The use of Capital Budgeting Techniques in businesses: a perspective from the Western Cape .

1. The use of Capital Budgeting Techniques in businesses: a perspective from the Western Cape. Paper prepared by: Pradeep Brijlal & Lemay Quesada

2. Presentation Outline • Background to capital budgeting • Rationale • Aim of the study • Methodology • Research findings • Conclusion

3. Background • There are a number of researches that have been conducted internationally in developed nations that provide interesting insight on the subject of capital budgeting practices in general for example: Hermes et al (2007), Lazaridis (2004), Sandahl & Sjogren (2002), George & Chong (2001), Kester et al (1997) Drury & Tayles (1996), and Jog & Srivastava (1995).

4. Background (cont) • According to Kester et al (1999:25), discounted cash flow (DCF) techniques, such as net present value (NPV) and internal rate of retun (IRR), have become the dominant method of evaluating and ranking proposed capital investments. • Hatfield, Horvath, and Webster (1998) as cited by Lazaridus (2004) investigated the importance of payback, average rate of return, IRR, and NPV capital budgeting techniques for the performance and value measures of firms.They found that in contrast to the theory of finance, that the NPV technique did not necessarily maximize the value of the firm.

5. Background (cont) • Their results thus suggested that firms should not use single capital budgeting technique but instead should apply as many methods as possible for a project evaluation. • There are varieties of methods and techniques that managers can use to facilitate capital budgeting procedures, (Horngren et al ,1997; Ross et al ,1995). While this is the case practice shows divergence from firm to firm and in some instances from manager to manager. • In some instances, theory seems to be ignored by managers in the process of decision-making (McDonald, 1998)

6. Aim and Rationale of study • Literature on capital budgeting practices in developing nations (RSA) is rare. • It is thus imperative to find out the nature of capital budgeting practices in South Africa. • Such knowledge will help develop theory on modern practice (in the South African context) while at the same time will be of great benefit to policy makers in areas such as financial management, taxation, education and training.

7. Aim and Rationale of study (cont) • This paper reports on the findings of a survey on managers of registered business entities in the Western Cape Province of South Africa on how they undertook capital budgeting practices.

8. Methodology • Data were obtained through a survey of registered businesses ranging from small to large businesses. • Respondents were selected randomly. Convenience sample was used. • Descriptive approach, Chi square for association (SPSS) were used.

9. Main research findings Capital Budgeting Techniques Employed? • 39% of respondents used Payback Period (PP) technique. • 36% of respondents use Net Present Value (NPV) technique. • 28% use Internal Rate of Return (IRR) • 22% percent of respondents use Profitability Index Accounting Rate of Return • 10% of respondents indicated use of “Gut feel”

10. Main research findings (cont ) Level of qualification across sector? • There is an association between the qualification of a decision maker and the use of NPV. • The NPV technique is used to the same extent by businesses in both the retail and service sectors. • PP is mostly used in the manufacturing sector, whereas IRR was mostly used in services sector. • ARR is the least used technique across all the business sectors.

11. Main research findings (cont ) Business size & Capital Budgeting Method used? • There is an association between the size of business and the use of the IRR and NPV techniques (p<0.05). • Also, statistics results show that the smaller the size of a business, the lesser the use of capital budgeting techniques (p< 0.05). • PP is more used in small businesses as compared to NPV and IRR which are more used by larger businesses.

12. Main research findings (cont ) Most Difficult Stage in CB process across sector? • Overall Project definitionandAnalysis & Selection are considered the most difficult stages (each 31%) according to the respondents, followed by Implementation (28%). • The Implementation stage : most difficult stage for the manufacturing sector. • Project definition, Analysis & Selection and Implementation were generally rated as being the difficult stages by the retail sector. • Project definition and Analysis and selection were found to be the most difficult stages by the service sector. Why the discrepancy? Future research

13. Main research findings (cont ) Interest Rate Charges and basis used in Capital Budgeting? • There was no association between the size of business and interest rate charged and between the sector of business and interest rate charged. • There was also no association between the age of the business and the interest rate charged. • 24% of respondents used the cost of bank loan as a basis, while 12% used weighted average cost of capital (WACC) and 15% used past experience as a basis of determining the cost of capital.

14. Main research findings (cont ) Capital Budgeting Decisions Makers? • At least a third of business owners were directly responsible for capital budgeting decision. • Policy issues or training related issues associated with capital decision-making should be directed towards owners.

15. Conclusion • Despite the lack of sophistication of the Payback period as a capital budgeting tool, still remains a popular method among business owners. • The association between the level of education and the use of the NPV technique, suggests that education plays an important role in the use of discounted cash flow techniques such as the case of NPV.

16. Conclusion (cont) • There is a need for managers to review their perception on the importance they attach to each stage in the process, which may assist them in identifying deficiencies in the methods or in the whole capital budgeting process itself. • Review process is not deemed important suggests that mangers continue to follow the same capital budgeting process without taking into consideration any comments from the review process.

17. Limitations & Recommendations • Despite the findings discussed above, the research was limited in the sense that it focused on firms located in the Cape Town metropolitan area of the Western Cape Province. • The definition of company size was based on the DTI (2006) definition, which focused on the number of employees. Other indicators of firm size such as capital employed were not considered. Lastly the research did not look into such aspects as race and gender of the managers involved in capital budgeting. • It is proposed that future researches may look into these variables to see their impact on capital budgeting.