Capital budgeting: advantages and limitations

2.2 Capital Budgeting Process

There are different sequential stages in the capital budgeting process. The capital budgeting

process is a multi-faceted activity. In a typical investment proposal of a large firm, the

sequential stages of the capital budgeting process can be depicted in a simple flow chart

below:-

Figure1: flow chart of the capital budgeting process (Don Dayananda et al. 2002).

2.2.1 Strategic Planning

A strategic plan could be referred to as the actual grand design of the firm which specifies the type of business the firm is involved in and where it intends to position itself in the future. Strategic planning translates the firm’s corporate goal into specific policies and directions, sets priorities, specifies the structural, strategic and tactical areas of business development and guides the planning process in the pursuit of solid objectives (Drury et al. 1993). A firm’s vision and mission is embedded in its strategic planning framework. It should be noted that the feedback to strategic planning during project evaluation and decision stages is very critical to the future of the firm. The various feedbacks may suggest changes which are likely to affect the future direction of the firm which may cause changes to the firm’s strategic plan.

2.2.2 Identification of Investment Opportunities

Identification and investment opportunities and generation of investment project proposals are

important steps in capital budgeting process. For instance project proposals have to fit into the firm corporate goal, vision and long-term strategic plan. In some cases, there is a two-way traffic between strategic planning and investment opportunities, especially when an excellent investment opportunity presents itself and the corporate vision and strategy have to be adjusted to accommodate it. Some investments are mandatory while others are discretionary and are generated by growth opportunities, competition, and cost reduction and so on. For instance those investments that are mandatory are investments that are required to satisfy particular regulatory, health and safety requirements – they are necessary for the continual existence of the firm in business. The discretionary investment usually form the basis of the business of the firm, it represents the strategic plan of the firm ultimately sets new directions for the firm’s strategic plans.

The firm should endeavor to search and identify potential lucrative investment opportunities and proposals because the remaining part of the capital budgeting process can only assure that the best of the proposed investments are evaluated, selected and implemented. It is also essential that a mechanism should be put in place within the firm such that investment suggestions coming from inside the firm such as the employees, or from outside such as the advisors to the firm are listened to by management. It is also interesting to know that excellent investment suggestions can come through informal meetings such as employee chats in a staff room or during break periods.

2.2.3 Preliminary Screening of Projects

Most often, there are always many potential investment proposals generated within any firm and obviously they don’t all scale through the rigorous project analysis process. Therefore, the identified and proposed investment opportunities are subjected to further preliminary screening by management to isolate the marginal and unreasonable proposal so that resources will not be wasted evaluating such proposals. At times, the preliminary screening may involve quantitative analysis and judgments based on intuition and experience.

2.2.4 Financial Appraisal of Projects

Project proposals which scale through the preliminary screening phase are further subjected to rigorous financial appraisal to ascertain if they would add value to the firm. This stage could also be referred to as the quantitative analysis, economic and financial appraisal, project evaluation or simply project analysis. The financial appraisal of the project may predict the expected future cash flows of the project, analyze the risk associated with those cash flows, develop alternative cash flow forecasts, examine the sensitivity of the results to possible changes in the predicted cash flows, subject the cash flows to simulation and prepare alternative estimates of the project’s net present value (Brian Baldwin 1997).

The project analysis could also involve the application of forecasting techniques, project evaluation techniques, risk analysis and mathematical programming techniques. The basic concepts, principles and techniques of project evaluation are the same for different projects while their application to particular types of projects requires special knowledge and expertise. For instance, property investment, forestry investment asset expansion projects, asset replacement projects and international investments have their own special features and peculiarities involved.

It should be noted that if the projects identified within the current strategic framework of the firm repeatedly produce negative NPVs in the analysis stage, these results sends a warning signal to the management to review its strategic plan. Therefore the feedback from project analysis to strategic planning is important in the overall capital budgeting process. The results gotten from the quantitative project analysis goes a long way to influence the final project selection or investment decision which ultimately affect the success or failure of the firm as a whole and its future direction.

