UNIVERSITY OF NAIROBI SCHOOL OF BUSINESS (MBA) DFI605: FINANCIAL SEMINAR

1.7 GROUP ASSIGNMENT: CAPITAL BUDGETING

COURSE LECTURER: DR. ADUDA/ MR. MIRIE

PRESENTED BY:

OGOLO AKOTH DORINE RAEL JELAGAT ROTICH PETER KAMAU WAGEREKA ANTHONY MAINA MWAI JOSEPH BORO NJOROGE WARUTERE JOSEPHINE NYAKIO

D61/62963/2011 D61/62980/2011 D61/60380/2010 D61/67629/2011 D61/68186/2011 D61/63326/2011

September 2012

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CHAPTER ONE 1.0 INTRODUCTION

Capital budgeting is obviously a vital activity in any business. Vast sums of money can be easily wasted if the investment turns out to be wrong or uneconomic. In modern times, the efficient allocation of capital resources is a most crucial function of financial management. This function involves organizations decision to invest its resources in long term assets like land, buildings, equipment, and vehicles. All these assets are extremely important to the firm because in general, all the organizational profits are derived from the use of its capital investment in assets which represent a very large commitment of financial resources, and these funds usually remain invested over a long period of time. The future development of a firm hinges on the capital investment projects, the replacement of existing capital assets, and/or the decision to abandon previously accepted undertakings which turn out to be less attractive to the organization. The business environment calls for the efficient allocation of resources by the management of any organization. Lately, a lot of emphasis has been placed on the view that a business firm facing a complex and changing environment will benefit immensely in terms of improved quality of decision making if investment decisions are taken in the context of its overall corporate strategy. This approach provides the decision maker with a central theme or a great picture of investment to keep in mind at all times as a guideline for effectively allocating corporate resources in any investment opportunities.

1.1 Definition of capital budgeting

Capital budgeting, sometimes referred to as investment appraisal, is a management process which involves evaluation of the investments of the company to determine whether they are viable or not and thus determine whether to accept a project or reject it all together. Some of the investment decisions that have to be made by the companies include replacement decisions for the company's fixed assets such as machinery, introduction of new products to the already existing products produced by the company, engaging in long term investments such as purchasing shares of other companies among other investment (Ross, Westerfield& Bradford, 1998). As such, capital budgeting decisions have a major effect on the value of the firm and its shareholders wealth. Investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decision. It is defined as the firm decision to invest its current funds most efficiently in the long-term assets in anticipation of an expected flow of benefits over a series of years (the long term assets are those that affects
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the firms operations beyond the one-year period) it includes expansion, acquisition, modernization and replacement of the long-term assets, sale of a division or business(divestment), change in the methods of sales distribution, an advertisement campaign, research and development programme and employee training, shares (tangible and intangible assets that create value) (Pandey 2010). Horne, (2000) define investment decisions as the allocation of capital to investment proposal whose benefits are to be realized in the future and includes, new product or expansion of existing products, replacement of equipment or buildings, research and development, exploration and others. Capital expenditure includes all those expenditures which are expected to produce benefits to the firm for a period of over one year, and this includes both tangible and intangible assets. Lynch (2001) looked at the tactics for improving the capital budgeting process to produce results, as a way of maximizing firms contribution to shareholders value. He argued that shareholders value can be increased by improving the capital expenditures process for fixed assets with the caveat that an understanding of the process and a functioning continuous capital budgeting system were prerequisite to improvement activities. Capital budgeting/investment appraisal is the process of evaluating and selecting long-term investments that are consistent with the businesss goal of maximizing owners wealth (Gitman, 2002). Financially successful companies have a continuing need for capital investment. Typically every organization that embarks on this process must take all necessary steps to ensure that their decision making processes and/or criteria supports the businesss strategy and enhances its competitive advantage. However, growth of a business can be limited by unavailability of capital. When capital is limited, allocating resources appropriately is a critical skill which involves taking into consideration current and future market conditions, such as inflation and demand for a certain product. Essentially it is the requirement of the management to pursue all the investments options that are available to the company in order to create wealth of the owners of the company or the shareholders but the resources available to the company are not sufficient and thus the management are required to conduct project appraisal in order to determine the projects that would bring the maximum return to the investors (Shim & Siegel, 2008). According to Pandey, (2010) investment decisions are decisions that influence a firms growth in the longterm, affect the risk of the firm, involve commitment of large amount of funds, are irreversible or reversible at substantial loss, and among the most difficult decisions to make. Investments should be evaluated on the basis of criteria that are compatible with the objectives of the shareholders wealth maximization. Therefore, all the stakeholders to some extent have an interest in seeing
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sensible financial decisions being taken. Many business decisions do not involve a conflict between objectives of each of the stakeholders. Nevertheless, there are occasions when someone has to decide which claimants are to have their objectives maximized and which are merely to be satisfied-that is, given just enough of a return to make their contributions (Arnold 2005). It is important for organizations to engage in capital budgeting before they invest in a certain projects because of the enormous resources required to start the project. Incase the project fails there would be huge losses that would be incurred by the firms. Another reason is that the investments decisions that managers make are not easily reversible, the projects that the company invest in have a long term implications on the operations of the organization and lastly due to the fact that the investments involves risks and uncertainty to the firm and thus the organization evaluate the suitability of the investment to the firm through carrying out capital budgeting. There are various methods that are used in capital budgeting which are classified into two; traditional methods and the discounting methods. Traditional methods of capital budgeting include payback period and the Average rate of return which the discounted methods of capital budgeting include Net Present Value (NPV) and Internal Rate of Return (IRR). Every method of capital budgeting has its weaknesses and strengths and thus no method is superior or inferior to the other (Brigham & Houston, 2008). A good capital budgeting system does more than just make accept-reject decisions on individual projects. It must tie into the firms long range planning process-the process that decides what lines of business the firm concentrates in and sets out plans for financing, production and marketing etc. It must also tie into a procedure for measurement of performance (Brealey& Myers, 2007) The term 'Capital Budgeting' is used interchangeably with capital expenditure management, capital expenditure decision, long term investment decision, management of fixed assets, etc. It may be defined as "planning, evaluation and selection of capital expenditure proposals." Capital budgeting involves a current outlay or serves as outlays of cash resources in return for an anticipated flow of future benefits. In other words, the system of capital budgeting is employed to evaluate expenditure decisions which involve current outlays, but likely to produce benefits over a period of time longer than one year. These benefits may be either in the form of increased revenue or reduction in costs. Capital expenditure management therefore includes addition, disposition, modification and replacement of fixed assets. The basic features of capital budgeting are: a) Potentially large anticipated benefits; b) A relatively high degree of risk; c) A relatively long time period between initial outlay and anticipated returns
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1.2 Historical Background of Capital Budgeting

The Period up to 1950 Earlier approaches to capital budgeting models were concerned mostly with theeconomic evaluation of

individual projects. For many years, most firms used Payback period to evaluate investment project. In 1899, Irving Fisher first articulated the concept of NPV as the market value of securities minus cost of resources. Fisher (1930) advanced the Theory of Interest in which he suggested that NPV is the key part in theory of optimal resource allocation. Fisher labeled his theory of interest the impatience and opportunity theory. He put forward that Interest rates, were as a result of the interaction of two (that forces:the time preference people have for capital now and the investmentopportunityprinciple

income invested now will yield greater income in the future). The interest rate, or what is called cost of Capital, forms the basis of the Internal Rate of Return (IRR) defined as the discount rate that will equate the present value of future cash flows to the resources employed now. Fisher defined capital as any asset that produces a flow of income over time. A flow of income is distinct from the stock of capital that generated it, although the two are linked by the interest rate. Specifically, wrote Fisher, the value of capital is the present value of the flow of (net) income that the asset generates. In the period between 1930s and 1950s non owner managed firms put in place capital budgeting control systems that identified planned capital investments going forward. The size of non financial investments and the number of non owner managed firms increased during the industrial revolution. These simultaneous changes created fertile ground for use of more sophisticated evaluation techniques and for the capital budgeting processes in use today (Chapman & Hopwood, 2007) 1951 to date During the 1950s, practicing financial controllers began to network with each other, with consultants and with academicians to develop models for capital budgeting (Chapman &Hopwood, 2007). Dean (1951), in his book Capital Budgeting, advanced the implementation of Discounted Cash flows (DCF) methodology in its current form. Managers are required to maximize return on investment at a given level of risk. However capital budgeting models only consider the return on investment. As a result, managers dont usually have all the information to make the right decisions as far as risk is concerned. To address this law, Hertz (1964) provided a discussion on how computer simulation can be used to provide managers with of Risk on a Capital Investment Project. Agency theory that developed in the late 1970s and early 1980s gave rise to analytical models of capital investment process. These models suggest that current capital budgeting procedures are a means of reducing agency costs that emanate from the
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conflict

