OKAFOR CAJETAN NDUBUISI PG/MBA/08/53193

Transcription

1 OKAFOR CAJETAN NDUBUISI PG/MBA/08/53193 PERCEPTION OF CAPITAL BUDGETING AS A TOOL FOR OPTIMUM INVESTMENT ANALYSIS A THESIS SUBMITTED TO THE DEPARTMENT OF BANKING AND FINANCE, FACULTY OFBUSINESS ADMINISTRATION, UNIVERSITY OF NIGERIA ENUGU CAMPUS BUSINESS ADMINISTRATION JULY 2O10 Digitally Signed by: Content manager s Name IJEOMAH CLARA DN : CN = Webmaster s name O= University of Nigeria, Nsukka OU = Innovation Centre

2 TITLE PAGE PERCEPTION OF CAPITAL BUDGETING AS A TOOL FOR OPTIMUM INVESTMENT ANALYSIS A CASE STUDY OF SELECTED COMPANIES IN PORT HARCOURT PROJECT PRESENTED BY OKAFOR CAJETAN NDUBUISI PG/MBA/08/53193 DEPARTMENT OF BANKING AND FINANCE FACULTY OF BUSINESS ADMINISTRATION UNIVERSITY OF NIGERIA, ENUGU CAMPUS (UNEC) IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE AWARD OF MASTER OF BUSINESS ADMINISTRATION IN BANKING AND FINANCE JULY, 2010

3 CERTIFICATION This research work titled Perception of Capital Budgeting as a tool for optimum investment analysis: A study of selected companies in port Harcourt was carried out under the supervision of Dr. J.U.J. ONWUMERE in partial fulfillment of the requirements for the award of Master s Degree in Banking and Finance (MBA) in University of Nigeria, Enugu Campus... Dr. J.U.J. Onwumere. Date (Supervisor). Dr. J.U.J Onwumere.. Date (Head of Department). External Examiner. Date

4 DEDICATION This work is highly dedicated to: My supportive and protective mother AND My loving and caring wife (Onyinye).

5 ACKNOWLEDGMENTS I express thanks to many people for their contribution and assistance especially Dr. J.U.J ONWUMERE my supervisor and Head of Department who meticulously proofread the manuscript and made very useful and significant contributions. Deep appreciation also goes to the following wonderful lecturers: Dr. Mrs. N. J. Modebe Prof. Chibuike Uche Mr. Asomuagha Mr. Okoro, I.E Okoro Thank you for your academic support and God Bless you. July, Okafor Cajetan Ndubuisi PG/MBA/08/53193

6 ABSTRACT Capital investment decisions are that decision that involves current outlays in return for a stream of benefits in future years. The distinguishing future between short-term decision and capital investment (long-term) decision is time. The objective of this study is the applications of capital budgeting patterns to enable the management of companies make credible investment decisions in areas like: Determining which specific investment projects the firm should accept. Determining the total amount of capital expenditure that the firm should undertake and determining how this portfolio of projects should be financed. As for the methodology, questionnaires were distributed to eight (8) companies in Port Harcourt. A total of 10 questions were proposed in the questionnaire to enable us carry out the study. The findings are as follows: That capital expenditure decisions made by companies have greater impact on their long-term operations and survival. That company employs professional financial manager to manage their capital investment activities. That companies employ appraisal techniques in making capital budgeting decisions, particularly, the net present value technique, and, That management of companies is responsible for all capital expenditure decisions and also authorizes such expenditure. Recommendation of computerization, application of DCF, adequate planning and control of capital budgeting decisions and training.

7 My suggestion is that if all the recommendations will be adapted, it will enhance good decision making on capital budgeting.

8 TABLE OF CONTENTS Title Page: i Approval Page: ii Dedication: ii Acknowledgment: IV Abstract: V Table of Content: VI CHAPTER ONE INTRODUCTION 1.1. Background of the Study: Statement of the Problems: Research Questions: Objectives of the Study: Statement of Hypothesis: Scope of Study: Significance of the Study:

9 1.8. Limitations of the Study: CHAPTER TWO REVIEW OF RELATED LITERATURE: Definition of Capital Budgeting: The Objective of Capital budgeting: Project Characteristics: Project Features: The Ranking and Selection of Projects: Analysis of Capital Expenditure Decisions: Nature of Investment Decision: Important of Capital budgeting Decision Classification of Investments Investment Appraisal: Discounted Cash Flow (DCF) Techniques Net Present Value (NPV) Internal Rate of Return (IRR) Non Discounted Cash Flow Criteria

10 Pay Back Period Accounting Rate of Return (ARR) Capital Rationing Risk Analysis on Capital Expenditure Decision Standard Deviation Coefficient of Variation Subjective Estimates Risk Adjusted rate of return Certainty-Equivalent Sensitivity Analysis Capital Expenditure Decisions Under Inflation References: CHAPTER THREE RESEARCH METHODOLOGY 3.1 Introduction Research Design: Source of Data