2.2.5 Qualitative Factors in Project Evaluation

These factors are factors that will have impact on the project but which are virtually impossible or difficult to evaluate in monetary terms.

These factors are as follows:

• the societal impact of an increase or decrease in employee numbers
• the environmental impact of the project
• possible positive or negative governmental political attitudes towards the project
• the strategic consequences of consumption of scarce raw materials
• positive or negative relationships with labor unions about the project
• possible legal difficulties with respect to use of patents, copyrights and trade or brand

             names

• impact on the firm’s image if the project is socially questionable.

2.2.6 Accept/Reject Decision

The results of the NPV from the quantitative analysis combined with the qualitative factors form the basis of the decision information. The information is relayed to the management with appropriate recommendation by the analyst. The management then looks into the given information and also brings in other relevant prior knowledge gained through their routine information sources, experience, expertise and judgment to make a major decision to either accept or reject the proposed investment project.

2.2.7 Project Implementation and Monitoring

Once the management has made a decision to accept a proposed investment project, then the project must be implemented by the management. During the implementation stage, various divisions of the firm are involved. Included in the project implementation phase is the constant monitoring of project progress with a view of identifying potential bottlenecks and thus providing early solutions or alternatives to salvage the situation when needed.

2.2.8 Post-Implementation Audit

This does not relate to the current decision support process of the project but rather it deals with a post-mortem of the performance of already implemented projects. An evaluation of the

performance of past decisions, however, can contribute greatly to the improvement of current

investment decision-making by analyzing the past ‘rights’ or ‘wrongs’. The post-implementation audit therefore provides useful feedback to project appraisal or strategy formulation. For instance, if the projects undertaken in the past within the framework of the firm’s current strategic plan do not prove to be lucrative as predicted, such information can prompt management to consider a thorough review of the firm’s current strategic plan (Drury et al. 1993).

2.3 Capital Budgeting Techniques

The requirement for relevant information and analysis of capital budgeting decisions taken by

management has paved way for a series of models to assist the organization in amassing the best of the allocated resources. Popular methods of capital budgeting techniques include:

• The Payback Period
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• The Real Options Approach

The above different methods of capital budgeting techniques will be discussed briefly but emphasis will be put on the payback method.

2.3.1 Payback Period

The payback period is defined as the time required to recover the initial investment in a project from operations. The payback period method of financial appraisal is used to evaluate capital projects and to calculate the return per year from the start of the project until the accumulated returns are equal to the cost of the investment at which time the investment is said to have been paid back and the time taken to achieve this payback is referred to as the payback period. The payback decision rule states that acceptable projects must have less than some maximum payback period designated by management. Payback is said to emphasize the management’s concern with liquidity and the need to minimize risk through a rapid recovery of the initial investment. It is often used for small expenditures that have obvious benefits that the use of more sophisticated capital budgeting methods is not required or justified (Cooper, William D. Morgan et al. 2001).

It should be noted that the required payback period sets the threshold barrier (hurdle rate) for the project acceptance. It often appears that in many cases that the determination of the required payback period is based on subjective assessments, taking into account past experiences and the perceived level of project risk. The payback period has shown to be an important, popular, primary and traditional method in the developed nations like the UK and the USA (Pike 1985).

Typically, the payback period expected by managers appears to be in the range of two to four years. For instance, (Fotsch 1983) reports from his USA survey that the average hurdle payback period is 2.91years while Woods et al 1985, stated from their UK survey: “Of the firms using new technology and also using the payback investment appraisal methods for all their investments, we had 31 observations of the standard payback period: the minimum observed was 1 yr and the maximum 5 yr, with a mean of 2.9 yr”. Also Drury et al (1993) reported that the average payback period for conventional projects was 2.83 yr, while for new technology projects the period was 3.11 yr.

