
been conducted extensively on the use of capital budgeting techniques. Hermes, Smid& Yao
(2007); Lazaridis (2004); Sandahl & Sjogren (2002); George & Chong (2001); Kester & Chong
(1999); Drury &Tayles (1996) and Jog & Srivastava (1995) provide details of empirical studies
on capital budgeting practices in Asia, Cyprus, Netherlands & China, Sweden, Canada,
Singapore and the UK respectively. These surveys, which have focused on methods of
evaluating project profitability and risk, have shown that the sophistication of the analytical
techniques used by United States executives has increased over time. Discounted cash flow
(DCF) techniques, such as Net Present Value (NPV) and Internal Rate of Retum (IRR), have
become the dominant method of evaluating and ranking proposed capital investment(Kester
George W and Chang Rosita P, 1999).
Capital Budgeting deals with the proportional survey on various methods on long term budgeting
in Indian context which has done a comparative study in India and observed that 25 percent of
sample companies invested for expansion and diversification and firms were making regular
investments for replacement and maintenance (Jain P K and Kumar M, 1998). (Kester George W
and Chang Rosita P, 1999).

8
Robert A Ashley, Stanley M Atikinson and Stephten M Lebrutho (2000), the objective of the
paper was to determine about the capital budgeting and cost of capital procedures being utilized
for the food industry sector of the hospitality industry and to evaluate the feedbacks. The study
also found the most popular and adopted technique was selected by the hospitality industry were
Excess PV and breakeven of NPV and also called as primary technique and payback method was
considered and selected as a secondary technique in the study. The paper was focused on the
overall working of capital budgeting techniques in the area of hospitality sector i.e. the food
service segment.
Beatrice Njeruwarue&thuo Vivian wanjaira (2013), the study assesses various factors affecting
the budgeting processes among small and medium enterprises i.e. the hospitality industry. The
research was descriptive and stratified random sampling was employed in selecting the sample.

Capital budgeting techniques highlighted the evidence on thegap in the implementation and it
practices in the country like United Kingdom. The researcher has done a study of the gap existed
in the Capital Budgeting which is consider to be the extent to which modern investment appraisal
techniques are being employed by the most significant United Kingdom corporations or
companies. The paper clearly state that modern methods were mostly used by their companies
than traditional methods(Arnold Glen C. and HatzopoulosPanos D 2000).

In past years importance was given to the traditional method of capital budget like PB period,
ARR and ROI etc. but changing trend shows the diversification of traditional techniques to
modern techniques like Excess present value method, Benefit Cost Ratio & Trial & Error method
(Ryan, P.A. and Ryan, G.P. 2002). As far as the observation of jeopardy and uncertainties and
the utility of investments budgeting techniques are relate to, it is shown here that there is still gap
in the implementation exists in the state (Fazilah Abdul samad and RoselerShahruddin 2009).

TomonariShinoda (2010), the paper is made to discuss the utility of long-term budgeting in the
country and focuses on the employment of various methods of capital budgeting. Almost all
investigative research in Japan has shown that the managers of Japanese firms tend to prefer a
non- discounted cash flow model, such as simple payback period method. The outcome of the
study shows that their companies administer their choice by using the mixture of two methods
i.e. PB period method and excess present value method. While many financial managers utilize

9
multiple tools in the capital budgeting process, these results reflect a better alignment of views
between the academia and business.

Interestingly Niels, Hermes, Smid& Yao (2007) provide evidence that Dutch managers on
average use more sophisticated capital budgeting techniques than Chinese managers tasked with
capital decision making. This finding may be attributed, amongst other factors, that the
Netherlands is more developed economy compared with China. In comparison South Africa is a
developing nation and may show similar results as that of China.