11 3.3.1 Primary Source of Data Secondary Source of Data Population: Description of Sample Instrumentation and Validation: Data Analytical Techniques The Questionnaire Data Treatment and Analysis Decision Criteria: CHAPTER FOUR DATA PRESENTATION, ANALYSIS AND DISCUSSION: 4.1. Distribution of Questionnaires and Responses: Distribution of questionnaire and responses: Data Analysis The First Research Question The Second Research Question

12 4.3.3 The Third Research Question The Fourth Research Question CHAPTER FIVE SUMMARY OF FINDINGS, CONCLUSION AND RECOMMENDATIONS: 5.1. Introduction: Summary of Findings: Recommendations: Suggestion Appendix: Bibliography:

13 CHAPTER ONE INTRODUCTION 1.1 BACKGROUND OF STUDY When a company identifies an investment opportunity, the company will not immediately commit funs into that line of investment. All the factors, both internal and external, must be critically analyzed before making any decision. In making investment decisions, the cost of capital should also be considered. This therefore, requires adequate planning on the part of management of companies. To make sound investment decisions, companies employ more modern and sophisticated quantitative method as linear programming, Critical Path Analysis (CPA), Program Evaluation and Review Technique (PERT), Stock Control Model (EDQ), etc. The use of these quantitative models results in better investment decisions. This is to enable the management of companies to effectively and efficiently use scarce resources in achieving their objectives. But one major area that tends to determine the colour and dimension of a company s survival is that which related to capital budgeting. That is the decision to acquire fixed assets for the operations of companies. This is the must difficult aspect considering the fact that such decisions are irreversible once they are embarked upon. Ordinarily, it would have been

14 so straightforward like the decision to buy a motorcar. Capital budgeting goes beyond that because the fixed assets to be acquired would be used for a long time. The decision to acquire fixes assets is very important to the realization of the objectives of a company. Whether a company operates in the manufacturing or service industry, fixed assets are very important to its operations. The acquisition of such fixed assets as land and building, plant and machinery, furniture and fitting, etc. will certainly impact on the performance of a company. These are long-term assets and require huge financial outlay on the part of a company. In order to make better and sound capital budgeting decisions, appraisal techniques are usually employed by companies. As a result of the strategic nature of such decisions, management of companies take active participation in making such decisions. In making capital budgeting decisions, management of companies always makes reference to the goals and objectives of the companies. Even though business enterprises are organized with the aim of making profit, the goals of a private company may not be clear. In large companies, most shareholders can effectively exercise their powers by selling their stocks when their companies performed very badly. Consequently, the management of a company may set goals that may include prestige, power, security, and continuity of the organization. However, the most specific objectives guiding the transactions of a company are: 1. Maximizing profits 2. Maintaining the market position 3. Stabilizing company s structure with regard to assets and liabilities

15 4. Expansion Because companies operate within defined areas, government impose certain regulations and tax laws. These limitations allow the government some elements of control over the activities of the companies in the economy. Before committing the resources of a company into new areas of investment, the dominant factors that may affect the marketing of the products or services must be considered. Capital investment decisions involve a high degree of risk. The need for careful planning and management of capital budgeting decisions is very important. Since cash flows from such investments are tied to the future, the risk level is on the high side. Because the future is not easy to predict, it becomes imperative to address such questions as: What will be the trend of technology? Will supply of natural resources including energy and materials be adequate? Will government regulations and tax policies become more restrictive? What will be the social value that may influence the manufacturing or provision of services and making demand? These are important questions that affect capital budgeting decisions. They all have future dimensions because they are tied to the nature. A critical analysis of these future trends will serve the purpose of making sound capital budgeting decisions by companies. This underscores the need for

16 companies to employ appraisal techniques to enhance their capital budgeting decisions. This study looks at how capital budgeting techniques could be employed to assist management of companies make sound investment decisions. 1.2 STATEMENT OF THE PROBLEM As a result of high level of risk and uncertainties inherent in capital expenditure decisions, it has become imperative for management of companies to critically analyze the intervening factors. The decision to acquire fixed assets is a very difficult management exercise. A good investment decision opportunity could turn out to be a pathway to suicide if a company fails to plan and make adequate capital budgeting decision. This has been a major cause of failure of companies in Nigeria. To a large extent, political, social, economic and technological variables direct the outcome of capital budgeting decisions by companies. These variables have far reacting influence on capital budgeting decisions as they are beyond the control of the decision maker. The employment of capital budgeting techniques is to minimize the effect of these variables and ensure sound decisions. The problem we intend to address in this study is directly related to capital budgeting.

