Capital Budgeting - Decision Making Practices in Pakistan

H. Jamal Zubairi, Associate Professor (Accounting, Finance & Economics) Farrukh Amin, Assistant Professor (Computer Science & MIS) Institute of Business Management, Karachi, Pakistan ABSTRACT A number of capital budgeting techniques find place in basic as well as advanced text books on Financial Management and Corporate Finance. Each technique has its pros and cons as a decision making tool. The research paper investigates the decision making practices of Pakistani companies with respect to Capital Budgeting including the techniques employed and basis for estimation of cost of Capital / Project risk. The paper also examines the linkage between the techniques employed and various factors such as; size of investment outlay, nature of industry, company size, growth rate and capital structure. Also probed is the extent of delegation of decision making authority in respect of capital budgeting decisions. Further, the respondents views on relative popularity/significance of the techniques and reasons for the same have also been studied. Furthermore, the differences in techniques and decision making practices of local and foreign companies operating in Pakistan have also been looked into. The information/data for the above stated purpose was collected through a questionnaire from sample companies listed on the Karachi Stock Exchange (KSE).The main findings extracted from the responses to the questionnaire are, that key decision makers in Pakistani firms are quite aware of and practically using sophisticated capital budgeting techniques. The study shows that bigger size companies give greater preference to IRR, while smaller firms rely more on NPV. Also smaller firms are keener in estimating the pay back period (PP) as compared to larger companies. Consciously or unconsciously the firms relying more on debt financing or with high growth rates give more preference to the NPV technique, while low leverage and low growth firms rely more on IRR. I. INTRODUCTION The importance of capital budgeting for a firm cannot be overemphasized. Capital budgeting decisions have a long term impact on the viability of a firm and its ability to operate as a going concern. Compared to current asset management decisions, there is almost no room for flexibility or correcting a mistake if a wrong capital budgeting decision has been made and implemented. For instance, if you once have a bad experience with a particular supplier for raw material inventory, you may change to a better and more reliable supplier the next time you order inventory. However, if you realize some time after procuring and installing a manufacturing plant that you chose the wrong process or wrong plant capacity, the cost of change in plant would usually be prohibitive. Given the importance of capital budgeting decisions, this research paper highlights commonly used capital budgeting techniques, computation of discount rate and methods for estimating project risk; as employed by business firms listed on Karachi Stock Exchange (KSE). In this regard, a survey questionnaire (see Appendix A) was designed to collect data from sample companies listed on KSE. The design of the survey permitted us to thoroughly understand the
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Electronic copy available at: http://ssrn.com/abstract=1308662

capital budgeting decisions making practices and their relationship with various characteristics of the firms. Specifically we mainly looked into the following: i) Relationship between the size of the firm and the capital budgeting techniques used ii) Extent of delegation of authority in the firms in respect of capital budgeting decisions iii) Relative importance and significance of different capital budgeting techniques iv) Linkages of capital budgeting techniques used with the investment outlay. v) Relationship of capital budgeting techniques used with financial leverage of firms vi) Linkage of capital budgeting techniques employed with growth rate of firms vii) Basis for risk assessment of a project and for change in riskiness viii) Frequency of review of firms cost of capital Section II describes the sample selected for this paper and outlines the research methodology, Section 100 III provides the findings and their impact for these firms in detail. 80 Section IV presents conclusions 60 and some recommendation. The 40 survey responses clearly show that firm size significantly affects the 20 practice of corporate finance. Most 0 companies follow academic theory and use discounted cash flow (DCF) techniques to evaluate investment projects.
%age of Usage by the firms

Techniques used by Respondents

91

88

85

52

52

49

0
NPV IRR ARR PP MIRR PI Others

II.

METHODOLOGY

We designed a comprehensive survey questionnaire to collect the responses of the business firms in Pakistan. We targeted only those firms which are listed on the Karachi Stock Exchange (KSE). Most of these firms have there head offices located in Karachi (Sindh) There were 685 firms listed on KSE as on December 31, 2007. Presently, about 230 firms scrips are more actively traded on the exchange. We sent our questionnaire to 150 firms but despite active follow up, only 35 firms responded in terms of providing completed questionnaire. This translates into a response of 23%, which looks healthy as most studies show a response of 8 to 10% in similar surveys. The questionnaire was designed to probe into the eight main areas detailed in Section I. The responses were then tabulated for the Respondents Role in Decision purpose of analysis and drawing conclusions. Making III. ANALYSIS
39% 46%

This paper investigates what capital budgeting decision making practices are used by firms listed on KSE based on the

15%
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Only Recommending to BoD Fully Authorised Electronic copy available at: http://ssrn.com/abstract=1308662