Gupta Sanjeev et.al. (2007), The researcher has made an attempt to explore which capital
budgeting techniques is used by industries in Punjab, and the influence of factors such as volume
of the investment budget, age and nature of the company, and education and experience of the
CEO in capital budgeting decisions. The research paper basically focused on Capital Budgeting
Practices in the companies working in Punjab which discusses all the traditional method i.e.
Recovery period of an investment and annual rate of return and modern methods i.e. NPV
method, PI and IRR.

Agarwal N. P. and Mishra B.K. (2007), the study reveals the capital Budgeting, Jaipur: RBSA
Publishers, the book is classified into 9 chapters which covers introduction to capital budgeting,
project formulation, condition of certainty & uncertainty of risk. Meaning & definition of capital
budgeting is covered along with its features, importance, types & procedures. Project
identification & formulation is also effectively explained. The paper reveals various aspects of
capital budgeting, where capital budgeting concept and its methods are also discussed. The paper
explored capital budgeting significance, its various types and the project evaluation and
techniques to be adopted is also discussed at the end of the study.

“A review of capital budgeting practices” explored the key challenge in government for using
capital budgeting practices. Budgeting is defined the appropriate balance between current and
capital expenditures. Capital budgeting for the government capital investment remains not well
integrated in the process of investment. (Davina F. Jacobs 2008).The poor choice method or a
combination of methods leads to the selection of a weak projects with greater profitability than in
case of choosing a good one. The study also identified various possible themes and modified

10
findings based on suggestions and comments for completing data analysis process(Xin Wang
2010).

Capital Budgeting decisions are most significant decision made by the organization. There is
certain pattern, which is decided by the organizations about the investments decisions and how
are they going to make the investment decisions (AgneKersyte2011). Excess present value
method is extensively used in their industries. Alternative methods were payback method were
also common. It is found in the study that 94 percent of the use of excess present value, IRR or
benefit cost ratio (PI) criteria in their capital budgeting decisions (Prakash Vir Gupta and Dr.
Ashok Purohit 2012).

Asif Hussain and Imran Shafique (2013): In the paper, the basic objective of the survey was to
find out the amount of current technique in the decision making of the capital budgeting in
Islamic banking sector in Pakistan. The most preferred technique among the other capital
budgeting techniques was IRR and NPV.In the selected sample, who used DCF were shown as
not so effective and also ignore real option. The paper at the end suggest that an analysis of
decisions making on long term capital assets, of different papers DCF where novel illustrations
are made advice was given to managers to improve the opportunities of investments by making
appropriate decisions.

Atul K. Saxena (2015), the study is based on the capital budgeting regulations and rules its wide
theory and implementation. The paper explains an evaluation of projects for the purpose of
newly started business set up. Depends on the categories of proposals required students forecasts
the new startup the generating and incurring the revenues and expenses over the estimated life of
the business and any terminating cash flows. Once the cash flows are estimated the business is
evaluated for profitability and risk using the capital budgeting techniques of the NPV and the
IRR.

Capital Budgeting evaluate various techniques i.e. PB period, average rate of return, excess
present value and IRR and PI of capital budgeting. Internal rate of return (IRR) or non-
discounted payback period were more preferred than Net Present Value (NPV) in the worldwide
(Pankaj Kumar Gupta and Dr. Vipul Jain 2016). There is linkage between employed and various
factors such as size investment, nature of investment, firms’ size and growth rate and capital

11
structure. Large scale organizations give first preference to IRR, while small scale entrepreneurs
are eager in forecasting the PB period as compared to larger firms (Anuradha Yadav 2018).

Mr. T. Venkatesh and Dr. SardarGugloth (2017), the paper discusses the effective control of
capital expenditure in order to achieve by forecasting the long-term financial requirements. The
objective of the paper was to ensure the selection of the possible profitable capital projects to
facilitate the coordination of interdepartmental project funds among in competing capital
projects. The paper objective is also to ensure the maximization of profit by allocating the
available investible. Both traditional methods and modern methods are discussed in the research
paper and gave different aspects of each technique thoroughly.