17 1.3 RESEARCH QUESTIONS Question 1: Question 2: Question 3: Question 4: What are the effects of capital budgeting decisions on the corporate strategies and long term survival of companies? What are the effects of outsourcing capital expenditure decisions of companies and consultancy firms to manage the company s capital investment? Are capital budgeting techniques applied in making capital expenditure decisions in your country? Given the strategic nature of capital expenditure decisions on company s performance, are such decisions made by management? 1.4 OBJECTIVES OF THE STUDY The objectives of this study are: (a) (b) (c) (d) To determine the perceived impact of capital budgeting criteria on the performance of companies. To determine the roles of management with respect to project appraisal. To determine the nature of capital budgeting decision making in companies. To study and analyze capital budgeting practices in companies.

18 1.5 STATEMENT OF HYPOTHESES Our hypotheses for this study are as follows: Ho 1 Capital budgeting techniques are not applied in making capital expenditure decisions. H A1 Capital budgeting techniques are applied in making capital expenditure decisions. Ho Outsourcing capital expenditure decisions to professionals and consultancy firms do not produce better results than when such decisions are taken internally. H A2 Outsourcing capital expenditure decisions to professionals and consulting firms do produce better results than when such decisions are taken internally. H o3 Decision making model stages have not been adapted to incorporate capital investment decisions.

19 H A3 Decision making model stages have been adapted to incorporate capital investment decisions H o4 Capital budgeting techniques have no effect on the corporate strategies and long-term survival of companies. H A4 Capital budgeting techniques have effect on the corporate strategies and long-term survival of companies. 1.6 SCOPE OF STUDY Our study covers selected companies in Port Harcourt. Specifically, we limited our study to eight companies. The study centers on the way and manner companies make capital expenditure decisions. Because company s studies are subject to the same legal, economic and social factors as prevalent in other parts of Nigeria. Our conclusion also apply to other companies outside our area or study. 1.7 SIGNIFICANCE OF THE STUDY The important of this research include:

20 (i) (ii) (iii) (iv) (v) It provides a basis for understanding the concept of capital budgeting decisions. It highlights the problems that management will encounter in making capital expenditure decisions and proffers useful suggestions. It provides useful information that will assist management to make sound decisions. Students offering financial and management accounting find this study useful at understanding capital budgeting as practical by companies. It also highlights how companies could use funds effectively and efficiently. 1.8 LIMITATIONS OF THE STUDY Financial and time constraints actually worked against this study. They made it very difficult and formed major obstacles to the smooth conduct of the work. As a result, we could not travel to other parts of the country to collect relevant data for the study.

21 The data collected and used in this study were from the eight companies studied in Port Harcourt, River State. Therefore, findings contained in this study are based on the companies studied.

22 CHAPTER TWO REVIEW OF RELATED LITERATURE 2.1 INTRODUCTION The investment in fixed assets by a company requires a huge capital outlay. Since such investments will require quite a sizeable amount of funds on the part of a company, it becomes very important to undertake an in-dept analysis at all the factors that are likely to affect such decisions by the management of companies. The concept of capital budgeting or capital expenditure deals exclusively on major investment proposals and is employed to aid the firm to invest its funds over the long-term. The decision to acquire fixed assets for the operations of a company will definitely impact on the company s survival and performance. By committing its scarce resources into the acquisition of fixed assets, the firm cannot easily withdraw or abandon such decisions without incurring huge financial losses. For example, if a manufacturing company forecasts the need for additional manufacturing space, it may begin the construction of a new factory. If, however, changing economic conditions eliminate the need for

23 the extra factory or capacity, the company may insure some financial losses as result. If the company decides to maintain the existing factory space and the new capacity, in the hope that the conditions will improve then the loss cannot be easily quantified. This will definitely play down on the aims and objectives of the company for as long as the conditions remain the same or get more severe. This long-term commitment, which is a basic characteristics of fixed assets, adds considerable risks to the company s capital budgeting decision. Because modern business organizations look at the customer as king, it has become important to analyze such success factors as price, quality and delivery time in the provision of goods and services. These factors are responsible for companies investment in manufacturing and service delivery facilities. The dynamic nature of the global economic conditions and technological innovations has made the task of deciding on the acquisition of fixed assets by companies more difficult. This is a tough management exercise that could affect the profitability, performance and survival of a company. Many specialists have dealt much on modern interest and emphasis on capital budgeting. Post Word War reconstruction efforts have stimulated the search for critical or systematic decision rules for investment appraisals. As a result of rapid economic growth and the ever dynamic nature of technology, there exist several investment opportunities available in all fields of human endeavors. The improvement in capital budgeting decision is due to technological advancement. The widespread applications of decision rules by companies have also resulted in making optimum capital budgeting decisions. A rule of thumb approach to capital