of

interest

between owners of firms and management. The internal rate of return (IRR) and the net present value (NPV) have long been the accepted capital budgeting measures preferred by corporate management and financial theorists, respectively. While corporate management prefers the relevancy of a yield-based capital budgeting method, such as the IRR, financial theorists, based on Orthodox economic theory, endorse the NPV method. The debate between NPV and IRR methods dates from the inception of modern interest theory. The introduction of the NPV as Amore superior model created the impetus for conflict

between the two methods. However, both methods suffer from inconsistencies when ranking potential investment projects based on the assumption of wealth maximization. Therefore, a consistent capital budgeting method must be robust when correctly ranking and selecting superior investments in varying Investment conflict between the two methods. However, both methods suffer from inconsistencies when ranking potential investment projects based on the assumption of wealth maximization. Therefore, a consistent capital budgeting method must be robust when correctly ranking and selecting superior investments in varying Investment environments, remain theoretically sound by maintaining the assumption of wealth maximization, and be expressed as a yield based measure as preferred by corporate management (Chapman & Hopwood, 2007) 1.3 Importance of Capital Budgeting Capital budgeting is of paramount importance in financial decision making. Special care should be taken in making these decisions on account of the following reasons (Pandey, 2010): (a) Growth The effects of investment decisions extend into the future and have to be endured for a longer period than the consequences of current operating expenditures. A firms 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 continued survival of the firm; unwanted or unprofitable expansion of assets will result in heavy operating costs for the firm. On the other hand, inadequate investment in assets would make it difficult for a firm to gain competitive advantage over its competitors. (b) Risk A long term commitment of funds may also change the risk complexity of the firm. If an investment in assets makes the earnings of an organization to fluctuate significantly over time, the firm will become more risky, hence investment decisions shape the basic character of a firm.

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(c) Funding Since investment decisions generally involve an outlay of large amounts of funds, an organization would need to plan well ahead and very carefully for such investments. It is imperative for the firm to make advance arrangement for procuring of finances internally or externally. (d) Irreversibility Most investment decisions are irreversible because it may be difficult to find market for such capital items once they have been acquired. The firm will incur heavy losses if such assets are scrapped. The Nation Media Group has for example invested in a printing press and refurbished it in the recent past. It would be very difficult for the media house to make an overnight decision to scrap the press since it may not be easy to find ready market owing to the small number of local media houses that are involved in printing and its affordability. (e) Complexity Investment decisions are among the firms most difficult decisions. They are an assessment of future events and the future is very difficult to predict. Political, economic, social, technological forces make the business environment very volatile. 1.4 Objectives a) To explain the motives for capital expenditures and the steps followed in capital budgeting b) To describe and compute cash flow components c) To explain the basic terminologies used to describe projects, funds, availability, decisions approaches and cash flow patterns therein d) To determine the payback periods, the net present values, profitability index and the rates of return of proposed investments e) Evaluate projects and rank them based on budgeting techniques f) Determine difficulties and conflicts in using discounted cash flow methods

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1.8 1.5 Capital Expenditure Motives A capital expenditure is an outlay of funds by the firm that is expected to provide benefits over a period of time greater than one year. The basic motives for capital expenditures are expansion, replacement or renewal of non-current assets, or to obtain some other less tangible benefits over a long period of time. These key motives may be outlined as follows; a) Expansion: The most common motive is to expand the cause of operations through acquisition of non-current assets. Growing firms therefore need to acquire new assets more rapidly. A company may add capacity to its existing product lines to expand existing operations. Nation Media Group, for example, refurbished its printing press in the year 2010 to expand its printing capacity and colour quality. b) Replacement and Modernization: As a firms growth slows down and reaches its maturity, most capital expenditures will be made in replacing obsolete and worn out assets. Outlays of repairing old machines should be compared with the net benefit of replacement. The main objective of modernization and replacement is to improve operating efficiency and reduce costs. Most of the times, modernization reduces costs only but sometimes also increases revenues resulting in increased profits. Monitor Publications, a subsidiary of Nation Media Group, for example, replaced its printing press in 2011 and disposed off the old press. c) Renewal: An alternative to replacement may involve rebuilding, overhauling or refitting an existing fixed asset an example being addition of air conditioning as a means of renewing a physical facility. d) Other purposes: Some expenditure may involve long-term commitments of funds in expectations of future returns such as advertising, Research and Development, management, consulting and development of view products. Others include installation of pollution control and safety devises mandated by the government. 1.9 1.6 Classification of Investment Projects and Terminologies Investment projects may be classified into three categories on the basis on how they influence investment decision process: independent projects, mutually exclusive projects and contingent projects. a) Independent Project: Is one the acceptance or rejection of which does not directly eliminate other projects from consideration or affect the likelihood of their selection. For example, management may want to introduce a new product line and at the same time may want to replace a machine which currently producing a different product. The projects will thenbe considered independently of each other if sufficient resources are available for both considerations, provided they meet the firms

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investment criteria. The projects therefore, can be evaluated independently and a decision to accept or reject be made depending on whether the project (s) add value to the firm.

b) Mutually Exclusive Investments: These are proposals, which compete with each other in a way that the acceptance of one precludes the acceptance of other or others. For example, if a company is considering use of ether a more labor intensive, semi-autonomous machine or a highly automated machine for production, it can only choose either of the two and not both. Choosing the semiautonomous machine precludes the acceptance of the highly automated machine (Pandey 2010, p160).

Mutually exclusive projects can be evaluated separately to select one which yields the highest net present value of the firm. The earlier identification of mutually exclusive alternatives is crucial for a logical screening of investments.

c) Contingent Project: Is one acceptance or rejection of which is dependent on the decision to accept or reject one or more other projects. Contingent projects may be complementary or substitutes. For example, a decision to construct a pharmacy may be contingent upon a decision to establish a doctors surgery in an adjacent building. In this case the projects are complementary to each other. The cash flows of the pharmacy will be enhanced by the existence of a nearby surgery and conversely, the cash flows of the surgery will be enhanced by the existence of a nearby pharmacy.

d) In contrast, substitute projects are those that the degree of success of one project is increased by the decision to reject the other project. For example, market research indicates demand sufficiency to justify two restaurants in a shopping complex and the firm is considering one Chinese and one Thai restaurant. Customers visiting the shopping complex seem to treat Chinese and Thai food as close substitutes and have a slight preference for Thai food over Chinese. Consequently, if the firm establishes both restaurants, the Chinese restaurants cash flows are likely to be adversely affected which may mean negative net present value for the Chinese restaurant. In this situation, the success of the Chinese restaurant project will depend on the decision to reject the Thai restaurant proposal. Since they are close substitutes, the rejection of one project will definitely affect boost the cash flows of the other. Contingent projects should therefore be analyzed by taking into account all the projects.

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1.10Terminologies a) Make or Buy decision: Make or buy decision is no longer a short run operating decision and it becomes a problem of capital expenditure which necessitates consideration of required rate of return. A company has to take this decision, when it has to face the following choice buy certain part or subassemblies from outside suppliers; or use available capacity to produce the item within the factory. In this decision, the following are major considerations: i. ii. iii. Costs that will be incurred under both alternatives are not relevant to the analysis. Potential uses of available capacity should be considered. Pertinent quantitative factors must be evaluated in the decision process. These considerations include price stability from suppliers, reliability of delivery and quality specifications of materials or components involved. Example 1 Make or Buy Decision You have the option to manufacture your own parts or purchase them from outside suppliers. If we purchase the parts, it will cost Kshs 50.00 per part. Our factory is operating at 70% of capacity and our total cost to manufacture parts is: Direct Materials Kshs Direct Labor Kshs 15.00 / part 19.00 / part

Overhead - Variable Kshs 14.00 / part Overhead - Fixed Kshs Total Costs Kshs 12.00 / part 60.00 / part