2.2 Research Gap

The chapter reviews the existing literature on the concept of capital budgeting and its techniques
used to measure and evaluate the financial performance of the companies. The section of review
of literature has provided on secondary data. The secondary data here in previous study depicts
the importance of capital budgeting among small, medium and large companies from all the
sectors i.e. Industry, hospitality, banking and finance sector, Multinational companies and other
sectors. Most of the previous studies focused on the capital budgeting practices of unlisted SMEs
of outside countries like South Africa, United States, United Nation, Germany, Pakistan and
others.

12
 Chapter Three

Capital Budgeting Methods

13
3.1 Capital Budgeting Methods

Over the last three decades, many researchers have been executed on capital budgeting
techniques. But financial managers and academics come to this agreement that there is no best
alternative among the methods for selecting investment. Therefore, different companies use
different methods according to their requirement for selecting any investment.

The most prevalent capital budgeting techniques in the public finance literature include payback
period (PB), accounting rate of return (ARR), net present value (NPV), internal rate of return
(IRR), and profitability index (PI) (e.g., Sekwat,1999; Cooper et al.,2002). Among them, four
methods. viz., NPV, IRR, PB and ARR, have been recognized as a leading method and used in
many practices (e.g., Pike,1996; Kester, Chang, Echanis, Haikal, Isa, Skully,Tsui& Wang, 1999;
Hermes, Smid, & Yao , 2007). These methods can either be the Discounted Cash Flow or non-
Discounted Cash flow methods. NPV and IRR are considered as DCF method and PB and ARR
are non DCF methods.

As Discounted Cash Flow method (DCF) consider time value of money, so Capital Budgeting
Technique favors the use of DCF. Brealey & Myers (2003) give an explanation that, managers
make decision on the assumption that maximize the shareholders wealth is the primary goal of a
business. The project that yield positive net present value will be the 1st choice for investing
among the investors. This theory is supported by many pragmatic works for example Graham &
Harvey (2001); Kester (1997) and many others.

Early studies show that DCF method is least popular Capital Budgeting method. This might be
cause of limited use of computer technology in that era. For that non-discounted methods are
most preferred methods (Pike, 1996). But now with the help of modern financial theory, DCF
has become the most preferred method.

3.1.1 Non - Discounted Cash Flow techniques

Payback Period (PB)

Payback period is the method that indicates the period of time required for recovering the
invested money. That means the time an investment reaches its break-even point is called
Payback Period. The lower the time required the higher the possibility of the project’s
14
acceptance. The standard decision is to approve one with the shortest payback for two or more
ventures. The rule of payback period is that it undertakes the cutoff period and rejected the
prolonged period (Shapiro &Balbirea 2000; Yard 2000). In several companies the payback
period PB is used as a measure of the desirability of capital investments. The use of PB is most
common in small and medium companies (Pike 1985; Yard 2000). For small projects firm
depends much on unsophisticated payback method (Ross 1986). This was also supported by a
study done by (Kester et al., 1999; Ross & Westerfield 1988: William et al., 2001)

Payback period can be calculated as:

Payback period = Cash outlay (investment) / Annual cash inflow = C / A

Where initial payment is the investment made in the start and the annual cash flows are the net
cash flows of a firm. For example, if €10 00 000 is invested with the aim of earning €250000 per
year (net cash earnings) the payback period would be 4 years.

Arguments in favor of payback method

The study by Awomewe and Ogundele (2008), has shown that the payback method is popular
because of the following reasons: easy to understand, by examining how long it will take to
recoup initial investment it can allows manager to cope with risk, it favors capital projects that
return large early cash flows, it addresses capital rationing issues easily, the ease of use and
interpretation permit decentralization of the capital budgeting decision which enhances the
chance of only worthwhile items reaching the final budget, it built a safeguard against risk and
uncertainty in that lower the risk when payback period is short and it remains a major
supplementary tool in investment analysis.