24 expenditure decisions could result in sub-optimization and this affects the corporate objectives. This is because a critical appraisal of available alternatives rising capital budgeting techniques highlight the best option to adapt. This will enhance the corporate objectives and result in an increase in the value of the firm and those of the shareholders. 2.1 DEFINITION OF CAPITAL BUDGETING Capital budgeting decision is one of the most difficult and important decisions that the management of any company makes. The reason, as already pointed out earlier, is that such decisions involve a substantial commitment of a company s funds in the acquisition of fixed assets. Pandey (1994: 11) points out those investment decisions of the firm are commonly referred to a capital budgeting or capital expenditure. He defined capital budgeting as: The firm s decision to invest its current funds most efficiently in long-term activities in anticipation of an expected flow of future benefits over a series of years. The long-term activities of a firm include those that span more than one accounting period. In other words, the firm s capital budgeting decision

25 includes addition, modification and replacement of long-term fixed assets. The benefits from such investments are tied to future cash inflows as against current cash out flows. The emphasis is on future anticipated earning or cash flows from such investments. Since they are inextricably tied to future conditions, which are far from certain. Schell and Harley (1979: 21) points out that: Capital assets are used by the company in the physical process of producing goods and services and are ordinarily used for a number of years. Their position were based on the fact that investments in fixes assets involve huge financial outlay on the part of companies. They concluded that business organizations carefully plan and evaluate available investment opportunities in the economy. This process of planning and evaluating available investments opportunities, they referred to as capital budget and the process of determining the total financial outlay and the required fixed assets for a given project they referred to as budgeting. Warren and Febb (1986: 15) define capital budgeting as: The process, by which management plans,

26 evaluates and controls such investment. The investment they referred to is that relating to acquisition of fixed assets. Investment in fixed assets has a long-term gestation period from the conceptual stage to when it starts to earn some stream of cash flows. Such investment should be capable of earning a reasonable rate of return, so that the business can meet its obligations to providers of capital and provide dividends to shareholders. Hampton (1986:36) defines capital budgeting as: The decision making process by which firms evaluate the purchase of major fixed assets, including buildings, machinery and equipment. It also covers decisions to acquire other firms, either common stock or groups of assets that can be used to conduct an on going business. He further stated that capital budgeting describes the firm s formal planning process for the acquisition and investment of capital. This results in a capital budget that is the firm s formal plan for the expenditure of money to purchase fixed assets. The point worth nothing in this definition is that capital budgeting involves investment in major fixed assets in order to enhance the activities of a firm. While firms explore the securities market for investment in stocks and bonds, capital projects is the creation of the firms. If a firm wants to buy or sell stocks or bonds, it wil approach the securities market for such

27 transactions. But this is not the case with capital budgeting, the firm has to plan and evaluate available alternatives and then decide on which fixed asset to acquire. In this sense, the firm is proactive since it must take the very first step or make the initiative in acquiring fixed assets. Eugene (1985: 37) states that: A sale representative may report that customers are asking for a particular product that the company does not now produce. The sales manager then discusses the idea with the marketing research group to determine the size of the market for the proposal product. If it appears likely that a significant market does exist, cost accountants and engineers will be asked to estimate production costs. If the whole analysis suggests that the product can be produced and sold to a sufficient profit, then the project will be undertaken. He further stated that a firm s growth and development even its ability to remain competitive and survive, depend upon a constant flow of new investment ideas. Accordingly, a well-managed firm will go a great length to develop good capital budgeting proposals. Therefore, capital budgeting decisions start right from when an investment opportunity is considered profitable. The company s planning committee in collaboration with the finance manager and the sales manager will estimate the future sales of the company before a decision is taken on the number of fixed assets to acquire. The production department then analyzes the cost of plant and equipment necessary to undertake the production of the goods and services.

28 Before a company can start the production of goods or services, it must first of all make adequate management for all the necessary facilities. The acquisition of such facilities involves an enormous amount of a company s funds. That is, the basis of capital budgeting decision is rooted in the efficient and effective use of the company s funds in the acquisition of fixed assets. Capital budgeting decision is based on the theory of capital budgeting. The application of the theory will enable the user to make optimum capital expenditure decision as by addressing the following three questions: 1. What specific investment should the firm accept to invest its scarce fund? 2. What amount of capital expenditure should the firm set aside for such investment? 3. How should the portfolio of projects be financed? A critical analysis of the above questions reveals that they are interrelated to each other, so that one expects a closely related answers or decisions. The problem is not simply one of deciding the investment portfolio to accept and finance with the company s funds. The amount of borrowing and the volume of shares to be issued in the event of raising the required capital are variables that the company must consider. In other words, the firm must make decision on what project to accept and the acquisition of funds to finance the project. In determining the criteria for project appraisal, it is important to consider the cost of capital to the company. Therefore, the amount of finance its investment will be predominantly determined by the nature and characteristics of the investment opportunities available to it.