Since we are operating at 70% capacity, we do not expect an increase in fixed overhead; this is a sunk cost. We would manufacture the parts since it is Kshs 2.00 / part cheaper: Purchase Kshs 50.00 vs. Manufacture Kshs 48.00 (Kshs 15.00 + Kshs 19.00 + Kshs 14.00) a) Unlimited funds: Is a financial situation in which an organization is able to accept all independent projects that provide an acceptable return ( capital budgeting decision are simply a decision of whether or not the project clears the hurdle rate) b) Capital rationing: Is the financial situation in which the organization has only a fixed number of cash (shillings) to allocate among competing capital expenditures. A further decision as to which of the projects that meet the minimum requirement is to invest in has to be taken.
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c) Conventional cash flows: Consist of an initial outflow (outlay) followed by only a series of inflows ( For example a firm spends KES 6 Million and expects to receive equal annual cash inflows of KES 2 Million in each year for the next 4 years) d) Non- Conventional cash flows: Is a cash flow pattern in which an initial outlay is not only followed by a series of inflows, but also cash flows (at least one). For example, the purchase of a machine may require KES 10 million (as initial outlay) and may thereafter generate cash inflows of KES 2 million for 5 years after which in the 6th year an overhaul costing of KES 6 million may be required. The machine would then generate KES 2 million for the following 5 years Evaluating projects with unconventional patterns poses challenges that require an analysts special attention. e) Relevant cash flows: To evaluate capital expenditure alternatives, the organization must determine the relevant cash flows which are the incremental after-tax initial cash flow and the resulting subsequent inflows associated with the proposed capital expenditure. Example 2 Calculate Relevant Cash Flows for Capital Project We plan on purchasing a new assembly machine for Kshs 25,000. It will cost Kshs 2,000 to have the new machine installed and we expect a Kshs 1,000 net increase in working capital. By making the investment, we will reduce our annual operating costs by Kshs 7,000 and we expect to save Kshs 500 a year in maintenance. The new machine will require Kshs 750 each year for technical support. We will depreciate the machine over 5 years under the straight-line method of depreciation with an expected salvage value of Kshs 5,000. The effective tax rate is 35%. Annual Savings in Operating Costs Annual Savings in Maintenance Annual Costs for Technical Support Annual Depreciation Revenues Taxes @ 35% Net Project Income Kshs 7,000 Kshs500 Kshs(750) Kshs (4,000) * Kshs 2,750 Kshs(962) Kshs1,788

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Add Back Depreciation (noncash item) Kshs4,000 Relevant Project Cash Flow Kshs 5,788

* Kshs 25,000 - Kshs 5,000 / 5 years = Kshs 4,000 We will receive Kshs 5,788 of cash flow each year by investing in this new assembly machine. Since we have a salvage value, we have a terminal cash flow associated with this project. f) Incremental cash flows: Represent the additional cash flows (inflows and outflows) expected to result from a proposed capital expenditure.

g) Sunk Costs: Are cash outlays that have already been made (past outlays) and therefore have no effect on the cash flows relevant to a current decision. Therefore, sunk costs should not be included in a projects incremented cash flows.

h) Opportunity Costs: Are cash flows that could be realized from the best alternative use of an owned asset. They represent cash flows that can therefore not be realized, by employing that asset in the proposed project. Therefore, any opportunity cost should be included as a cash outflow when determining a projects incremental cash outflow 1.8 Capital Budgeting Process Capital budgeting as a process can be divided into four major stages; identification and development of investment proposals; financial evaluation of projects; implementation of projects; and project review. The financial evaluation portion has a number of tools to determine the wealth that a project can create for the organization; these methods can be split into accounting based concepts and economic based concepts (Northcott, 1992) Capital budgeting is a multi-faceted activity with several sequential stages as indicated above. For typical investment proposals of a large corporation, the distinctive stages in the capital budgeting process are depicted in the form of a highly simplified flow chart Strategic Planning The key components of 'strategic planning' include an understanding of the firm's vision, mission, values and strategies. It is the grand design of the firm and clearly identifies the business the firm is in and where it intends to position itself in the future. Strategic planning translates the firms corporate goals in to specific
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policies and directions, sets priorities, specifies the strategic and tactical areas of business development and guides the planning process in the pursuit of solid objectives. The vision and mission are often captured in a Vision Statement and Mission Statement. Vision: outlines what the organization wants to be, or how it wants the world in which it operates to be (an "idealized" view of the world). It is a long-term view and concentrates on the future. It can be emotive and is a source of inspiration. For example, a charity working with the poor might have a vision statement which reads "A World without Poverty." Mission: Defines the fundamental purpose of an organization or an enterprise, succinctly describing why it exists and what it does to achieve its vision. For example, the charity above might have a mission statement as "providing jobs for the homeless and unemployed". Values: Beliefs that are shared among the stakeholders of an organization. Values drive an organization's culture and priorities and provide a framework in which decisions are made. For example, "Knowledge and skills are the keys to success" or "give a man, bread and feed him for a day, but teach him to farm and feed him for life". These example values may set the priorities of self -sufficiency over shelter. Strategy: Strategy, narrowly defined, means "the art of the general." A combination of the ends (goals) for which the firm is striving and the means (policies) by which it is seeking to get there. A strategy is sometimes called a roadmap which is the path chosen to plow towards the end vision. The most important part of implementing the strategy is ensuring the company is going in the right direction which is towards the end vision. Proposal Generation Identification of investment opportunities and generation of investment project proposals is an important step in capital budgeting process. The investment opportunities have to fit in with the organizations corporate goals, vision, mission and long-term strategic plan. Moreover, if an excellent investment opportunity presents itself, it is prudent to change the corporate vision and strategy to accommodate the change(s). Thus, there is a two-way traffic between strategic planning and investment opportunities. Some investments are however mandatory for instance, those required to satisfy particular regulatory, health or safety requirements- and they are essential for an organization to remain in business. Other investments are discretionary and are generated by growth opportunities. , competition, cost reduction opportunities and so on. These discretionary investments form the basis of the business of the organization.
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A profitable investment proposal is not just born; someone has to suggest it. The organization should ensure that it has searched and identified potentially lucrative investment opportunities and proposals. There should be a mechanism such that investment suggestion coming from inside the organization, such as from its employees, or outside the organization, such as from advisors to the organization. Some organizations have research and development (R&D) divisions constantly searching for and researching into new products, services and processes and identifying attractive investment opportunities. Sometimes, excellent investment suggestions come through informal processes. Preliminary Screening of Projects Generally, in an organization, there will be many potential investment proposal generated. Obviously, they cannot all go through rigorous project analysis process. Therefore, the identified investment opportunities have to be subjected to a preliminary screening process by the management to isolate the marginal sound proposals. This may involve some preliminary quantitative analysis and judgments based on intuitive feeling and experience. Review and Analysis Projects that pass through the preliminary screening process become candidates for rigorous financial appraisal to ascertain if they would add value to the firm. This stage is also the quantitative analysis, economic and financial appraisal, project evaluation or simply project analysis. Capital Expenditure proposals are formally reviewed for two reasons; First, to assess their appropriateness in light of the organizations overall objectives, strategies and plans and secondly, to evaluate their economic viability. Review of proposed project(s) may involve lengthy discussions between senior management and those members of staff at the division and plant level who will be involved in the implementation if adopted. Benefits and costs are estimated and converted into a series of cash flows and various capital budgeting techniques applied to assess economic viability. The risks associated with the projects are also evaluated Qualitative Factors in Project Evaluation When a projects passes through the quantitative analysis test; it has to be further evaluated taking into account qualitative factors. Qualitative factors are those which will have an impact on the project, but which are virtually impossible to evaluate accurately in monetary terms. These are: a) Societal impact of an increase or decrease in employee numbers
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b) Environmental impact of the project c) Possible positive or negative governmental political attitudes towards the project d) Strategic consequences of consumption of scarce raw materials e) Positive or negative relationships with labour unions about the project f) Possible legal difficulties with respect to the use of patents, copyrights and trade or brand names g) Impact on the organizations image if the project is socially questionable Some of the mentioned items may or may not affect the value of the organization. The organization can address these issues during project analysis by means of discussion and consultation with various parties, but these process is considerably lengthy and outcomes often unpredictable. It requires considerable management experience and judgmental skills to incorporate the outcomes of these processes into the project analysis. Making Decision (Accept/ Reject) NPV results from the quantitative analysis combined with qualitative factors from the basis of the decision support information. The analysis relays this information to management with appropriate recommendations. Management considers this information and other relevant prior knowledge using their routine information sources, experience, expertise, gut feeling and of course, judgment to make a major decision to accept or reject the proposed investment project Implementation and Monitoring Once investment projects have vetted, then they have to be implemented. During this phase of implementation, various divisions of an organization are likely to be involved. An integral part of project implementation being the monitoring of projects progress with a view to identifying potential bottlenecks thus allowing early intervention. Deviations from the estimated cash flows need to be monitored on a regular basis with a view to taking corrective action(s) when need be. Post- Implementation Audit Post-implementation audit does not relate to the current decision support process of the project; it deals with a post-mortem of the performance of already implemented projects. An evaluation of the performance of past decisions, however, can attribute greatly to the improvement of current investment decision making by analyzing the past rights and wrongs. The post-implementation audit can also provide useful feedback to project appraisal or strategy formulation. It therefore helps pin-point sectors in the organizations activities that may warrant further financial
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commitment; or may call for retreat if a particular project becomes unprofitable. The outcome of an investment also reflects on the performance of those members of the management involved with it. Finally, past errors and successes provide clues on the strengths and weaknesses of the capital budgeting process itself. 1.9 Capital budgeting techniques Capital budgeting process involves investment decisions in long term assets. Capital budgeting techniques are used to evaluate the acceptability of each project in order to make accept or reject decisions and ranking decisions. The success of any business can be determined through its capacity to generate positive cash flows. Therefore, cash inflow or outflow is considered one of the most essential elements which give us an idea about the continued existence of a business in the future. The shareholders focus on two things while investing in business: first, how does business generate funds and second, where does the business invest those funds for generating more. The process involves three basic steps: a) Identifying potential investments b) Analyzing investment opportunities, isolating those that will create shareholders value and prioritizing them, and; c) Implementing and monitoring the investment project selected in step 2 (Megginson, Smart &Gitman, 2007). Bringham and Besley (2000) identified several basic methods used by businesses to evaluate projects and to decide whether they should be accepted for inclusion in the capital budget. These methods are; Payback period, net present value and internal rate of return. The payback period method is a non-discounting technique since it does not consider the time value of money. NPV and IRR are referred to as discounting techniques since they take into account time value of money. Relevant cash flows The relevant cash flows include; a) An initial investment relevant cash outflow for a proposed project at time zero. Example3 Calculate Initial Investment Referring back to Example 2on calculation of relevant cash flows, we can calculate our Net Investment. We will also assume that an existing machine can be sold for Kshs 6,000.