Arguments against payback method

The writings by Yard (2000) and Soni (2006), has highlighted that payback method omits cash
flows meaning to say that it does not bear into account cash flows subsequent to the project's
payback period. The method only considers project returns up to the payback period. Also, the
payback method does not consider the time value of money (Yard, 2000). In spite of this, a
solution to this deficiency has been put forward by way of modifying the simple PB method into

15
a discounted payback period (DPP); thereby searching the payback period when the accumulated
present value of the cash flows covers the initial investment outlay.

Accounting Rate of Return (ARR)

Accounting Rate of Return is the expected return of an investment as a percentage of the

investment made or asset compared to the initial cost of investment. It is defined as the average
project income after deducting taxes and depreciation divided by the average book value of the
investment during its life time (Davies &Boczko 2005; Elumilade et al., 2006; Ross et al., 2009).
Instead of actual cash flows the method uses net income and book value of the investment. ARR
is established from information which is for a particular year and other parts of the project has no
reference (Vatter, 1966). ARR can also be calculated by total profit instead of average profits,
then divided by average investment (Davies and Boczko 2005). The method used from the start
should be continued by the management.

For an independent project to be acceptable, its ARR should meet the set level which is the
hurdle rate or the cutoff rate (Artrill & Maclaney 2009; Williamson 1996). Accept the project
with higher ARR for mutually exclusive projects, and the additional condition for accepting the
selected project is that it should attain the predetermined rate (Williamson, 1996).

ARR can be calculated using the following formulas:

ARR (total investment) = Average Annual Profits/Initial Capital Investment * 100

ARR (average investment) = Average Annual Profits/Average Capital Investment * 100

Arguments in favor of ARR

The study by Soni (2006) has shown that the use of ARR has got the following benefits: there is
no need of doing some calculations because the method uses information which is in the books
of accounts. The method is easy to understand and so those who are not into finance can easily
understand what is going on. This method can also be used to measure the performance of
investments and even company subsidiaries.

16
Arguments against ARR

The accounting rate of return is prone to the same condemnation as the payback period as it does
not take into consideration the properties of capital flows, but looks at the accounting profits
instead of cash flows over the life time of the capital investment (Elumilade et al., 2006; Soni
2006). The method does not take into consideration the time value of money (Drury 2004; Pike
& Neale 1996). “Managers would be conventional in their choice between one project and other
with after tax profits, which may occur in the opposite chronological order because both projects
would have similar accounting rate of return” (Elumilade et al., 2006; Van Horne 1992). The use
of depreciation could lead to a false analysis of net cash flows emerging from the project outlay
since depreciation of the initial cost of capital over the future of the investment is treated as cash
cost.

The real options approach

“Though Real Option is right but there is no obligation to undertake business decision; typically,
the option to make, abandon, expand, or contract a capital investment” (Trigeorgis, 1993). Many
academies and practitioners have mentioned some problems with using the NPV for making
capital budgeting decisions, the fact is, NPV and management can make changes after
acceptance of a project but all other capital budgeting methods ignores the changes
(Alkaraan&Northcott2006; Ross et al., 2009). These adjustments or changes are called real
options.

Bailey and Sporleder (2000), states that the value of option reduces due to the passing of time
and the potential of the project at hand becomes clearer. Real options are unique from other
methods in the sense that at time, it enables managers to consider all the options available to
them, good and bad. Since some projects involves sunk costs which can never be reversed any
more but the real options method takes into consideration the managerial flexibility over time
(Bailey &Sporleder, 2000). “Assumption of Real options models are that there is an underlying
source of uncertainty, such as the price of a commodity or the outcome of a research project.
Over time, managers can adjust their strategy accordingly when the outcome of uncertainty is
revealed” (Bowman & Moskowitz, 2001:772). The method acknowledges that the options
acquired in some capital projects has value for example the option to expand, defer, downsize or

17
abandon a major capital investment project; this enables the firm to react to strategic and
competitive prospects rather than hanging around in the same course of action (Black & Scholes,
1973). Many authors have supported the use of real options approach in evaluating strategic
capital investments (Alkaraan&Northcott, 2006).Although this method has been seen as a
valuable tool in evaluating strategic capital investments, the study by Busbya and Pittsb (1997),
has shown that few managers understands or use this method. Real options cannot be helpful
especially where a regulation or legislation has to be met and considered not to be so important
since they lessen organizational dedication to a prearranged outcome or event(Busbya&Pittsb,
1997).