The payback method by definition, only takes into account project returns up to the payback period. However, for certain projects which are long term by nature and whose benefits will accrue some time in the future and well beyond the normal payback may not be accepted based on the calculation used by the payback method, although such projects may actually be vital for the long-term success of the business. It is therefore important to use the payback method more as a measure of project liquidity rather than project profitability.

The payback method (PB) is commonly used for appraisal of capital investments in firms despite its deficiencies. In many firms, the payback period is used as a measure of attractiveness of capital investments. Although the use of payback period as a single criterion has decreased over time, its use as a secondary measure has increased over time (Segelod 1995). This method is commonly used in pure profit evaluations as a single criterion and also sometimes used when focusing on aspects such as liquidity and project time risk. The obvious cases of profitable and unprofitable investments are sorted out, when the payback method is used as the first screening device, leaving only the investments that have survived the screening process in the middle group to be scrutinized by means of more advanced and more time consuming calculation methods based on discounted cash flows (DCF), such as the Internal Rate of Return (IRR) and Net Present Value (NPV) methods.

However, it should be noted that there are many companies of considerable size, where the

payback period is used as the single criterion in investment evaluations (Blatt 1979).

The use of the payback method as the only or the major method seems to be more commonly

used in small and medium-sized companies (Longmore 1989). Various studies of the use of

the payback method in investment evaluation have been done at different points in time but some of the recent overviews of various studies are presented by Lefley (1996). Although the results from different studies at different points in time are not totally consistent, the payback method seems to be more frequently used in Europe than in the United States of America.

Most importantly the overall conclusion seems to reveal that the payback method is much in

use by firms for investment appraisals and it is therefore necessary to reduce some of its deficiencies.

2.3.1.2 Discounted Payback Period Method (Payback DCF)

The payback method have gone through various development stages over the years, with the different variations aimed at eliminating some of its disadvantages and at the same time keeping the method as simple as possible. The payback method based on discounted cash flow figures was proposed by Rappaport (1965) which related the opportunity investment rate notion to the payback period measurement.

This method attempted to overcome one of the drawbacks of the conventional payback calculation which failed to take into account a firm’s cost of capital. The discounted payback period method proposed by Rappaport is an improved measure of liquidity and project time risk over the conventional payback method and not a substitute for profitability measurement because it still ignores the returns after the payback period. He stated that, the proper role for the discounted payback period analysis is as a supplement to profitability measures and thus highlighting the supportive nature of the payback method, whether conventional or discounted payback period.

Longmore (1989) also proposed a generalized time-adjusted payback rule which states that “If the investment proposal’s payback, adjusted for the timing of the net cash flows, is less than or equal to the present value of annuity factor at the firm’s cost of capital for the life of the proposal, the investment should be accepted”. He argues that by adjusting the discount rate, the discounted payback decision rule can be modified to handle risky investments. This method is seen as a modification of the NPV method and will always give the same decision result as the NPV. In practice it appears that the standard payback DCF uses discounted figures in its calculation but allows managers to determine the payback hurdle rate, which in many cases is based on the subjective judgment. It should however be noted that the payback period is determined from the present value annuity factors used and not predetermined by the managers. If, as Longmore proposed, project risk is taken into account by the adjustment of the discount rate used in the discounted payback period method, this will result in overcompensation of risk if perceived risk is also taken into account in the determination of the required payback period; the discount rate being increased while the required payback period is reduced (Drury et al. 1993). The payback method is simply regarded as the simplest way of looking at one or more major project ideas and simply reveals how long it will take to earn back the money spent on a particular project.

The payback method is computed as follows:

2.3.1.3 Advantages of the Payback Period

• It is widely used and easily understood.
• It favors capital projects that return large early cash flows.
• It is simple to compute.

• It addresses capital rationing issues easily.
• It provides some information on the risk of the investment.

2.3.1.4 Disadvantages of the Payback Period

• It ignores any benefits that occur after the payback period i.e. it does not measure total income.
• The time value of money is ignored.
• It is difficult to distinguish between projects of different size when initial investment amounts are vastly divergent.

• It over-emphasizes short run profitability.