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Acquisition Costs Installation Costs

Kshs 25,000 Kshs2,000

Increase in Working Capital Kshs1,000 Proceeds from Sale Less Taxes @ 35% Kshs 6,000 Kshs(2,100)

Net Proceeds from Sale Kshs(3,900) Net Initial Investment Kshs24,100 b) Operating cash inflows the incremental after-tax cash inflows resulting from execution of a project during its life. c) Terminal cash flow- the after-tax non-operating cash flow occurring in the final year of the project. It is usually attributable to liquidation of the project.

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CHAPTER TWO 2.0 CAPITAL BUDGETING TECHNIQUES

Capital budgeting techniques are categorized into two; Non Discounted Cash Flow Techniques a) Payback period (PBP) b) Accounting Rate of Return (AROR) Discounted Cash Flow Techniques a) Net Present Value (NPV) b) Internal Rate of Return (IRR) c) Profitability Index (PI) Most large companies according to Ryan (2002) utilize all, one or more of these methods when evaluating capital projects. Cadbury Schweppes, as previously mentioned, utilizes three of these, namely: Payback period, internal rate of return and profitability index when evaluating capital projects. 2.1 Pay Back Period (PBP) Brigham and Besley (2000) define payback period as the number of years required to recover the original investment. Its the simplest and the oldest formal method used to evaluate capital budgeting method. Using the pay back to make capital budgeting decisions is based on the concept that its better to recover the cost of a project sooner rather than later. As a general rule a project is considered acceptable if its payback period is less than the maximum cost recovery time established by the firm. The major limitations of this method are the failure to recognize the time value of money and cash flows beyond the payback period.

To compute the payback period for a project using this technique, compute the present value of all future cash flows expected to be generated and then subtract its initial investment to find the net benefit the firm will realize from investing in the project. If the net benefit computed on a present value basis is positive, then the project is considered an acceptable investment, (Brigham & Besley, 2000). The shorter the payback period, the sooner the company recovers its investment.

Payback (Even Cash Flows)=

Initial Investment Annual Cash Inflow

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For uneven cash flows, sum cash flows and get a moving balance. The PBP is then computed using the formulae below;

PB = Year before full recovery + Cash flows remaining to full recovery Cash flow the following year

Example 6- Payback Period (Even Cash Flows) A project requires an outlay of Kshs 50,000 and yields annual cash inflows of Kshs 12,500 for 7 years. The payback period for the project is: PB= Kshs 50,000 Kshs 12,500 = 4 years

Example 7- Payback Period (Uneven Cash Flows) If the Turtles Co. has a project with a cost of $150,000, and net annual cash inflows for the first seven years of the project are: $30,000 in year one, $50,000 in year two, $55,000 in year three, $60,000 in year four, $60,000 in year five, $60,000 in year six, and $40,000 in year seven, then its cash payback period would be 3.25 years. See the example that follows.

The Payback period has the following merits: a) Easy to calculate b) It is the simplest capital budgeting tool used for decision making c) It provides a crude way of dealing with risk. The risk of a project can be tackled by having a shorter standard payback period as it may ensure guarantee against loss. d) It emphasizes liquidity
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In spite of its simplicity and widespread use, the Payback Period technique suffers the following limitations: a) It ignores cash flows that are received after the cut-off period. This leads to discrimination against projects which generate substantial cash inflows in later years. b) It is the measure of a projects capital recovery, not its profitability. Though it measures a projects liquidity, it does not indicate the liquidity position of the firm as a whole, which is more important. c) It ignores the time value of money. In the payback calculation, cash inflows are simply added

without suitable discounting. This violates the most basic principle of financial analysis, which stipulates that cash flows occurring at different points of time can be added or subtracted only after suitable compounding or discounting. 2.2 Accounting Rate of Return (ARR) The Accounting Rate of Return (ARR) is defined as an investments average net income divided by its average book value. Simply put, it can be defined using the below equation:

ARR = Profit after tax Book value of the investment The numerator of this ratio is the average annual post-tax profit over the life of the investment; the denominator is the average book value of investment committed to the project.Traditionally, a popular investment appraisal criterion, the Accounting Rate of Return has the following advantages: a) It is simple to calculate. b) It is based on accounting information which is readily available and familiar to the businessman. c) It considers benefits over the life of the project. Despite these merits the ARR also has the following disadvantages: a) It is based on accounting profits not cash flows, and b) It does not take into account the time value of money. The acceptance rule using the Accounting Rate of Return technique in capital budgeting is that a project is acceptable if its accounting rate of return exceeds a target average accounting return. However, this rule has some limitations: a) ARR ignores the time value of money. In using average figures that occur at different times, the near future and the distant future are treated in the same way.
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b) ARR uses net income and book value instead of looking at the cash flows and market values. As a result, the ARR does not provide information on what the effect on share price will be for undertaking an investment. c) ARR lacks an objective cut-off period. That is, a calculated ARR is really not comparable to a market return, the target ARR must somehow be specified. There is no generally agreed way to do this.

2.3 Net Present Value (NPV) (Bringham & Besley, 2000), defines NPV as a method of evaluating capital investment proposals by finding the present value of future net cash flows discounted at a rate of return required by the firm. To implement this approach, we find the present value of all future cash flows a project is expected to generate and then subtract its initial investment to find the net benefit the firm will realize from investing in the project. If the net benefit computed on a present value basis is positive, then the project is considered acceptable investment. Formula for calculating the NPV is as follows:

NPV=CFo+CF1/ (1+r) 1} + {CF2/ (1+r) 2} + . + {CF/ (1+r) n} Where: CFOxis the initial cost of investment CFi is the expected net cash inflow at time t, (t>0) ris the projects opportunity cost of capital nis the expected life of the project It is assumed that the cost of capital is constant The NPV decision rules for selecting or rejecting a project are as follows: Independent projects: If NPV>0: Accept the project If NPV<0: Reject the project If NPV=0: The project may be accepted

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Example4 Calculate Net Present Value The Cottage Gang is considering the purchase of $150,000 of equipment for its boat rentals. The equipment is expected to last seven years and has a $5,000 salvage value at the end of its life. The annual cash inflows are expected to be $250,000 and the annual cash outflows are estimated to be $200,000. Assuming a required rate of return of 12%, the net present value is $80,452. It is calculated by discounting the annual net cash flows and salvage value using the 12% discount factors. The Cottage Gang has equal net cash flows of $50,000 ($250,000 cash receipt minus $200,000 operating costs) so the present value of the net cash flows is computed by using the present value of an annuity for seven periods. Using a 12% discount rate, the factor is 4.5638 and the present value of the net cash flows is $228,190. The salvage value is received only once, at the end of the seven years (the asset's life), so its present value of $2,262 is computed using the Present Value of the table factor for seven periods and 12% discount rate factor of .4523 times the $5,000 salvage value. The investment of $150,000 does not need to be discounted because it is already in today's dollars (a factor value of 1.0000). To calculate the net present value (NPV), the investment is subtracted from the present value of the total cash inflows of $230,452. See the examples that follow. Because the net present value (NPV) is positive, the required rate of return has been met. Mutually exclusive projects Accept the project with the highest NPV. If no project has positive NPV, then reject all projects

Brigham and Earnhardt (2011) referred to the NPV generally as the best screening criterion which has the following merits: a) It is the true measure of an investment profitability in that it provides the most acceptable investment rules; b) It recognizes the time value of money; c) It uses all cash flows occurring over the life of the project in calculating its worth; d) It is consistent with value additivity principle; NPV of different projects can be summed up to arrive at the overall increase/ decrease in firm value as a result of investing in different projects; e) It relies on the discount rates rather any arbitrary assumptions, and f) It is consistent with the objectives of shareholders value maximization.