29 2.2 THE OBJECTIVE OF CAPITAL BUDGETING Decision making is quite a difficult managerial exercise because it requires adequate planning and evaluation of variables that are likely to affect it. Quality decisions can only be possible if and only if the decision maker critically analyzes the necessary inputs. However, any decision, made by a company must have a direct bearing on the objective(s) of the company. If this is not the case, then such decisions will impact negatively on the operations of the company. Objectives setting therefore, provides the milestone for making decision by companies. The objective of employing capital budgeting techniques is to ensure a quality and optimum capital expenditure decision by companies. Therefore, good decision is the under current making for the application of capital budgeting techniques. Eugene (1986: 19) states that: A good decision can boost earning sharply and Increase dramatically the price of a firm s stock. A Bad decision can lead to bankruptcy. The question is: What is the objective of capital budgeting? The answer to this question requires a close analyses in order to really

30 appreciate what the objective of capital budgeting is to companies. Citing the examples of the Lock head s production of the L-1011 Tri-Star commercial jet, Eugene (1986: 14) states: A classic example of a bad capital budgeting decision which could have easily been avoided involved Lockhead s production of the L Tri-Star commercial jet. At the time Lockhead made the final decision to go forward with Tri-Star production, it estimated the breakeven volume at about 200 planes. The company had orders for about 180 planes, and was sure of getting at least 20 more orders. Consequently, it decided to commit $ 1 billion and to commence production. However, Lockhead s analysis was flawed it failed to account properly for the cost of the capital used up in the project. Had its analysis appraised the project correctly, they would have found that the break-even point was far above 200 planes- so far above that the Tri-Star program was almost certainly doomed to financial failure. This mistake contributed to a decline in Lockhead s Stock from $73 per share to $3. This was an outrageous result to the management of Lockhead because of the dramatic fall in the value of the company s share from %73 to $3 per share. This embarrassing situation arose out of improper capital

31 budgeting and appraisal of capital investment decision by the management of the company. Such free fall in its share price could have waned the confidence of both existing and potential investors in the company shares. The entire process of capital accumulation overtime requires the commitment of great deal of company s resources. Management has the sole responsibility of setting the objective(s) that relates to capital budgeting, from the classic example given above, we can conclude that the capital budgeting seeks to achieve efficiency and effective operations to meet the demand of the company and thus reduce waste to the barest minimum possible. The fact that management takes full responsibility for capital budgeting decisions justifies the strategic nature of such decisions. This very fact goes a long way to define the objective(s) that management may set with respect to capital expenditure decision. Capital budgeting therefore boils down to making optimum capital expenditure decision by companies. This is the objective and pillar on which companies applied such techniques PROJECT CHARACTERISTICS Every project has a unique feature that distinguishes it from others. These characteristics define the kind of project that a company intends to embark upon. For a better understanding and appreciation of project characteristics, it is important to define what constitute a project. Kayoed (1979: 68) defines a project as:

32 An optimum set of investment oriented actions by means of which a defined combination of human and material resources is expected to cause a determined amount of economic and social development. Also Okafor (1981: 82) defines a project as: A group of real assets which taken together can complete a service or production cycle. In general terms, projects could be in the form of expansion, acquisition, replacement and modernization of long-term assets. The need to expand on the part of a company may be premised on the reason of satisfying an existing and expanding market for its products or services. To attain this objective, company may increase its stocks of new equipment. Even if a company decides to establish new branches or increase its production time, the need for new equipment is always there. Through the modernization of its plants and equipment, a company is capable of improving the efficiency of existing productive capacity. On the whole, modernization results not in improving products, quality, but also in increasing the production output of a company. 2.3 PROJECT FEATURES The underlying features of a project are almost the same as undertaken by all companies. The reason is that they are based on planned project. Nothing makes them unique, though there may be differences in

33 structure and details, especially the weight of the project. The differences arising from the accept/reject rule or criteria for appraising a project notwithstanding, the technical requirements may not change. The major features of investment project are: (a) (b) (c) (d) Creation of fixed capital assets Time separation of investment cost and benefits time for project planning, investment and operation. Use of scarce invests able resources like economic resources of land, labour etc. used for closely defined projects. The resources can be wasted if the project is not well planned. Offer several alternative means of using resources THE RANKING AND SELECTION OF PROJECTS It is the responsibility of management to decide and select the fixed assets to be acquired by a company. A careful appraisal of investment in fixed assets is very important considering the strategic nature of such investment analyzing at a project, Wayne (1978: 20) recommends two important criteria viz:- (i) Liquidity and (ii) profitability. If a project generates enough liquid assets (cash) to meet current obligations of a company and same time make sizeable amount of project, then that project is viable for other words, a project acceptance or rejection should be based on its liquidity and profitability.