2.4. Net Present Value (NPV)

The Net Present Value is defined as the different between the present value of the cost inflows and the present value of the cash outflows. In other words, a project’s net present value, usually computed as of the time of the initial investment is the present value of the project’s cash flows from operations and disinvestment less the amount of the initial investment. For instance, in computing the projects net present value, the cash flows occurring at different points in time are adjusted for the time value of money using a discount rate that is the minimum rate of return required for the project to be acceptable. Projects with positive net present values (or values at least equal to zero) are acceptable and projects with negative net present values are unacceptable. In case the project is rejected, it is rejected because cash flows will also be negative.

NPV is used in capital budgeting to analyze the profitability of an investment or project and it is sensitive to the reliability of future cash flows that the investment or project will yield. For instance, the NPV compares the value of the dollar today to the value of that same dollar in the future taking inflation and returns into account. The NPV is computed as follows:

 Higher NPVs are more desirable. The specific decision rule for NPV is as follows:

NPV < 0, reject project

NPV > 0, accept project

2.4.1 Advantages of Net Present Value (NPV)

• It is considered to be conceptually superior to other methods.
• It does not ignore any period in the project life or any cash flows.
• It is mindful of the time value of money.
• It is easier to apply NPV than IRR.
• It prefers early cash flows compared to other methods.

2.4.2. Disadvantages of Net Present Value (NPV)

• The NPV calculations unlike IRR method, expects the management to know the true cost of capital.

• NPV gives distorted comparisons between projects of unequal size or unequal economic life. In other to overcome this limitation, NPV is used with the profitability index.

2.5 The Internal Rate of Return (IRR)

The internal rate of return (IRR) is the discount rate often used in capital budgeting that makes the net present value of all cash flows from a certain project equal to zero. This in essence means that IRR is the rate of return that makes the sum of present value of future cash flows and the final market value of a project (or investment) equals its current market value (Stefan Yard 1999). The higher a project’s internal rate of return, the more desirable it is to undertake the project. As a result, it is used to rank several prospective projects a firm is considering. As such the internal rate of return provides a simple hurdle, whereby any project should be avoided if the cost of capital exceeds this rate. IRR is also referred to as economic rate of return (ERR). A simple decision making criteria can be to accept a project if its internal rate of return exceeds the cost of capital and rejected if the IRR is less than the cost of capital. Although it should be noted that the use of IRR could result in a number of complexities such as a project with multiple IRRs or no IRR and also that IRR neglects the size of the project and assumes that cash flows are reinvested at a constant rate. Internal rate of return is the flip side of net present value (NPV), where NPV is discounted value of a stream of cash flows, generated from investment. IRR computes the break-even rate of return showing the discount rate.

IRR can be mathematically calculated using the following formula:                    

In the above formula, Cn is the cash flow generated in the specific period (the last period being ‘n’). IRR, denoted by ‘r’ is to be calculated by employing trial and error method.

2.5.1 Advantages of Internal Rate of Return (IRR)

• It is considered to be straight forward and easy to understand.
• It recognizes the time value of money.
• It considers all cash flows of the project.
• It considers the risk of future cash flows through the cost of capital in the decision rule.
• It tells whether an investment increases the firm’s value.

2.5.2 Disadvantages of Internal Rate of Return (IRR)

• It often gives unrealistic rates of return and unless the calculated IRR gives a reasonable rate of reinvestment of future cash flows, it should not be used as a yardstick to accept or reject a project.
• It may give different rates of return; in essence it entails more problems than a practitioner may think.
• It could be quite misleading if there is no large initial cash outflow.

2.6 The Real Options Approach

The real options approach applies financial options theory (the best known form is the Black-Scholes model) to real investments, such as manufacturing plants, line extensions and research and development investments. This approach provides important insights about business and strategic investments which are very vital given the rapid pace of economic change. A financial option gives the owner the right, but not the obligation, to buy or sell a security at a given price. Analogously, companies that make strategic investments have the right but not the obligation to exploit these opportunities in the future.