Limitations of NPV Method a) It is difficult to obtain the estimates of cash flows due to uncertainty;
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b) It is difficult to precisely measure the discount rate; c) It does not incorporate managerial flexibility in calculating the NPV; d) Caution needs to be taken when using NPV method to evaluate mutually exclusive projects with unequal lives, or when there are fund constraints. e) The ranking of projects is not independent of discount rates under NPV.

2.4 Profitability Index (PI) The profitability index (PI) shows the relative profitability of any project or the present value per dollar of initial cost. Pike & Neale (2009) defined the PI as the ratio of the present value of project cash flows to the present value of its initial cost. The PI is the ratio of investment to payoff of a suggested project. It is a useful capital budgeting technique for grading projects because it measures the value created by per unit of investment made by the investor. This technique is also known as profit investment ratio (PIR), benefit-cost ratio, and value investment ratio (VIR). The PI can be calculated as follows:

PI = Present Value of Cash Inflows Initial Cash Outlay

Example5- Profitability Index The initial outlay of a project is Kshs 100,000 and it can generate cash inflow of Kshs 40,000, Kshs 30,000, Kshs 50,000 and Kshs 20,000 in year 1 through to 4. Assume a 10% rate of discount. The PV of cash inflows at 10% discount rate is:

NPV= Kshs 112,350-Kshs 100,000= Kshs 12,350

PI= Kshs 112,350 Kshs 100,000 = 1.1235 Decision Rule for PI Technique If the PI for a project is greater than one, then accept the project; if the PI of a project is less than one, then reject the project; if the PI of the project is equal to 1 the project may be accepted. The PI and the NPV techniques are closely related. If a project has a positive NPV, the present value of the future cash flows must be bigger than the initial investment and the PI for such project would therefore be bigger than one. On the other hand, a project with a negative NPV will have a PI less than one.
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The PI technique enjoys some advantages which include: a) It recognizes the time value of money b) It is consistent with value maximization. A project with a PI greater than 1 when accepted will increase shareholders wealth. The PI measures the value created per dollar. c) It gives a relative measure of project profitability.

2.5 Internal Rate of Return (IRR) IRR is the discount rate that forces the present value of a projects expected cash flows to equal its initial cost. As long as the projects IRR, which is its expected return, is greater than the rate of return required by the firm for such an investment, the project is accepted. If the return is greater than the cash outlay for the project, then the difference is a bonus to shareholders which causes share price to rise. If the return is less than the cash invested for the project, then shareholders will have to make up for the shortfall, a situation that hurts the stock price (Brigham &Earnhardt, 2010).

IRR is computed as follows: ( )+ + + . + =0

NPV =

=0

The decision rules for accepting or rejecting project based on the IRR technique are as follows: Independent Project a) If IRR is greater than the opportunity cost of capital (IRR>k), then accept the project b) If IRR is less than the opportunity cost of capital (IRR<k), then reject the project c) If IRR is equal to the opportunity cost of capital (IRR=k), then decision makers may accept. Mutually Exclusive Projects a) Accept project with the highest IRR provided that its IRR is greater than the opportunity cost of capital (IRR>k). b) Reject if IRR is less than the opportunity cost of capital (IRR<k)

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Example 8- Calculate Internal Rate of Return Referring back Example2 on calculation of relevant cash flow for projects, we would solve for IRR as follows: Kshs 5,788 x discount factor = Kshs 24,100 or Kshs 24,100 / Kshs 5,788 = 4.164.If we look in the Present Value Tables for n = 5 years, we want to find apresent value factor nearest to 4.164. By referring to published presentvalue tables, we find the following: At 6%, n = 5 As Calculated At 7%, n = 5 Difference .0484 4.2124 4.2124 4.1640 4.1002 .1122

.06 + (.0484 / .1122) x (.07 - .06) = .0643 Internal Rate of Return = 6.43% The IRR faces the following setbacks: a) Problems with the IRR may arise when cash flows are not conventional or when two or more mutually exclusive projects are under consideration for investment. b) It gives unrealistic rate of return. In the case of a mutually exclusive project in which firms are faced with take-it-or-leave-it projects, the decision rule is that the firm should choose the one that add most to shareholders wealth. That is choosing the project with the highest NPV. It would also be misleading to choose the one with the highest rate of return, according to the return rule. c) In comparing projects with the same life but different outlays, the IRR may mistakenly favour small projects with high rates of return but low NPVs (Brealey, Myers & Marcus, 2009). The IRR method also poses a multiple rates of return problem. This occur when there are two discount rates or two IRRs that equate the present value equal to the initial investment or a rate that makes the NPV equal to zero. Hence the question that arises is which of these rates is correct. The answer is both or neither. More precisely, there is no unambiguously correct answer. Purpose of this question is not to resolve the cases where there are different IRRs. The purpose is to let you know that the IRR method, despite its popularity in the business world, entails more problems than a practitioner may think. This multiple rates problem indicates that despite the widely used IRR technique amongst firms in the business world it still contains
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some little problems than we think. Unless the calculated IRR is a reasonable rate for reinvestment of future cash flows, it should not be used as a yardstick to accept or reject a project. 2.6 Modified Internal Rate of Return (MIRR) Bringham & Besley (2000) define MIRR as the discount rate at which the present value of a projects cost is equal to the present value of its terminal value, in which the terminal value is found as the sum of the future values of the cash flows, compounded at the firms required rate of return. The use of the technique helps overcome the IRRs limitation resulting from the reinvestment rate assumption.

The MIRR has two advantages over the IRR which makes it theoretically superior to the IRR. The MIRR assumes that cash flows from each project are reinvested at the firms cost of capital or some explicit rate. It is an indicator of a project true profitability. Secondly, it eliminates the multiple IRRs problem: there is only one MIRR for a project; it can be compared to the cost of capital when deciding to accept or reject (Brigham &Ehrhardt, 2010). Despite these advantages over the IRR, it is not as widely used as the IRR. The MIRR can be computed as follows:

PV (Costs) = PV (Terminal value) = Here, COF refers to cash outflows, or the cost of the project, and CIF refers to cash inflows. The left term is the PV of the investment outlays when discounted at the cost of capital, and the numerator of the right term is the compounded value of the inflows, assuming that the cash inflows are reinvested at the cost of capital. The compounded value of the cash inflows is also called the terminal value. The MIRR is the discount rate that forces the PV of the terminal value to equal the PV of the costs. 2.7 Discounted Payback Period One of the limitations in using the payback period is that it does not take into account the time value of money. Thus, the future cash inflows are not discounted or adjusted for debt/equity used to undertake the project, inflation, etc. However, the discounted payback period solves this problem. It considers the time value of money; it shows the breakeven after covering such costs. This technique is similar to payback period except that the expected future cash flows are discounted for computing payback period. Discounted payback period is how long an investments cash flows, discounted at the projects cost of capital, will take to cover the initial cost of the project. In the approach, the present values of the future cash inflows are cumulated up to the time they cover the initial cost of the project. Discounted payback period is generally

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higher than payback period because it is money you will get in the future and will be less valuable than money today. Example 9 Calculate Discounted Payback Period Referring back to Example 2, we can calculate the discounted paybackperiod as follows: Year Cash Flow x P.V. Factor = P.V. Cash Flow Total to Date 1 Kshs 5,788 2 3 4 5 5,788 .797 5,788 .712 5,788 .636 5,788 .567 .893 4,613 4,121 3,681 3,282 1,843 Kshs 5,169 9,782 13,903 17,584 20,866 22,709 Kshs 5,169