34 Pandey (1994: 119) recommends the following three steps in the evaluation of an investment: 1. Estimation of cash flows 2. Estimation of the required rate of return 3. Application of decision of rule for making the choice Therefore a good ranking and selection criteria should possess the following features: 1. Recognize the time value of money by preferring an early receipt to a later one. 2. Consider the cash flows over the project entire life 3. Incorporates the firm s cost of capital 4. Weigh the uncertainty involved in the project. The project analyst should determine the cash flow of any project. In appraising a project, the historical cash flows may be used in some cases. However, such cases are hard to come by in the real world situation. Everything about a project is based on estimates and forecast of future trends, which are far from certain. The analyst should also determine when to employ absolute, relative or incremental cash flows. Where the alternative investments are mutually exclusive, the project analyst can rely on absolute cash flows. The employment of relative cash flows becomes important in some other circumstance. For example, company would consider the impact on the company s sales volume and revenue on the decision to improve the quality of its products through the acquisition of

35 modern equipment or through increased financing of research and development efforts. Another way is for the company to evaluate the impact of such improvement on costs of production. The benefits that are likely to arise from investments in certain projects are usually compared with the incremental cost of the projects. This underscores the relative cash flow approach and tends to compare the incremental costs with benefits of implementing the project so that an estimation of the cash flows on a given set of investment opportunities will be dependent on the nature of the investments undertaken by a company. In almost all cases, estimating cash flow boils down to estimating the initial investment cost and operating cash flows. This requires estimating the sales volume and revenue over a project life span and the after tax and adjustment for no cash expenditure or revenue. 2.4 ANALYSIS OF CAPITAL EXPENDITURE DECISION NATURE OF INVESTMENT DECISION The expenditure profiles of companies with respect to acquisition of fixed assets are usually very high. This is understandable because the need to invest in a new area of trade, modernization, expansion or replacement usually go with heavy investment in fixed assets, capital expenditure decision tend to determine the value and size of a company by influencing its growth, profitability and risk. It is worth noting that capital expenditure covers expansion, acquisition, modernization and replacement of long-term assets, but also include disposal of a division on business. The

36 later aspect of investment decision is referred to as divestment. Besides, research and development and advertising promotions are also classified as investment decisions as they have long-term effect on the company s operations. Pandey (1994: 181) states the following as features of investment decision: 1. The exchange of current funds for future benefits 2. Funds are invested in long-term assets. 3. Future benefits will be enjoyed by the company over a number years. However, he emphasized that expenditures and benefits of an investment could be measured in cash. According to him, in analyzing investment, the over riding point should be based on the cash flow rather than the accounting profit. Investment decisions have a direct impact on the value of a company. Therefore, the value of a company will increase if the investments made are profitable and also increase the wealth of the shareholders with the objective of the shareholders wealth maximization. To give a better understanding of capital investment decision we shall now consider how they fit into overall framework for decision making. A decision making model as shown below by Drury (1992:218) is usually adapted companies to incorporate capital investment decisions. 1. Identify objectives 2. Search for Investment 3. Identify states of nature

37 Figure: A decision-making model for capital investments decision IMPORTANCE OF CAPITAL BUDGETING DECISIONS Quirin (1977: 179) outlines the following reasons why capital budgeting decisions requires special attention:

38 1. they have long-term implication for the firm and can influence its risks complexion. 2. They involve commitment of large amount of funds. 3. They are irreversible decisions. 4. They are among the most difficult decisions to make. The activity of a company, in future, will be determined by the capital budgeting decisions taken today. Pandey (1994: 315) supports this vie when he states that: A firm s decision to invest in long-term assets has a decisive influence on the rate and direction of its growth. A wrong decision can prove disastrous for the continual survival of the firm unwanted or unprofitable expansion of assets will result in heavy operating costs to the firm. On the other hand, inadequate investment in assets would make it difficult for the firm to compete successfully and maintain its market share. The investments of funds in long-term assets by companies have the tendency to increasing the risk complexion of the company. If by investing its funds in a particular project result in a company making average profit, but causes frequent fluctuations in its earnings, the company will become more risky.