If real options are used as a conceptual tool, it allows management to characterize and communicate the strategic value of an investment project. The real option method represents the new state-of-the-art technique for the evaluation and management of strategic investments. The real option method enables corporate decision makers to leverage uncertainty and limit downside risk. The Black-Scholes model applies when the limiting distribution is the normal distribution, and it explicitly assumes that the price process is continuous and that there are no jumps in asset prices. The version of the model presented by Black and Scholes was designed to value European options, which were dividend-protected. Thus, neither the possibility of early exercise nor the payment of dividends affects the value of options in this model.

The value of a call option in the Black-Scholes model can be written as a function of the following variables:

S = Current value of the underlying asset

K = Strike price of the option

t = Life to expiration of the option

r = Riskless interest rate corresponding to the life of the option

 2 = Variance in the ln (value) of the underlying asset

The model itself can be written as:

Where

The process of valuation of options using the Black-Scholes model involves the following steps below:

Step 1: The inputs to the Black-Scholes are used to estimate d1 and d2.

Step 2: The cumulative normal distribution functions, N(d1) and N(d2), corresponding to these         standardized normal variables are estimated.

Step 3: The present value of the exercise price is estimated, using the continuous time version of the present value formulation:

Present value of exercise price = K e-rt

Step 4: The value of the call is estimated from the Black-Scholes model.

2.6.1 Advantages of Real Options Approach

• Projects can be viewed as real options can be valued using financial option pricing techniques.

• Technically, it allows managers to bundle a number of possible outcomes into a single investment.
• A decision maker has greater flexibility and improved method to value opportunities.

2.6.2 Disadvantages of Real Options Approach

• When applied to stock evaluation real options technique is complicated.
• While real options have some theoretical validity and can be relatively simple to value in simple situations, the approach is probably better suited to a firm deciding on its strategy than to an investor picking stocks.

• The firm must have the management skills and the wherewithal to exploit options; moreover, an option doesn't have much value if it cannot be funded effectively.

2.7 Sources of Funds

When a firm determines its capital, it must acquire said funds. Three methods are generally available to publicly traded firms: corporate bonds, preferred stock and common stock. The ideal mix of those funding sources is determined by the finance managers of the firm and is related to the amount of financial risk that firm is willing to undertake. Corporate bonds entail the lowest financial risk and therefore generally have the lowest interest rate. Preferred stock has no financial risk but dividends, including all in arrears, must be paid to the preferred stockholders before any cash disbursements can be made to common stockholders. They generally have higher interest rates than those of corporate bonds. Finally, common stocks entail no financial risk but are the most expensive way to finance capital projects.

However, there are many more sources available to firms who do not wish to become “public” by means of shares. These alternatives include bank borrowing, government assistance, venture capital and franchising. All have their own advantages, disadvantages and degrees of risk attached.

CHAPTER THREE

DISCUSSIONS

3.0 Introduction

This chapter focuses on the advantages and limitations of capital budgeting. Capital budgeting decisions are the most crucial and critical decisions firms make. The advantages and limitations are explained below:

3.1 Advantages of Capital Budgeting

Effective capital budgeting improves both the timing and the quality of asset acquisitions. If a firm forecasts its needs for capital assets in advance, it can purchase and install the assets before they are needed. Unfortunately, many firms do not order capital goods until existing assets are approaching full-capacity usage. If sales increase because of an increase in general market demand, all firms in the industry will tend to order capital at about the same time. This results in backlogs, long waiting times for machinery, a deterioration in the quality of the capital equipment, and an increase in costs. The firm that foresees its needs and purchases capital assets during slack periods can avoid these problems.

Capital budgeting helps a firm to plan its financing. This is because a firm can only take a capital budgeting decision when it has funds available. Proper capital budgeting analysis is critical to a firm’s successful performance because capital investment decisions can improve cash flows and lead to higher stock prices. Yet poor decisions can lead to financial distress and even to bankruptcy.