6 3,250 .567

Under the Discounted Payback Period, we would never receive a payback on our project; i.e. the total to date present cash flows never reached Kshs 24,100 (net investment). If we had relied on the regular payback calculation, we would falsely assume that this project does payback inthe fourth year. 2.1 Methods of calculating the overall cost of capital a) Weighted Average Cost of Capital (WACC.), b) Capital Asset Pricing Model (CAPM) c) Arbitrage Pricing Theory (APT)

a. Weighted Average Cost of Capital (WACC) The weighted average cost of capital (WACC) according to Bierman and Smidt (1980:258) represents the average cost of funds to an organization and as such represents the sources of capital and their uses. WACC for a given capital structure reflects the characteristics of organizations assets and in particular, their average risk as well as the timing of expected cash proceeds. WACC represents an averaging of all the financial risks of an organization. The calculation of the weighted average cost of capital (WACC) according to Northcott (1992:77) has several steps:
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a) The identification of the ranges of the sources of long-term capital. b) The determination of the cost of the capital sources. c) The determination of the market value of the capital sources. d) The calculation of the WACC. Four sources of long-term capital exist; (a) long-term debt, (b) preferred shares, (c) common shares, and (d) retained earnings (Gitman, 2003: 472; Lovemore, 1996: 87). The cost of each of the above mentioned sources of capital can be calculated; this is not being explored in this text but is extensively covered in management accounting texts. It is sufficient to note for the purpose of this text that the cost of long-term debt is a function of the interest payable, the tax rate, any issuing expenses and the market value of the debt. The cost of equity capital sources (ordinary or preference shares) for listed organizations depends on dividend payable, the cost of issuing equity and the market price of shares. Retained earnings are usually a less expensive source of capital than issuing new shares, due to the fact that they do not incur the transaction costs associated with the public offering of shares (Gitman, 2003: 473; Bierman&Smidt, 1980:245-251). The weightings given to each source of funds in the WACC calculation are based on the market value of the debt, ordinary shares and preference shares and are impacted on by the relative proportions employed of each capital source (Nortcott: 1992:78). The literature identifies two problems with the use of WACC for all projects, namely (Lovemore, 1996: 8789; Northcott, 1992:79; Bierman&Smidt, 1980: 258): i. WACC is a reflection of the current cost of a pool of funds used for financing the current investments of the organization. An investment outside of the normal activity of an organization should have a different risk profile and hence the current WACC rate will not sufficiently allow for that risk profile. ii. If the investment is large enough, it might alter the WACC rate by its implementation, for example, a large loan might have to be incurred that could then alter the weighting of the long term debt and hence the WACC rate. As WACC does not consider unique risk, it could lead to the acceptance of a high return but overly high-risk projects (Brealey& Myers, 1991). A model suggested by the literature that considers a projects unique risk is the capital asset pricing model (CAPM).

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b. Capital Asset Pricing Model (CAPM) According to Samuels, Wilkes and Brayshaw (1990), the CAPM assess risk by showing the connection between individual project returns and the market for risky assets as a whole. The CAPM evaluates the projects unique risk against its own returns and not the return that an investor could earn from the organizations cost of capital (Samuels et al, 1990).Risk, as viewed by investors, needs better definition to allow for a better understanding of the CAPM model and hence is briefly discussed. Northcott (1992) defines risk as the unpredictability of returns from an investment. Gitman (2003) breaks risk down into two components (a) diversifiable risk and (b) non-diversifiable risk. Diversifiable risk or unsystematic risk is considered by Gitman (2003) to be the portion of an investments risk that can be associated with random causes and that can be eliminated by the use of diversification. Examples of organizational specific diversifiable risks are: strikes, lawsuits and loss of a key account (Gitman, 2003). Non- diversifiable risk or systematic risk according to Gitman (2003) is that portion of an investments risk that is attributable to market forces, affects all organizations in that market place, and as such cannot be eliminated by diversification. Examples of systematic risks are war, inflation, international incidents and political events (Gitman, 2003). Investors are able to establish a portfolio of investments that can eliminate diversifiable risks but are unable to eliminate non-diversifiable risks, hence non-diversifiable risk is the only important risk and as such, the measurement of non-diversifiable risks in the selection of investments with the best risk return characteristics is the most important (Gitman, 2003). The CAPM model links non-diversifiable risk and the return for all assets. A measure of non-diversifiable risk is the beta coefficient. c. Arbitrage Pricing Theory In finance, arbitrage pricing theory (APT) is a general theory of asset pricing that holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient. The model-derived rate of return will then be used to price the asset correctly - the asset price should equal the expected end of period price discounted at the rate implied by the model. If the price diverges,arbitrage should bring it back into line.The theory was proposed by the economist Stephen Ross in 1976.

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Riskyassetreturns are said to follow a factor structure if theycanbeexpressed as:

where is a constant for asset is a systematic factor is the sensitivity of the and th asset to factor , also called factor loading,

is the risky asset's idiosyncratic random shock with mean zero.

The APT states that if asset returns follow a factor structure then the following relation exists between expected returns and the factor sensitivities:

where is the risk premium of the factor, is the risk-free rate, That is, the expected return of an asset j is a linear function of the assets sensitivities to the n factors. Note that there are some assumptions and requirementsthat have to befulfilled for the latter to be correct: There must be perfect competition in the market, and the total number of factorsmayneversurpass the total number of assets (in order to avoid the problem of matrix singularity).

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CHAPTER THREE
1.103.0 THEORIES OF CAPITAL BUDGETING AND EMPIRICAL EVIDENCE

3.1 Theories of Capital Budgeting

1.113.1.1 Real Options theories In the works of Black, Scholes, and Merton (1973) we are provided with a standard pricing model for financial options. Together with Stewart Myers of Massachusetts Institute of Technology (MIT), they recognized that option-pricing theory could be applied to real assets and non-financial investments. To differentiate the options on real assets from the financial options traded in the market, Myers coined the term real options, which has been widely accepted in academic and industry world. Unlike the standard corporate resource allocation approaches, the real options approach acknowledges the importance of managerial flexibility and strategic adaptability. Its superiority over other capital budgeting methods like discounted cash flow analysis has been widely recognized in analyzing the strategic investment decision under uncertainties (Luehrman, 1998). Traditional approaches to capital budgeting, such as discounted cash-flows (DCF), cannot capture entirely the project value, for different reasons: it is assumed that investment decision is irreversible, interactions between decisions today and future decisions are not considered, and investment in assets seems to be a passive one i.e. management doesnt interfere during the life of the project. Managerial flexibility generates supplementary value for an investment opportunity because of managerial capacity to respond when new information arises, while the project is operated. Investment in real assets includes a set of real options that management can exercise in order to increase assets value (under favorable circumstances) or limit loses (under unfavorable situations). Managerial flexibility in decision-making process introduces an asymmetry for probability distribution of net present value (NPV) for a project. An investment opportunity value is dependent on future uncertain events, so it will be greater than forecasted value in the situation of passive management. From this perspective, a project has a standard value, determined through traditional techniques (DCF, which does not capture adaptability and strategic value), but also a supplementary value, coming from operational and strategic real options held by an active management (Vintila, 2007).

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The real options in capital budgeting decisions include the following: i) Option to Expand (Growth Options) This occurs when managers accept investment projects that have negative or insignificant NPV but may enable companies to find greater opportunities in the future that add considerable profitability and value to the firm. ii) Timing Option (Option to Wait/ defer) This gives management an option to choose an investment timing now or later. If the project turns out to be a winner project, then invest in it now; if the project turns out to be a loser project with negative NPV now, then it may pay to wait and get a better fix on the likely demand. This usually occurs in the oil and other extractive industries. iii) Option to Abandon If a project does not perform favorably and there is little promise for improvement, the firm can consider the exit options. The firm needs not continue with an uneconomically vibrant project indefinitely. An abandonment or exit option, like a shut- down option, reduces the downside risk of the project. iv) Flexible Production Facilities Apart from the options that naturally exist in most projects, managers can incorporate flexibility in designing the project. The designedin options may take the form of input flexibility options, and output flexibility options. An input flexibility option allows a firm to switch between alternative inputs. For example, an electric power plant may go for a flexible dual fuel boiler which can switch between gas or oil as fuel, depending on which source of energy is cheaper at a given point of time. An output flexibility option allows a firm to alter the product mix. Oil refineries are typically designed with this flexibility. This permits them to switch from one product mix to another, depending on which product mix is the most profitable at a given point in time (Pandey, 2010). v) Time-to-Build (Staged Investment)