According to the importance in capital budgeting various types of real options identified in a
study undertaken by Vintila (2007), and these are as follows:

Timing options: investor will wait for the specific information to be arisesand help him to
understand, until then the investor may postpone the investment decision, even partly, the
uncertainty connected with the analyzed project.

Staging options: are useful in assessing multistage projects, in order to learn about cost pattern
and profitability of the project, investor must undertake the project in small increments, even if
uncertainty is not resolved over time.

Exit (abandon) options: this allows the investor to avoid or at least reduce loses if bad
circumstances appear, by turning negative cash-flows into null payoffs;

Operating options: scaling up to enhance earnings or scaling down to reduce damagesreflects

economic changes and enable the firm to organize operations for adjusting its processes to
business environment, depending on given circumstances;

Flexibility options: purchasing or building a flexible production capacity or asset will give you
the opportunity of using them in different ways, depending on market conditions.

Growth options: these are usually associated with strategic investments, though NPV is
negative sometimes, but with substantial positive NPV can indispensable for implementing
following projects, greater (in module) than loses from the initial project.

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Arguments in favor of real options

By using this method decision makers can put together a number of options into a single
investment. A greater flexibility and improved method allowed for valuing prospects. Real
options increase the manager ‘s general understanding of the investment decision and helps them
in recognizing and accounting for uncertainty (Bailey &Sporleder, 2000).

Arguments against real options

The research by Awomewe and Ogundele (2008), has shown that real options have got the
following disadvantages: itis complicated when applied to stock evaluation, the method is not
suitable to an investor picking stock but is benefited fora company deciding on its strategy and
the company must have the management skills and the resources to make use of the options;
furthermore, an option is not worth pursuing if it cannot be funded effectively.

3.1.2 Discounted Cash Flow techniques

Net Present Value (NPV)

This is the parameter which measures the variation between the current value of Cash inflows
and outflows (Awomewe&Ogundele 2008; Van Horne 1992). The required rate of return is used
to discount present value of all cash flows in this method (Van Horne, 1992). The evaluation of
the NPV of a project must encompass measuring the project’s future net cash flows, obtain their
present value by discounting these at suitable cost of capital, deducting the initial capital cost or
net investment outlay, at the beginning period of the project (Elumilade et al., 2006). For
example, if the present value of a project is €1million and the initial investment is €600 000; this
means that the net present value of this project is €400 000. In calculating the project’s net
present value, the cash flows accumulating at different times are modified using a discount rate,
that is for accepting a project the minimum rate of return required (Awomewe&Ogundele 2008;
Ross et al., 2009). The rule of thumb with the NPV method is that, projects which are having
positive net present values or values at least equal to zero are acceptable and projects having
negative net present values are unacceptable (Drury, 2004). Using inflation rate and returnsNPV
compares the value of a euro today to the value of that same euro in the future (Sony, 2006).The

19
required rate of return or the rate at which cash inflows are discounted will remain the same
when cash inflows are reinvested (Drury, 2004). The study of Bhandari (2009) has indicated that
NPV has the following qualities which qualify it to be regarded as the best technique, these are:
it adjusts for time value of money, measures profitability, consistent with the wealth
maximization goal, can adjust for risk, considers all cash flows, and assumes realistic
reinvestment of intermediate cash inflow

The NPV is computed using the following formula:

NPV = Ct / (1+r) t – Co

Where Co is the present value of cash outflows, if cost is incurred over a period of time. Note
that higher NPVs are more desirable.