Partly Authorised

sample survey. The findings of the paper show that majority of the respondents (46%) are only partly authorized to take capital budgeting decisions on their own. 39% of the respondents only have recommending authority, while only 15% were fully authorized to take decision on their own. This significance of decision making authority is true even in case of multi-national companies (MNCs). About 49% of respondents out of the total MNCs take capital budgeting decisions with a combination of both i.e. independently as well with the approval of head quarters. We have found through Sophisticated DCF Techniques' linkage with Investment Outlay this study that most of 50 the firms employ Net Present Value, NPV, 43 40 (91%), Internal Rate of 30 Return, IRR, (88%) and 27 Payback Period, PP, 20 (85%) in making capital 15 15 budgeting decisions. 10 However, firms also use 0 MIRR (52%), PI (52%) 0 All Amounts >10 m >25 m >50 m NA and some firms use other techniques (49%). According to the sample data collected, none of the firm uses ARR as their decision making tool for Capital Budgeting. 27% of the firms use these tools for every investment outlay, 43% of the firms apply these when investment amount is more than Rs. 25 million and only 15% of the firms use these techniques only when the size of investment is more than 50 million. Significance of these techniques a) Net Present Value (NPV) The study shows that majority of the firms (55%) rate NPV as a very important tool, 18% rate it as important and the rest of the firms consider it as moderately important. Only 9% of the firms do not consider it as a significant technique. b) Payback Period (PP) This technique is also given high importance by the firms (79%), whereas 6% of the firms consider it as important in decision making. Only 6% of the firms rate it as moderately important. c) Internal Rate of Return (IRR) In the view of 73% of the firms this tool is very important for decision making, 6% of the firms rate it as important and only 9% firms consider it as moderately important. d) MIRR This technique is rated as important by 21% of the sample firms while an equal 21% regard it as very important. Large number of firms (58%), either do not use this tool or do not consider it at all as decision making tool for capital budgeting. e) Accounting Rate of Return (ARR)
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% of Firm age s

Electronic copy available at: http://ssrn.com/abstract=1308662

Our responses show that none of the firm uses this tool for capital budgeting decisions.
Significance of Capital Budgeting Tools are used by the Firms Tools Applied NPV PP IRR MIRR PI ARR Other Not App 9 9 12 58 46 100 91 9 Not Imp Mod. Imp 18 6 9 Important 18 6 6 21 54 Very Imp 55 79 73 21

Upon asking the firms, what cost of Basis for Cost of Capital for DCF Analysis (%age of Respondents) capital rate /discount rate they use in case they employ a technique 46 involving discounted cash flows, we 15 49 received the feed back that 49% of the firms use Risk Free Rate plus a 67 52 Risk Premium based on judgment regarding their risk class. 52% of the responding firms said that they used Weighted Average Cost of Capital, 46% responded that they use Cost of Equity Capital and very large CoE CoD WACC RFR Others number of firms (67%) use Cost of Debt. The responses in respect of discount rate total to more than 100% since the respondents were free to give more than one response. The cash flow used in their analysis for capital budgeting decision making were mostly After-Tax Flows (79%). The firms also confirmed that most of them (82%) use different capital budgeting techniques for different risk classes. In order to assess the riskiness of a project, most firms take into account more than one measure. For example, 55% of the firms use their Subjective Judgment, large number of firms (79%) considers Probability Distribution of the Projects Projected Cash Flows, 46% of the responding firms use Covariance of Projects Cash Flow with Cash flows of other Projects and 49% of the firms give weightage to Probability of Loss in the projects. The firms assess the impact of change in the riskiness of a project by employing various methodologies. 37% of the firms do
Basis for Risk Assessment of Projects by Respondents

%age of the Opted Firm

80 60 40 20 0
Firm Ignore it Cov. of Proj CFs
40 35 30 25 20 15 10 5 0

79 55 46

49

Basis for Assessing Impact of Change in Riskiness (%age of Respondents)

Subjective Judgement Probability of Loss

Prob. Dist of CFs Others

37

33 21

9
Shortening the Reqd. Raising the Reqd PP Raising the Disc. Rate PP in PV None of these

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so by raising the required payback period, 33% of the firms resort to raising the discount rate in computing the present value of the investment and only 9% of the firms shorten the required payback period. Also quite a few of the firms (21%) use none of the methodologies mentioned in our questionnaire.