Another advantage of capital budgeting is that, it avoids forecast error. The future success of a firm largely depends on the investment decisions that finance managers make today. Investment decisions may result in a major departure from what the firm has been doing in the past. Through making capital investments, the firm acquires the long-lived fixed assets that generate the firm’s future cash flows and determine its level of profitability. Thus, this decision greatly influences a firm’s ability to achieve its financial objectives. For example, if the firm invests too much, it will cause higher depreciation and expenses. On the other hand, if the firm does not invest enough, the firm will face a problem of inadequate capacity and thus, lose its market share to its competitors.

Furthermore, capital budgeting makes a comparative study of the alternative projects for the replacement of assets which are wearing out or are in danger of becoming obsolete so as to make the best possible investment in the replacement of assets. For this purpose, the profitability of each project is estimated.

Wealth maximization of shareholders is also an advantage of capital budgeting. The impact of long-term capital investment decisions is far reaching. It protects the interests of the shareholders and of the firm because it avoids over-investment and under-investment in fixed assets. By selecting the most profitable projects, the management facilitates the wealth maximization of equity shareholders.

Capital budgeting is a crucial and critical measuring tool for a firm which helps the firm to stay in competition as the expansion of the business takes place. For example, purchasing of equipment to produce additional and new products.

Capital budgeting assists in formulating a sound depreciation, assets replacement policy and general policy.

Finally, a firm’s capital budgeting decisions define its strategic direction, because moves into new products, services, or markets must be preceded by capital expenditures.

3.2 Limitations of Capital Budgeting

Capital budgeting decisions have long-term implications on the operations of the business. It affects the firm’s future cost structure over a long time span. A wrong decision affects the long-term survival of the firm. The investment in fixed assets increases the fixed cost of the firm which must be recovered from the benefit of the same project. If the investment turns out to be unsuccessful in future or gives less profit than expected, the firm will have to bear the extra burden of fixed cost. Such risk can be reduced or minimized through the systematic analysis of projects which is the integral part of investment decision.

Secondly, capital budgeting decisions are irreversible without much financial loss to the firm because there may be no market for second-hand plant and equipment and their conversion to other uses may not be financially viable. Hence, capital budgeting decisions are to be carried out and performed carefully and effectively in order to save the firm from such financial loss. The investment decision which is undertaken carefully and effectively can save the firm from huge financial loss aroused due to the selection of unfavourable projects.

Another key limitation of capital budgeting is that, it involves huge amount of funds. In other words, there is long-term commitment of funds. As such, it is necessary to take the decision very carefully and to make the arrangements of funds available for the procurement of the assets. The long-term commitment of funds leads to financial risk. Hence, careful and effective planning is a must to reduce the financial risk as much as possible.

Capital budgeting decisions are difficult to make because it involves the assessment of future events, which are difficult to ascertain. The investments are required to be made immediately but the returns are expected over a number of years. In other words, capital budgeting decisions can be complex. They often require projecting cash flows for a wide range of uncertain outcomes.

Capital budgeting decisions are not well suited for learning. As Kahneman and Lovallo (1993) noted, learning occurs “when closely similar problems are frequently encountered, especially if the outcomes of decisions are quickly known and provide unequivocal feedback.” In most firms, managers infrequently encounter major investment policy decisions, experience long delays before learning the outcomes of projects; and usually receive noisy feedback. Furthermore, managers often have difficulty rejecting the notion that every situation is new in important ways, allowing them to ignore feedback from past decisions altogether. Learning from experience is highly unlikely under these circumstances (Einhorn and Hogarth, 1978; Brehmer, 1980).

Uncertainty of the future is also a limitation of capital budgeting. The benefits from investments are received in some future period and the future is uncertain (Risk Involvement).

It is often impossible to calculate in strict quantitative terms all the benefits or the costs relating to a particular investment decision.

Finally, costs incurred and benefits received from the capital budgeting decisions occur in different time periods (Time Value of Money).