The specific decision rule for NPV is as follows:

NPV = 0, reject project

NPV > 0, accept project

For mutually exclusive projects, accept the project with a higher NPV.

Arguments in favor of NPV

By discounting the cash flows the NPV method takes into account the time value of an
investment opportunity (Awomewe&Ogundele 2008; Bennouna 2010; Sony 2006). Sony (2006),
in his study has argued that accounting practices such as depreciation and non-cash expenditures,
managements taste and profits from existing business do not affect the decision since the
computation of NPV is based on the predicted cash flows from the investment. Also, compared
to others such as the payback period which ignores the cash flows after the payback period
methods NPV uses all cash flows of the project (Ross et al., 2009).

Arguments against NPV

Many writers agree that NPV is the superior method but it also shows an inconsistent behavior.
When discount rate increases NPV increases and decreases when discount rate decreases
(Oehmke, 2000). When evaluating highly technical and risky projects this cause the NPV to be

20
less useful. No decisions would be taken in the forthcoming years after the investment decision
as NPV systematically ignore all investment projects (Sony, 2006).

Internal Rate of Return (IRR)

This is the discount rate at which the present value of expected capital investment outlays is
same as the current value of anticipated cash earnings on that capital project
(Awomewe&Ogundele 2008; Kunsch 2008; Soni 2006). The study by Awomewe and Ogundele
(2008) brought to light that IRR can also be referred to as the economic rate of return (ERR).
This has also been defined by Soni (2006), as the rate at which the net present value of a project
equals zero. It can also be considered as the annualized rate of return (in percent) of an
investment using compound interest rate calculations (Soni, 2006). The rate of return over cost is
that rate which is used in calculating the current values of all the costs and the present value of
all the revenues (Diacogiannis 1994; Elumilade et al., 2006).This denotes that the IRR is the
breakeven point of cost of capital and therefore a measure of investment liability with regard to
the rate of return instead of value (Elumilade et al., 2006; Van Horne 1992). IRR rule is
straightforward and gives a valuable understanding to decision-makers about appropriate
evaluation of expected rate of return per unit of time throughout the investment process (Drury
2004; Elumilade et al., 2006). The study by Graham and Harvey (2001) has shown that IRR is
the primary method mostly used by large firms.

The rule of thumb for IRR states that the higher the return from the project, the more attractive it
is to undertake the project. As a result, it is used to rank several prospective projects a firm is
considering (Awomewe&Ogundele, 2008).

IRR can be calculated using the following formula;

IRR = Cash flows / (1+r)i– initial investment

Arguments in favor of IRR

The IRR method calculates the current value of investment opportunities’ cash flows and hence
takes into account the time value of money (Bennouna 2010; Diacogiannis 1994; Sony 2006).
This time value states that today’s money is worth more than the money received in future. This
is a primary condition in the selection of investment appraisal methods (Correia & Cramer 2008;

21
Sony 2006). The IRR uses net cash flows of the project in its computation. These cash flows are
computed as total cash inflow fewer total cash outflow (Sony 2006; Van Horne 1992). The
method is easy to understand; and communicate for managers and shareholders compared to
NPV, due to inexperience with the details of the appraisal techniques (Sony 2006; Van Horne
1992).

Arguments against IRR

Reinvestment assumptions developed by IRR that make bad projects look beneficial and good
ones look awful (Kelleher &MacCormack, 2004). The technique supposes that the intermediate
cash flows can earn similar rate of returns as the initial 44 projects, and this creates unrealistic
returns to the management and shareholders. (Kelleher &MacCormack, 2004). This method can
mislead management and shareholders with regards to the viability that the returns changes over
the life of the project. The project has got difficulties in handling project with unconventional
cash flows (Atrill&Mclaney, 2009).

Profitability Index (PI).