The firms cost of the capital may Frequency of Review of Cost of Capital Estimates be reviewed at various times. Very 90 high percentage of the firms (85%) 85 80 review the cost of capital at Project 70 67 60 Evaluation time and 67% of the 50 firms evaluate it when there is 40 Significant Business Environment 39 30 Change. 39% of the firms review 24 20 their cost of capital on Semi-annual 10 12 Basis, only 24% of the firms 0 Quarterly Semi-Annually Annually On Proj. On Sigf Bus.Env review it on Quarterly Basis and Evaluation Change only a few (12%) of the firms assess it on annual basis. While reviewing the periodic cost of capital, it may involve estimating the Opportunity cost of capital, Cost of debt only and Weighted Average Cost of Equity and Debt. There are 46% of the firms who give preferences to Weighted Average Cost of Equity and Debt, 45% only to Cost of Debt and just 9% to Opportunity Cost of Equity.
%age of Firm

For evaluating the relationship Basis of Periodic Reveiw of Cost of Capital between growth rate of the firms and capital budgeting techniques, we 9 have found that the companies 46 whose P/E ratio is high (more than 45 30), give most importance to use of MIRR (50%) followed by PP (16%) and NPV (14%). Similarly when the P/E ratio is moderate say less than 30 but more than 10, the firms give nearly equal importance to MIRR, NPV and PP i.e. 50%, 45% and 52% Opportunity Cost of Equity Cost of Debt Only Weighted Average CoE & Debt respectively. Whereas companies whose P/E ratio is low (below 10), rate IRR, NPV and PP as high in importance i.e. 57%, 41% and 32% respectively. NPV Growth High P/E (>30) Moderate P/E (<30 & 14 45 IRR ARR Others PP MIRR %age value of the responding firms 0 43 0 0 0 50 16 52 50 50 PI 0 0
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>10) Low P/E (<10)

41

57

50

32

Similarly regarding the relationship between financial leverage of firms and capital budgeting techniques used, we found that highly leveraged firms use MIRR (50%), NPV (25%) and PP (17%), moderate leveraged firms use MIRR (50%), NPV (13%), IRR (17%) and PP (17%). However, low leveraged firms extensively use IRR (83%) followed by PP (66%) and NPV (62%). The study clearly shows that none of the leveraged firms use either ARR or PI. Leverage
(Long Term Debt to Total Capitalization Ratio)

NPV

IRR

ARR

PP

MIRR

PI

High 25 0 0 17 50 0 (More than 70:30) Moderate 13 17 0 17 50 0 (31:69 to 70:30) Low 62 83 0 66 0 0 (0:100 to 30:70) IV. CONCLUSION The trend towards the use of more sophisticated capital budgeting techniques is evidenced by the most popular use of NPV followed closely by IRR, MIRR and PP. The study shows that there is a significant negative correlation between the size of the firm and the use of NPV and PP. This is perhaps because big firms have large investments and therefore prefer IRR because even a marginally higher return than the cost of capital would translates into a huge rupee benefit for the firm. There is virtually no correlation between the size of the company and the use of IRR. In other words irrespective of size , all firms are interested in knowing the IRR of an investment project, while the smaller ones might be more inclined to use NPV for decision making. It also emphasizes that authority for capital budgeting decision lies mainly with higher management/ Board of Directors and not with the individuals. The more advanced techniques are used mainly when investment amount exceeds Rs.25 millions. It is also noted that highly leveraged firms tend to prefer NPV, PP and MIRR, while low leverage firms give more preference to IRR but also employ NPV and PP. Similarly high growth firms use NPV, PP and MIRR as tools for decision making whereas moderate and low growth firms use NPV, PP and IRR. This is because higher leverage and higher growth firms rely more on debt financing. Thus these firms are more concerned that their net cash flows after accounting for debt servicing should be positive. Hence, the greater preference towards NPV and MIRR. It is heartening to note that sophisticated capital budgeting techniques are practically being used by Pakistani firms and are not confined to text book study at Business Schools. However, keeping in the view the importance and virtual irreversibility of a major capital budgeting decision, there is a need for improvement of decision making quality at the Industry level. In this respect Industry Associations of various industries can play a lead role, so as to minimize the wastage of resources on account of bad or faulty capital budging decisions. More specifically, industry associations should form expert working groups comprising relevant professionals, who can develop industry bench marks and guidelines for capital budgeting decisions, focusing on the following:
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1. Which capital budgeting techniques to be employed for major investments such as new projects, expansion or BMR projects and small investments like replacement or renovation of machinery / other fixed assets. 2. Basis to be used for estimating: a. Companys cost of capital b. Project Riskiness c. Appropriate Capital structure for new as well as existing projects in the Industry. Once the above proposed exercise has been done, the industry associations can arrange for regular training programs on Capital Budgeting for new professionals entering the industry. This would augment the theoretical knowledge which the fresh graduates bring with them from Business Schools. It can be expected that if the above referred proposal is implemented seriously, a more professional approach to Capital Budgeting will also find its way into Provisional / Federal Government Departments and Autonomous Bodies. Ultimately this will go a long way towards helping in optimizing the use of our resources and minimizing the chances of projects going sick due to incorrect or faulty capital budgeting decisions.

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V.