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When investment costs occur in stages, management has an option to abandon the next stage of investment if expectations become unfavorable. Therefore, each stage becomes an option of the subsequent stages. vi) Shut Down Option A project may temporarily shut down if it is economical to do so. For example, an iron ore mining project may be closed for a while if the output price of the iron ore is depressed. In general, shut down options are more valuable when the variable costs are high. A shut down option reduces the downside risk of the project. vii) Option to Alter Operating Scale (e.g. to Expand; to Contract; to Shut Down) If market conditions are more favorable than expected, the firm can expand the scale of production or accelerate resource utilization. Conversely, if conditions are less favorable than expected, it can reduce the scale of the operations. Examples of this real option can be found in natural-resource industries (mining), consumer goods and commercial real estate. Among the above options, option to wait and option to abandon are recognized as the most important real options which are embedded in most investment opportunities. 3.1.2 MMs capital budgeting theory MM pursues value maximization to increase the combined market values of debt and equity. In MMs theory the two sources of financing used are permanent and equity is a form of permanent financing. Since permanent financing is employed, the payment of principal is unnecessary so unlike in normal capital budgeting depreciation is set aside each year to replace the obsolete capital and investors do not recover the initial investment at all. According to MM the cost of capital is the weighted average cost of capital. To sum up MM theory, the value of a levered firm is the after tax cash flows for the stockholders discounted at the cost of equity plus the after tax flows from bondholders discounted at the cost of debt or identically its value is the NOI discounted at the WACC. Therefore MM maximized the combined value of equity and debt or equivalently the combined wealth of the stockholders and bond holders. 3.1.3 Contemporary capital budgeting theory Contemporary capital budgeting theory is deeply rooted in MM's theory which was discussed in the previous section. Slight differences abide, though, because, contrary to MM's permanent cash flows, investment projects have limited useful lives in the real world. In making capital budgeting decisions, five important elements are to be considered: the initial investment, the operating cash flow, the useful life of the project, the salvage value, and the cost of capital. Since the limited project life creates discrepancies between MM's
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and contemporary theory, it is discussed before the other four components. In most major textbooks, a fixed serviceable life is assumed, so the project will be in place for a few years, and, after that period, it will be closed. See Block and Hirt (1994), Brigham and Gapenski (1993), Kolband Rodriguez (1992), Van Home (1992), and Weston and Brigham (1993). The implication is that, upon the close of the project, the venture is to be dissolved, so the company must pay back the par value of bonds to bondholders and the par value of common shares to stockholders. Therefore, unlike in MM, depreciation is not accumulated from year to year to replace the capital asset. Instead it is added back to the NOI to increase the operating cash flow for the investors. The initial investment is the amount of capital required upfront to start a project which includes, but is not limited to, the purchase price of the capital asset, sales taxes, transportation cost, installation cost, and the working capital needs. In MM, the investors never recapture the initial investment because the project will go on forever; in current theory this amount is recovered through the operating cash flows from the project. The operating cash flow in current theory is the cash inflow to the investors from the project. MM's cash flow is the NOI given by equation (1), but the operating cash flow in today's capital budgeting (OCF, hereafter) is MM's NOI less the tax shield benefit of interest payment plus depreciation. 1.12 Empirical Evidence (Njiru, 2008): A survey of capital investment appraisal techniques used by commercial parastatal in Nairobi. The studys objective was to identify the most commonly used capital investment appraisal technique by commercial parastatals and determine the factors that influence the choice of capital investment appraisal technique used by commercial parastatals. It covered all commercial parastatals with headquarters in Nairobi and was for the period of 5 years between 2003 and 2008. The researcher used the survey method. He asked questions about capital investment appraisal technique used in the organizations andexplored factors considered by the parastatals in making these decisions. He used questionnaires consisting of both closed and open-ended questions. Interpretation and analysis of data was done using the statistical package for social science (SPSS). Out of the 30 parastatals targeted, only 20 responded which was a response rate of 67%. Descriptive statistics, in particular, arithmetic mean and standard deviation were used to interpret responses to the questionnaires. The analysis revealed that on average, the annual size of capital budget is 1.4% of thetotal asset base of the organizations studied. This implies a low intensive capital investment during the study period (2003-2008). The study also found that all the parastatals had a capital investment policy. The results showed that incorporating risk, determination of the appropriate discount rateand incorporating inflation in the capital investment analysis were the three main challenges that parastatals faced in the capital investment appraisal process. According to the study, the three main capital investment appraisal techniques used by commercial parastatals are IRR (65%), NPV (25%) and pay-back period technique (10%). The amount of funds required for the capital investment, size of the
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organization, government policy and industrial practices are the main factors that influence the choice of the capital investment appraisal technique. Further the study found that 75% of the respondents preferred discounted cash flow (DCF), 10% nondiscounted cash flow (DCF) technique whereas 15% did not respond. (Kadondi, 2002) A survey of Capital Budgeting Techniques used by companies listed at the Nairobi Securities Exchange (NSE)-Previously Nairobi Stock Exchange In her study, Kadondi (2002) carried out a survey on capital budgeting techniques used by companies listed at Nairobi Securities Exchange (NSE). The objectives were to document the capital budgeting techniques used in investment appraisal by corporations in Kenya, to determine whether the techniques used conform to theory and practices of organizations in developed countries and to determine how firms and CEO characteristics influence the use of a particular technique. She intended to conduct the study on 54 Companies listed at the NSE but the analysis included only 43 Companies whose annual reports and accounts were available. Of these, only 28 Companies responded of which 50% were small companies and 50% large companies. Data was collected through questionnaires. Data was analyzed using SPSS and was put into frequency distribution tables. Chi-square test was used to test relationships between techniques and firm characteristics. The findings of the study were that 31% of the companies used Payback Period method, 27% use NPV while 23% uses IRR. According 71% of respondents, their companies considered capital budgeting process a strategy for achieving competitive advantage. Another finding of the study was that small companies use IRR and Payback Methods while large Companies with high net profit margins use NPV, IRR and Payback Period methods. This study is consistent with the survey done by (Graham & Harvey, 2002) who found that large firms favored the sophisticated techniques of capital budgeting while the smaller firms favored the traditional methods of payback and ARR. The issue of capital budgeting techniques being used as a strategic tool for benchmarking and gaining competitive edge was imminent in the study and we concur with the findings. (Grinstein &Tolkowsky, 2004)): The Role of the Board of Directors in the Capital Budgeting Process - Evidence from S&P 500 Firms Grinstein and Tolkowsky (2004) carried out a Survey to determine the role of the board of directors in capital budgeting process. The study was carried out in the United States of America. The sample consisted of S&P 500 firms and covered the period from 1995to 2000. Their final sample consisted of 2,262 firms after excluding financial institutions due to their special governance regulations and requirements and a further 292 firms for whose proxy statement information was not obtained. They used several financial and governance variables to characterize what determines theestablishment of the capital budgeting committees which included firm size, boardstructure and the ratio of number of independent directors to total number of directors. They used both univariate and multivariate data analysis methods in their survey. The findings were that 17% of the boards of directors of the sampled firms disclosed that they establish committees that have a capital budgeting role. The study
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revealed that boards of directors have four main roles in capital budgeting. These roles include reviewing of; annual budgets, large capital expenditure requests, merger and acquisition proposals and performance of approved projects. They found that committees that review budgets and capital expenditure requests perform a monitoring role which is consistent with existing theories. They also found that boards are more likely to establish special committees to perform these tasks where the auditing costs are low and when the overinvestment problem is severe. Some committees have an advisory role in capital budgeting process. The main finding of the study was that boards of directors have a dual role in capital budgeting process, that is the disciplinary role and the advisory role. In our opinion, the findings of this study are very relevant, and the role of the board and that of management should be clearly spelt out in the capital budgeting process of most firms. It is evident that to reduce agency conflict, the board needs to play a more active role of major capital projects. (Pradeep & Quesada, 2008): The use of Capital Budgeting Techniques in Business a perspective from the Western Cape. Pradeep and Quesada (2008), in a study on the use of capital budgeting techniques in businesses in the Western Cape Province of South Africa, investigated a number of variables and associations relating to capital budgeting practices. The sample consisted of 600 firms but only 211 interviews were conducted successfully giving a response rate of 35%.A descriptive approach to the research finding was adopted. Chi-square test technique was used to measure association between variables. Data analysis was carried out using SPSS software. The results revealed that payback period followed by NPV appear to be the most used method across the different sizes and sectors of businesses. 39% of respondents used Payback period technique while 36% used NPV. 28% of respondents used internal rate of return and profitability index. 22% of respondents used Accounting rate of return while10% did not use any capital budgeting technique. The study also revealed that 64% of the business surveyed used only one method of capitalbudgeting while 32% used between two and three different techniques to evaluate capital budgeting decisions. The more complicated methods such as NPV and IRR were favored by large businesses compared to small businesses. The findings of this study are contrary to earlier studies by (Graham and Harvey, 2001).The finding that most firms prefer Payback period to NPV is a pointer to other behavioral factors like use of intuition, fear of failure and resistant to change. (Robichek& Van Horne, 1967): Abandonment Value and Capital Budgeting In their study, Robichek and Van Horne (1967) noted that routine consideration of the abandonment option reduces the potential for down side movement in value. Using the option-pricing they have shown that an asset payoff is bonded from below when the abandonment option is explicitly considered. Their approach emphasizes the reduction of the potential losses as opposed to risk and the increase in firm value implied by the abandonment option is more obvious. According to them, the abandonment value is the value of the abandonment option and its worth should be included in the calculation of the present value of the future
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cash inflows. The calculations of the present value at time zero (PVO), provide the market valuation at such a point in time. As time passes, conditions, either endogenous or exogenous to the firm, will change the present value of an asset. Thus the present value of future cash flows of the same asset will be different at any given point in time. The question of whether to abandon and the decision process of the optimal timing of abandonment have been considered. They suggest that a policy of abandoning an asset one period after abandonment value becomes greater than the present value (AV>PV) would benefit the firm. They considered investment in a mine when mothballing can occur by incurring maintenance cost and costless abandonment of the mine is possible. They found that its optimal to close the mine only when the output price has fallen considerably below production cost, and conversely, its not optimal to re-open a mothballed mine even when the output rises, well above the production costs. Thus, there is a range of value of output prices over which it is optimal to produce. This phenomenon, that is a consequence of the interaction of sunk costs and uncertainty, is referred to in economic literature as hysteresis. (Myers& Majd, 1990): Abandonment Value and Project Life. Advances in Futures and Options Research, 4, 1-21 Intheir paper, Myers and Majd (1990) presented a general procedure for estimating the abandonment value of a capital investment project. To develop their model, they equated an investment project to an American put-option on a dividend paying stock. They equated the exercise price of the put to the salvage value of the project; the cash flows from the project to the dividend payments on the stock and assumed the project can be abandoned at any time during its life. They showed that, other things held constant, the value of the abandonment option increases with salvage value (the exercise price), project volatility, and project life (maturity) while it decreases with project value, as predicted by put-option pricing theory. (Graham& Harvey, 2002): How Do CFOs Make Capital Budgeting and Capital Structure Decisions? In their survey, Graham and Harvey (2002) sought to find out how chief finance officers (CFOs) make capital budgeting decisions and identify areas where theory and practice are consistent. They asked CFOs to rate how frequently they used different capital budgeting techniques on a scale. The sample consisted of 4,440 US firms. A total of 392 CFOs responded to the survey giving a response rate of 9%. Though low, the rate was consistent with the response rate for the quarterly FEI-Duke survey whose response rate is usually 8-10%, given the length (three pages) and depth (approximately 100 questions) of the survey. They reported results by summarizing the percentage of CFOs who said that they always or almost always used a particular capital budgeting evaluation technique. The study found that NPV and IRR were the most frequently used capital budgeting techniques, 74.9% of CFOs always or almost always used NPV, 75.7% almost or always used IRR while 56.9% of CFOs used hurdle rate. They also found out that companies that pay dividends were significantly more likely to use NPV and IRR than firms that do not pay dividends regardless of firm size. Public companies were found to be more likely to use NPV and IRR than private companies. Other than NPV, IRR and the hurdle rate, the payback period was the most frequently used capital budgeting technique (56.7% always or almost used use this technique). This was found surprising because finance textbooks have lamented shortcomings of payback
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criterion for decades. The choice of evaluation technique was found to be linked to firm size and executive characteristics. They also observed that payback period method is used by less sophisticated, older managers without MBAs. (Holmn& Pramborg, 2009): Capital Budgeting and Political Risk-Empirical Evidence In their work, Holmn and Pramborg (2009) investigated Swedish firms use of capital budgeting techniques for foreign direct investments (FDI). Questionnaires were sent to the CFOs of the Swedish firms that had responded to a survey from the Swedish central bank (Riksbanken) in the spring of 2003, regarding how much FDI the firm had invested as of December 2002. A total of 497 firms met the criteria and 200 responded. They surveyed to what extent firms actually use pre-investment strategies to manage political risks. They focused the analysis on whether firms were more likely to use the Payback method instead of the theoretically correct NPV method when the risk of expropriation was perceived to be high. For data analysis they used Spearman rank correlation and cross-sectional regressions. The study found that the expropriation risk index was quite skewed and most countries (31 countries out of 61) had the lowest possible ranking of 1. Only a few countries had an index value larger than 2. They concluded that in the presence of political risks, managers are reluctant to rely on the traditional NPV method and suggest this is due to the fact that they find it difficult to take such risks into account. This is consistent with managers being bounded rational decision makers, using simple rules of thumb when the deliberation cost is high. Further, the results are consistent with the notion that the rules of thumb are adjusted to proxy optimal decision as far as possible. (Block, 2005): Are There Differences in Capital Budgeting Procedures Between Industries? Block (2005) carried out a study on the use of capital budgeting procedures between industries. He stated that while it is easy to state that the use of capital budgeting analysis has become more sophisticated over the decades, the question remains as to whether different industries have followed the same pattern. He conducted a survey comprising of three hundred and two Fortune 1,000 companies and organized them along industry lines. Chi-square independence of classification tests indicated that a null hypothesis of no significant relationship between industry classification and capital budgeting procedures could be rejected in a number of decision-making areas including goal setting, rates of return, and portfolio considerations. This emphasized the point that, just as industry patterns affects financing decisions; they also affect capital budgeting decisions. (Uddin& Chowdhury, 2009): Do We Need to Think More about Small Business Capital Budgeting? Uddin and Chowdhury (2009) sought to find out whether the capital budgeting theory of large business is well applicable for the small businesses or not. He suggested that if it is not, then further development of theory becomes necessary. He found that out that there is no well accepted standard definition of small business in the literature that can be used to create the basis of applying
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the theory of capital budgeting. It is possible to say that the theory of capital budgeting, which is constructed under assumptions related to large incorporated businesses, is not fully applicable for small businesses. He argued that NPV however is the ultimately suggested method of capital budgeting that involves estimation of cash flows, and the market determined discount rate. Both of these two tasks require expertise and relevant knowledge. Decision-makers in small businesses may lack this knowledge or may find it cost ineffective to hire that kind of expertise. Moreover, market determined discount rate is not possible to find since the market for small businesss capital is not liquid, which does not allow thinking about separation of investment and financing decision. Also, the effect of agency conflict, when it is present, on the investment decision, is different for small businesses because of lack of separating ownership and control. Size and availability of capital as well as investment opportunities are also among some other factors contributing to this conclusion. He found that the reasons for the inapplicability were: - lack of knowledge, cost of hiring outside consultants, low priority of planning, size and availability of capital, size and availability of investment opportunities, tendency of high reliance on easy techniques like payback period, short operating history, credit constraints, difficulties in quantifying future cash flow, and limited discretionary alternatives for investments. Stein C. Jeremy and Scharfstein S. David (1997): The Dark Side of Internal Capital Markets: Divisional Rent-Seeking and Inefficient Investment Stein and Scharfstein (1997) developed a two-tiered agency model that shows how rent-seeking behaviour on the part of division managers can subvert the workings of an internal capital market. By rent-seeking, division managers can raise their bargaining power and extract greater overall compensation from the CEO. And because the CEO is herself an agent of outside investors, this extra compensation may take the form not of cash wages, but rather of preferential capital budgeting allocations. One interesting feature of his model is that it implies a kind of socialism in internal capital allocation, whereby weaker divisions get subsidized by stronger ones.