The Profitability Index (PI) is the ratio of the present value of future cash flows to the actual cash
outflow and it also known as the “Benefits-Cost Ratio” (Elumilade et al., 2006; Van Horne
&Wachowicz 2001). How a projects total net cash flows (in today’s value) cover its initial
investment can be showed by PI method (Diacogiannis, 1994). Among several option it can help
managers or decision makers to select the best project (Elumilade et al., 2006). The PI method has
been seen to have the following attributes: considers all cash flows, can adjust for risk, simple to
understand, measures profitability,assumes realistic reinvestment of intermediate cash inflow and
time value of money adjusted (Bhandari, 2009). If profitability index is 1 or more then the
project will be accepted that means the actual cash outflow is lower than the project’s present
worth which means NPV is greater than zero (Van Horne &Wachowicz, 2001).

Mathematically, this can be calculated using the following formula:

Profitability Index PI = PV of future cash flows / Initial investment

For independent projects, the PI decision rule is

22
Accept an independent project if PI > 1.

Reject if PI is < 1.

For mutually exclusive projects, the PI decision states that accept the project with a higher PI.

Arguments in favor of PI

In evaluating capital budgets Profitability index has been seen as a better method to useby
Diacogiannis(1994), because it considers the size of the project and the timing of its cash flows
over its life time. It also provides a comparative measure of the current worth for each dollar of
actual investment. The method is also easy to understand (Botha et al., 2007).PI adjusts for
riskaccording to Hawawini and Viallet (2007).

Arguments against PI

This method has been seen by Diacogiannis (1994), when interpreting the profitability,it is
difficult to use becauseit does not have the innate attractiveness of a rate of return. Also, when
mutually exclusive projects with different sizes are being considered the method may provide
unacceptable results (Diacogiannis, 1994).

3.2Comparison between NPV and IRR

NPV; this term’s abbreviation is Net present Value. This term reflects both positive and negative
flows of cash in all respects of a particular project’s life cycle discounted today. NPV reflects a
pureevaluation, this is applicable in accounting and finance there this thing is used to find
investment security, judging new ventures, value a startup, and also to get ways to make impact
oncost to reduce it.

IRR; this term’s abbreviation is Internal Rate of Return which is term usable in capital budgeting
technique. This thins can be used to estimate the profitability of a probable business venture. The
metric works as a discounting rate that equates NPV of cash flows to zero.

Under the NPV approach, the present value can be calculated by discounting a project’s future
cash flow at predefined rates known as cut off rates. However, under the IRR approach, cash
flow is discounted at suitable rates using a trial and error method that equates to a present value.

23
The present value is calculated to an amount equal to the investment made. If IRR is the
preferred method, the discount rate is often not predetermined as would be the case with NPV.

NPV takes cognizance of the value of capital cost or the market rate of interest. It obtains the
amount that should be invested in a project in order to recover projected earnings at current
market rates from the amount invested.

On the other hand, the IRR approach doesn’t look at the prevailing rate of interest on the market,
and its purpose is to find the maximum rates of interest that will encourage earnings to be made
from the invested amount.

NPV’s presumption is that intermediate cash flow is reinvested at cutoff rate while under the
IRR approach, an intermediate cash flow is invested at the prevailing internal rate of return. The
results from NPV show some similarities to the figures obtained from IRR under a similar set of
conditions, while both methods offer contradicting results in cases where the circumstances are
different.

NPV’s predefined cutoff rates are quite reliable compared to IRR when it comes to ranking more
than two project proposals.

3.3Sensitivity analyses (SA)

Sensitivity analysis to examine how the NPV or IRR results might improve if the projected
financial performance haven't yet been achieved or if the fundamental assumption changes. This
also helps executives focus on choices that are much more vulnerable to different assumptions
and a little less concerned about not so crucial choices. The probability was never assessed
throughout this method. Variables of responsiveness comprise selling rates, volume of sales,
capital cost, original costs, operating benefits and costs. It needs to be taken into account for the
investment evaluation while the more critical factors can be identified.