REFERENCES

J.A. Fremgren. Capital Budgeting Practices: A Survey, Management Accounting, (May 1973), PP 1925. D.F. Istvan. The Economic Evaluation of Capital Expenditures, Journal of Business, (January 1961), PP 45-51 Lawrence D. Schall, Gary L. Sundem and Willaim R. Geijsbeek, Jr, Survey and Analysis of Captial Budgeting Methods, Journal of Finance, (March 1978), PP 281-288 T.Klammer, Empirical Evidence of the Adoption of Sohisticated Capital Budgeting Techniques, Journal of Business, (October 1977) PP 387-397 John Graham and Campbell Harvey, How do CFOs make capital budgeting and capital structure decisions? Journal of Applied Corporate Finance, (2001), Vol 60 J. Moore and A. Reichert, An Analysis of the Financial Management Technqiues currently eimployed by Large U.S. Corporations, Journal of Business Finance and Accounting, Vol 10 (1983), pp 623645

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APPENDIX Survey Questionnaire

Preliminary Information Companys Name Responding Persons Name Respondents Position (Title) Last Qualification (with Major) How long has respondent been working in the current job? Contact Number E-mail Date 1. What is your role in decision making? Recommending decision to higher management Fully authorized to take decisions Partly (a) and Partly (b) 2. How long have you been in this firm? (Please Tick any one) Up to 1 year 3. 1 to 3 years 4 to 7 years 8 to 10 years More than 10 years

Companys business falls in the following sector: Closed-End Mutual Funds Modaraba Leasing Investment Bank/COS/Securities Commercial Bank Insurance Textile Spinning Textile Weaving Textile Composite Synthetic & Rayon Jute Sugar & Allied Cement Tobacco Refinery Power Generation & Distribution Oil & Gas Mktg Oil & Gas Exploring Engineering Automobile Parts Automobile Assembler Cable & Electronic Goods Transport Technology & Comm. Fertilizer Pharmaceuticals Chemicals Paper & Board Vanaspati & Allied Leather & Tanneries Food & Personal Care products Glass & Ceramics Other (Please Specify) ____________________________________________

4.

Number of people working in the company are: 1 50 51 150 151 300 300 500 Over 500

5.

Companys current Paid-Up Capital (in Rs. million) is: Less than 20 100 200 20 50 200 500 50 100 More than 500

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6.

Please mark the Capital Budgeting tools/techniques used by your company: Net Present Value (NPV) Payback Period (PP) Internal Rate of Return (IRR) Modified Internal Rate of Ret (MIRR) Accounting RoR (ARR) Profitability Index (PI) Others (Please Specify) ________________________________________________________

7.

Capital budgeting techniques marked in 6 above are used for decisions pertaining to following investment amounts (Rs. in million) All Amounts More than 50 More than 10 Not Applicable More than 25

8.

Indicate the significance of each capital budgeting technique used by you? Technique NPV PP IRR MIRR PI ARR Others Not Applicable Not Important Moderately Important Important Very Important

9.

What cost of capital rate/discount rate do you use in case you use a technique involving discounted cash flows? Not Applicable Cost of Debt Cost of Equity Capital A measure based upon past experience Weighted Average Cost of Capital Risk Free Rate + Risk Premium based on judgment regarding your risk class Others (Please Specify)_____________________________________________________

10.

The cash flow that you use in your analysis is: Before-Tax Cash Flow After-Tax Cash Flow

11.

Do you make use of different Capital Budgeting Technique for different classes of Risk? Yes No

12.

If you are an MNC, capital budgeting decisions are made: Independently by the local management With approval of the Regional Head quarters A combination of both of the above

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13.

On what basis do you assess the riskiness of the project? Ignore risk and use single standard for all projects Based on subjective judgment Probability distribution of projects projected cash flow Covariance of Projects cash flow with cash flows of other projects Probability of loss Others (Please Specify) ________________________________________________________

14.

How do you assess the impact of change in riskiness of a project? Shortening the required payback period Raising the required payback period Raising the discount rate in computing present value None of the above

15.

How often does your company review its cost of Capital Estimates? Quarterly Semi-Annually Annually Whenever there is new project to be evaluated Whenever there is a significant change in business environment

16.

The periodic cost of capital review involves, estimating: Opportunity cost of Equity Cost of Debt only Weighted Average Cost of Equity & Debt

17.

As per your companys latest Balance Sheet, the long term debt to total capitalization ratio (Long term debt / long term debt + equity) is nearly: 20 : 80 30 : 70 40 : 60 50 : 50 60 : 40 70 : 30 80 : 20 Other (Please Specify)_________________________________________________________

18.

What is your companys latest credit rating? Short Term:___________ Long Term _________ Name of Rating Agency:__________________________________________________________

19.

Based on current market price of your companys share and latest earning figures, what is your companys current P/E (Price to Earning) Ratio? Market Price: Earning Per Share: Rs__________ Rs__________ as on ___________________(Date) for the year ended _____________

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