CHAPTER FOUR

SUMMARY, CONCLUSION AND RECOMMENDATIONS

4.0 Introduction

This chapter provides summary, conclusion and recommendations on the findings made in the study.

4.1 Summary

The objectives of the study were to identify the advantages of capital budgeting as well as its limitations. The study was conducted using secondary data (books, articles, journals, etc).

The study identified Payback Period, Net Present Value, Internal Rate of Return and Real Options Approach as the popular methods used by firms in capital budgeting decisions. From the study, the payback period was indicated as the most widely used by firms due to its simplicity, not forgetting the payback period ignores the time value of money.

The research also indicated the advantages of capital budgeting. These include improvement in both the quality and timing of asset acquisitions, helping a firm in planning its financing, making a comparative study of the alternative projects and wealth maximization of shareholders.

The limitations of capital budgeting are, it has a long-term implication, it involves huge amount of funds, capital budgeting decision is irreversible, it is difficult to make and finally it is often impossible to calculate in strict quantitative terms all the benefits or the costs relating to a particular investment decision.

4.2 Conclusion

The study found that the importance of using investment appraisal method in capital budgeting has gained a wide acceptance in firms. Different methods have been employed, but the significant of using the payback period has been increasing every time despite its critics. The reason why many firms still prefer using the payback period to other methods can be traced to different reasons like the simplicity of the method. Firms try to avoid other appraisal methods like NPV, IRR and Real Options Approach because of the complexity that is built in them.

It has also been found that, capital budgeting is an important aspect of a firm’s financial management. The importance of capital budgeting included, avoidance of forecast error, timely acquisition of assets. Capital budgeting can be a useful tool in the analysis of huge profits. However, there are serious limitations that must be considered when evaluating the results of these projects. These limitations can be used to manipulate the results of an otherwise unfavourable project and make it appear to have a larger return than it actually has.

The study indicated one of the key limitations as its irreversibility. In other words, once a capital budgeting decision has been taken, it cannot be reversed. In view of this, crucial steps and analysis should be made before taking a capital budgeting decision.

4.3 Recommendations

These recommendations were made based on the study.

Firms should deal with uncertainty, a three-stage process:

• Build knowledge through decision analysis.
• Recognize and encourage options within projects.
• Invest based on economic criteria that have realistic economic assumptions.

Once the three-stage process (as outlined above) has been completed, capital projects should be evaluated using a mix of economic criteria that adhere to the principles of financial management. Three good economic criteria are Net Present Value, Modified Internal Rate of Return and Discounted Payback.

Additionally, management of project risk should be different. Tools to manage risks include increasing the discount rate.

Post analysis and tracking of projects should be implemented after the investment has been made. This helps eliminate bias and errors in the capital budgeting process.

Firms should plan for funds far ahead of time. This makes capital budgeting decision by firms simpler when the time is due because the funds needed for the project are now available.

Further studies and research by any individual or group are also recommended on topics relating to capital budgeting. This will broaden the horizon of capital budgeting and contribute substantially to economic growth and development.

REFERENCES

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Brian Baldwin (1997). Economic Justification of Process Improvement and Automation Projects, ABB Industrial Systems Inc.

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Dean, Joel (1951). Capital Budgeting. New York: Columbia University Press

Don Dayananda et al (2002). Capital Budgeting: Financial Appraisal of Investment Projects.

Drury C. Braund, S; Osborne P. and Tayles, M. (1993). A Survey of Management Accounting Practices in UK Manufacturing Companies

Einhorn, Hillel J; and Robin M. Hogarth (1978). “Confidence in Judgement: Persistence of the Illusion of Validity.” Psychological Review 85:5, pp 395-416

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Pike, R. H. (1985). Disenchantment with DCF promotes IRR. Certified Accountant, July: pp 14-17

Stefan Yard (1999). Development of the Payback Method Int. J. Production Economics 67 (2000), pp 155-167

Woods M. Pokorny; M. Lintner, V. and Blinkhorn, M. (1985). Appraising Investment in New Technology. Management Act, October: 42243