24
3.4 CAPITAL BUDGETING DECISIONS:

The crux of capital budgeting is profit maximization. There are two ways to it; either increase the
revenues or reduce the costs. The increase in revenues can be achieved by expansion of
operations by adding a new product line. Reducing costs means representing obsolete return on
assets.

Accept / Reject decision – If a proposal is accepted, the firm invests in it and rejected if the firm
does not invest. Generally, proposals that yield a rate of return greater than a particular required
rate of return or cost of capital are accepted and the others are rejected. All independent projects
are accepted. Independent projects do not compete with one another in such a way that
acceptance gives a fair possibility of acceptance of another.

Mutually exclusive project decision – Mutually exclusive projects are projects that compete
with other projects in such a way that the acceptance of one will exclude the acceptance of the
other projects. Only one may be chosen. Importance gain by Mutually exclusive investment
decisions when more than one proposal is acceptable under the accept / reject decision. The
acceptance of the best alternative eliminates the other alternatives.

Capital rationing decision – During a situation where the firm has unlimited funds, capital
budgeting becomes a very simple process. In that, independent investment proposals yielding a
return greater than some predetermined level are accepted. However, actual business has a
different picture. They have fixed capital budget with bigger number of investment proposals
competing for it. Capital rationing means the firm has more acceptable investments requiring a
greater amount of finance than that is available with the firm. Ranking of the investment project
is employed because of some predetermined criterion such as the rate of return. The project with
highest return is ranked first and the acceptable projects are ranked thereafter.

25
 Chapter Four

Findings, Conclusion & Recommendations

26
4.1 Findings
• Capital budgeting prefers in using DCF method (NPV, IRR, PI) and non DCF method
(PB and ARR) for making capital budgeting decisions.
• Non discounted cash flows do not consider time value of money but discounted cash
flows such as NPV and IRR consider cash flows and time value of money.
• A business can gain a better competitive advantage to its conflicts in an environment by
using capital budgeting techniques.
• Modern methods such as NPV and IRR are mostly used over traditional methods like
payback period.

4.2 Conclusion

Capital budgeting is a process of making decisions on a cash outlay in order to get benefit in the
future through cash inflows. Shareholder value is produced if the present value of the cash
inflows exceeds that of the cash outlay but this will mainly depend on the minimum acceptable
target set by the management. Different stages are involved in the capital budgeting process
which enables decision makers to make reasonable decisions. Managers can make use of several
techniques when evaluating their projects which have been deal with in the literature study.
These are the Net Present Value (NPV), Internal Rate of Return (IRR), Discounted Payback
Period (DPP), Profitability Index (PI), Payback Period (PB) and Accounting Rate of Return
(ARR). These methods have their own advantages and disadvantages. These advantages and
disadvantages make other techniques to be more superior to others. The real option has to be
used only in making decisions on whether to continue or abandon a project which has already
been undertaken. This method enables the managers to make decisions about abandoning,
postponing a project, operating options etc. Once a firm has adopted one method in evaluating a
project, it is wise that they should continue using that same method for them to be able to get
comparable results.

The NPV technique should be used in all large projects which involve large sums of money
because it considers all cash flows and is consistent with the wealth maximization goal.
Therefore, managers will be in a position to go ahead with a project which they know very well

27
that it will maximize the shareholder value. PI should be used for small projects, social and
administrative projects because of it not being consistent with the wealth maximization goal. The
IRR can be used on small projects. ARR and PB can be used in social and administrative projects
where the company is not worried about the profitability of the project.

4.3 Recommendations

• The most relevant costs are needed to consider in determining the success of the project.
• Risk factors should be evaluated at the planning stage and analyses should be performed
to decrease the risk.
• Managers should apply all methods to effectively allocate all the resources when
choosing one method over another.
• The use of real options techniques is recommended as they facilitate the linkage of
financial objectives with corporate strategy in the ever-increasingly complex business
environment.

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