39 CLASSIFICATION OF INVESTMENTS Generally, investments can be classified into the following: 1. Mutually exclusive investments 2. Independent investment 3. Contingent investment Mutually exclusive investments, according to Hampton (1986), investments are classified as mutually exclusive if the acceptance of one project rubs out the need for another. An example, according to him, is a situation where a firm has two alternatives to undertake to transport its supplies to the warehouse. The firm will be considering two proposals-fork lifts to pick up the goods and move them, or a conveyor bet belt connecting the dock and warehouse. If the firm accepts one proposal, it eliminates the need for the other. Independent investments according to Pandey investments serve different purposes and do not compete with each other. An example, given by him is a heavy engineering company, which is considering expansion of its plant capacity to manufacture a new product - Light commercial vehicles, depending on their profitability and availability of funds, the company can undertake both investments. Contingent investments, Pandey (1994: 371) states that contingent investments are dependent projects, the choice of one investment necessitates that one or more other investments should be undertaken. According to him if a company decides to build a factory in a remote,

40 backward area, it may have to invest in houses, roads, hospitals, schools, etc. for employees. The total expenditure will be heated as one single investment. 2.5 INVESTMENT APPRAISAL Capital expenditure decision is based on capital budgeting theory which centers on the employment of sophisticated methods or analysis and formal planning in an effort to make optimal decisions. To the larger and more capital intensive companies, the issue relating to investment appraisal ranks very high considering the important of such decisions on their performances. Therefore, a sound appraisal technique should be used to measure the economic worth of an investment project. An appraisal technique is considered sound if its application in evaluating an investment results in the maximization of shareholders wealth. Besides, the three steps involved in the evaluation of an investment above, portal field (1965: 98) points out that a sound investment criterion should possess the following characteristics: 1. It should be a measure of the project s profitability by considering all cash flows. 2. It should provide a means of distinguishing between acceptable and unacceptable projects. 3. It should recognize the fact that bigger cash flows are preferable to later ones.

41 4. It should provide in ranking of projects in order of their economic desirability. 5. It should help to choose among mutually projects which maximize the shareholders wealth. To evaluate or appraise a given number of projects, or make capital expenditure decisions, the decision maker has a number of techniques, which he can rely on in order to make optimal and sound decisions. They may be categorized into: 1. Discounted cash flow (DCF) techniques unit. 2. This we have the following: a. Net Present Value (NPV) b. Internal Rate of Return (IRR) c. Profitability Index (PI) 1. Non-discounted cash flow techniques. We have the following under these categories: a. Payback Period (PP) b. Accounting Rate of Return (ARR) DISCOUNTED CASH FLOW (DCF) TECHNIQUES

42 The discounted cash flow (DCF) techniques of investment appraisal are sophisticated means of measuring the profitability of an investment proposal for general terms, discounted cash flow techniques recognize time value of money their applications and provide the users apt opportunities to determine the optimum investment opinion NET PRESENT VALUE This is one of the discounted cash flow techniques. It is a classic economic model of evaluation investment proposals. The flaws in the pay back period method made financial experts earnings receive immediately is preferable to earnings received at some future date. The development of discounted cash flow techniques have assisted greatly in solving these problems as they recognize the time value of money. One of each discounted cash flows techniques of the net value or economies referred to as the present value method. The application of the present value technique involves finding the present value of the expected net cash flow of an investment, discounted at the cost capital, and subtracted from the initial cost outlay of the project. A positive net present value indicates that the investment will be profitable. Based on this computed result, the project should be accepted, but if the result is negative, it should be rejected. If a company has two mutually exclusive projects to invest its funds, the one with the highest net present value should be undertaken.

43 To compute the net present value, the following equation is employed. NPV = f 1 + f 2 + f 3 f 4-1 = N (1 + k) (1+ k) 2 (1+ k) N t = 1 f r (1 + k) t - 1 Where f 1, f 2, and so forth represent the cash flows from an investment over its useful life. K represents the cost of capital; I is the initial cost of the project; and N is the project s expected life. Basically, the net present value method measures the different between the initial cost of investment and the subsequent cash inflow

44 discounted at the company s cost of capital over the project s expected lif. A positive difference means that project will be viable and vice versa. The net present value method calculates the present value of the stream of cash earnings (that is cash inflows) at some predetermined interest rate for comparison with the present value of the stream of investment. For a management, this predetermined rate of interest should be greater than or equal to the cut-of rate or the minimum rate of return. Pandey (1994) Stated that the steps involved in the NPV method are: First, an appropriate rate of interest should be selected to discount forecasted cash flows. Generally, the appropriate rate of interest is the firm s opportunity cost capital which is equal to the minimum rate of return expected by investors to be earned by the firm on investments of equivalent risks. Second, the present value of investment s cash flow should be computed using the opportunity cost of capital and the discounting rate. Third, the net present value should be found out by subtracting the initial cash outlay from the present value of the flows. The very tact that the NPV method exhibits all the desired decision rule properties makes it the best technique for evaluating project. Home 1985 stated that:

45 The market value of the firm would increase if project with positive net present value were accepted. The reason had been that projects with positive net present value would result in the generation of cash flows at a rate greater than the minimum rate acceptable to investors. The problem with the NPV techniques is in the allocation or correct measurement of the discount rate. Illustration 1 Suppose a project has the following cash flow patterns: Year N N N N N N Cash flows 3,500, , , ,000 1,200,000 1,500,000 Profit - 800, , ,000 1,100,000 1,400,000 Assuming the company s cost of capital is 12%. Determine the NPV of the project? Solution: Year Cash flow DCF(12%) NPV N N 0 (3,500,000) (3,500,000) 1 900, , ,000, ,000

46 3 850, , ,200, , , ,850 NPV +s 319,600 Comment: The result of the computation showed a positive NPV of N319,800 for the project. This means that the project is viable and should be accepted INTERNAL RATE OF RETURN (IRR) Another very important discounted cash flow technique is the internal rate of return (IRR). Eugene (1985) defines the IRR as: That discount rate, r. which equals the present value of a project s expected cash flows to the present value of the project expected cost. From this definition, it means that the IRR can be simply expressed as: PV (inflows) - (investment costs) or mathematically. N cf t = 0 (1 + r) t

47 t = 0 That is, IRR is that rate of interest that equates the NPV of the expected future cash flows or receipts of a project to the initial cost outlay. We already know what CF t represents (the expected future cash flows for t years) in the given equation. The problem is that we do not know the value of r, in other words the equation contains an unknown, r. by way of calculation, we will find out that some value of r will cause the sum of the discounted receipt to equal the initial cost of the project, making the equation equal to nil. The value of r is defined as the internal rate of return. That is, the solution value of r is the IRR. The internal rate of return is the Break-even point as the net present value of a project is equated to the cost of investment. The internal rate of return is: The interest rates at which the present value of the stream of cash flows equal the present value of the stream of cash out flow. It may also be demanded as the interest rate, which reduces the present value of the net cash flow to zero. It is sometimes referred to as discounted rate of return. It is important to note that the IRR formula and the NPV formula are the same, the difference is that the IRR formula contains an unknown

48 discount rate, r. the rate k. in the NPV formula is specified as representing the cost of capital. According to Dean (1951), the IRR method is another discounted cash flow technique which takes account of the magnitude and timing of cash flows. Other terms used to describe the IRR method are yield of an investment marginal efficiency of capital rate of return over cost, time adjusted rate of return and so on. The decision rule becomes very important when determining the project to accept or reject. According to Pandey (1994): The accept or reject rule, using the IRR method is to accept the project if its interest rate of return is higher than the opportunity cost of capital (r > k). He noted that it is also known as the required rate of return, or the cut-off, or hurdle rate. A project should be rejected if its internal rate of return is lower than the opportunity cost of capital (r < k). In his own contribution, Drury (1992: 281) states that:

49 The investment decision rule is that a project should be undertaken if the IRR expected from the project is greater than the opportunity cost of capital. He also noted that in perfectly competitive market, the equilibrium market price of an asset is the present value of the asset to the most efficient user. In such a market, it would not be possible for a firm to acquire an asset at a price less than its present value to the firm discounted at the firm s cost of capital. On a general note, the IRR may be interpreted as the highest rate of interest a firm would be ready to pay on the fund borrowed to finance the project without been financially worse of by repaying the loan principal and interest out of cash flows generated from the project. That was the explanation given by Ravindran and Sivakuraar (1982: 110). The problem with the IRR technique as pointed out by Pandey (1994: 291) is that it can give misleading and inconsistent results when the NPv of a project does not decline with the discount rates. Besides, this technique fails to indicate the correct choice between mutually exclusive project under certain situations. To determine the discount rate involved, some rigorious and elaborate computations based on trial and error approach. Ravindran and Sivakumar (1982) submitted that: As the complexities of modern management in today s context go on increasing, the calculation of IRR becomes difficult and the interpretation is even more difficult.

50 They however, concluded that the IRR as a tool is gaining more and more acceptance from today s decision makers even in India. According to them, major financial institutions in India as well as the International Finance Corporation look at the IRR method as a theoretically sound technique to appraise the investment worth of a project and it has psychological appeal to the user since this method is more meaningful and acceptable to them than an absolute figure under the NPV method. Illustration 2. project? Using facts as in illustration 1 above, determine the IRR of the 3,500,000 = 2000, , , , ,000 (1+ r) (1 + r) 2 (1 + r) 3 (1 + r) 4 (1 + r) 5 Try 15% Discount Factor Year Cash flow DCF(12%) NPV

51 N N 0 (3,500,000) (3,500,000) 1 900, , ,000, , , , ,200, , , ,500 NPV +s 30,200 Try 15% Discount Factor Year Cash flow DCF(12%) NPV N N 0 (3,500,000) (3,500,000) 1 900, , ,000, , , , ,200, , , ,000 NPV-144,300 Using interpolation technique, IRR = X% + a (Y X) Where X = lower discount rate (a + b)