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Summary of unresolved issues:

a) Researchers have not been able to conclude studies on the relationship between the firms investment risk characteristics and the right capital budgeting technique. b) The evaluation of project success against capital investment appraisal method used is yet to be studied. c) An investigation to determine the existence of a relationship between capital budgeting method used by the firms and profitability is another area that is yet to be fully explored.

4.0 CONCLUSION
A capital expenditure budget is one of the components that make up the financial budget. Each of the budget components has its own unique contribution to make toward effective planning and control of business operations. Capital budgeting is the process of identifying, evaluating planning and financing major investment projects of an organization. For a single conventional, independent projects, the IRR, NPV and PI methods lead us to make similar accept/ reject decision. Various types of circumstances and projects differences can cause ranking difficulties. Four situations that could cause include; when funds are limited necessitating capital rationing, when ranking two or more projects proposals with varied lives, when ranking two or more projects with different Investment scales and when projects have opposite cash flow patterns. Although the area of capital budgeting has been studied widely and various recommendations made on the most preferable methods, there is still a lot that needs to be done. The area of real options in capital budgeting, though explored quite widely, has not been studied locally and this will form very good grounds for a local study. In their study, Li and Johnson (2002) concluded that although some recent studies recognized the potential of real options theory in evaluating strategic IT investment opportunities, they believed that the applicability of various real options models should be scrutinized under different scenarios. Standard real options models assuming symmetric uncertainty in future investment payoffs cannot be directly applied to the shared opportunities because of the competitive erosion. With the presence of potential competitive entry, real options analysis should balance the strategic benefit of preemptive investment and the value of the option to wait. IT switching cost is another important factor that must be considered when conducting real option analysis. As high IT switching cost or technology locking is very common in the digital economy, decision makers should pay more attention to the technology uncertainties. Since the dynamics of the technology competition and standardization play an important role in IT investment decision, more studies should be done to incorporate it into the real options based decision-making process. Further real options analyses should be conducted to explore the functions of open standard and technology interoperability in fostering IT investment. According to Grinstein &Tolkowsky (2004) most studies on the role of the board of directors in capital budgeting have focused on the disciplinary or monitory role of the board of directors.
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The advisory role of the board of directors is under explored. Studying capital budgeting mechanisms that have both features is an important topic for future research.

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Stein, C. J. &Scharfstein, S.D. (1997). The Dark Side of Internal Capital Markets: Divisional Rent-Seeking and Inefficient Investment Uddin, M.. & Chowdhury, R. (2009). Do We Need to Think More about Small Business Capital Budgeting? International Journal of Business and Management, 4(1). Van Horne, James C. (1980) "An Application of the CAPM to Divisional Required Returns", Financial Management 9, 14-1.

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