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CAPITAL BUDGETING TECHNIQUES ADOPTED BY COMPANIES LISTED AT THE NAIROBI SECURITIES EXCHANGE BY DOROTHY KIGET UNITED STATES INTERNATIONAL UNIVERSITY SUMMER 2014
CAPITAL BUDGETING TECHNIQUES ADOPTED BY
COMPANIES LISTED AT THE NAIROBI SECURITIES
EXCHANGE
BY
DOROTHY KIGET
UNITED STATES INTERNATIONAL UNIVERSITY
SUMMER 2014
ii
CAPITAL BUDGETING TECHNIQUES ADOPTED BY
COMPANIES LISTED AT THE NAIROBI SECURITIES
EXCHANGE
BY
DOROTHY KIGET
A Project Submitted to the Chandaria School of Business in
Partial Fulfillment of the Requirement for the Degree of
Masters in Business Administration
UNITED STATES INTERNATIONAL UNIVERSITY
SUMMER 2014
iii
DECLARATION
I, the undersigned declare that this is my original work and has not been submitted to any
other college, institution or university other than the United States International
University in Nairobi for academic credit.
Signed:____________________________ Date:_____________________________
Dorothy C. Kiget (ID 626662)
This project has been presented for examination with my approval as the appointed
supervisor
Signed: _________________________Date: _________________________________
Mr. Kepha Oyaro
Signed: _________________________ Date: ________________________________
Dean, Chandaria School of Business
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ACKNOWLEDGEMENT
I thank the Almighty God for enabling me reach this far. It has been a challenging
project. In addition, I would also like to thank the individuals who have contributed to the
successful completion of this project.
I thank my husband and my children for the encouragement and patience to see me
through this period.
I would also like to appreciate the respondents for making the time to give feedback on
the questionnaire which went a long way in ensuring that the project was insightful on
completion.
Last but not least, I would like to extend my utmost gratitude to my Business Research
Methods lecturer Dr. Peter Kiriri and my Supervisor Mr. Kepha Oyaro for their patience,
support, encouragement and contributions that made the completion of this research a
reality.
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ABSTRACT
Capital budgeting decisions are very important for financial managers since they
determine the choice of investment projects that will affect company value. The adoption
of the appropriate capital budgeting tools provides managers with both the processes and
techniques required to make decisions that will enhance the organization‟s resource base
while improving its ability to serve its members and evaluate effectiveness of its
investments. The general objective of this study was to assess the capital budgeting
techniques adopted by companies listed at the Nairobi Securities Exchange. The study
had four specific research objectives including: determining the structure of capital
budgeting process adopted by companies listed at the Nairobi Securities Exchange;
determining the capital budgeting techniques adopted by companies listed at the Nairobi
Securities Exchange; analyzing the factors affecting choice of a capital budgeting
technique by companies listed at the Nairobi Securities Exchange; and determining the
risks in capital budgeting techniques adopted by companies listed at the Nairobi
Securities Exchange.
This study applied a descriptive study design. The target population comprised all the
companies listed at the Nairobi Securities Exchange as at December 31st, 2013. A sample
size of 42 firms was selected from a total population of 62. Primary data was collected
using a questionnaire. Data analysis was done using SPSS and Microsoft Excel to
generate quantitative reports. The collected data was analyzed and presented in the form
of tabulations, percentages, mean and standard deviation. The study found out that the
companies had a clearly defined process governing capital budgeting. The study further
found out that the organizations collected relevant and detailed information on each
investment opportunity presented to them, analyzed investment opportunities thoroughly
to establish their worthiness to the organization and their alignment to the strategic plan
and set budgets for each investment project to be undertaken. The companies also
evaluated the fitness of the investment opportunities against the corporate strategic plan.
On the capital budgeting technique, the study found out that all the proposed capital
budgeting techniques were utilized in the organization.
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The most utilized capital budgeting method was internal rate of return followed by net
present value technique. Profitability index technique was third while Present- Value
technique was fourth. Other techniques utilized included discounted Payback technique,
Accounting/Average Rate-of-Return technique and Modified Internal Rate of Return
(MIRR) technique. For those least utilized, the respondents identified failure to take into
account time value of money as they key reason for not applying some techniques
followed by lack of familiarity with the technique and cumbersome computations
involved. On the factors affecting the choice of capital budgeting technique among the
organizations listed at the NSE, certainty of the cash flow affected the choice of capital
budgeting technique, The size of the firm, the state of the economy, prevailing corporate
taxes in the economy, limitation of the strategic plan of the organization, amount of
capital available for investment, environmental impact of the project and profitability
levels of the project. Government regulations on the sector, affected the capital budgeting
technique to little extent. On the risks in capital budgeting techniques, high inflation
affecting interest rates ranked the greatest risk, other risks such as cash flow not flowing
in as anticipated. Collapse of the investee company, management investing the invested
funds in risky projects, and fluctuating cost of capital used in computations, re
encountered only to a little extent with an average were encountered by the firms.
The study recommends that capital budgeting be a key process in an organization‟s
development plan which needs to be handled with strict care because of the impact it has
on the future of the organization. It recommends that capital budgeting appraisers collect
as much information as possible concerning the investment project, macro-economic
changes that are likely to affect the operating environment so as to come up with
appropriate inflation adjusted cost of capital used in appraising projects. The study
further recommends that capital budgeting process incorporate risk management officers
who would advice the team on ways of minimizing such risks.
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TABLE OF CONTENTS
DECLARATION.............................................................................................................. iii
ACKNOWLEDGEMENT ............................................................................................... iv
ABSTRACT ....................................................................................................................... v
TABLE OF CONTENTS ............................................................................................... vii
LIST OF TABLES ............................................................................................................ x
LIST OF FIGURES ......................................................................................................... xi
LIST OF ABBREVIATIONS ........................................................................................ xii
CHAPTER ONE ............................................................................................................... 1
1.0 INTRODUCTION....................................................................................................... 1
1.1 Background of the Study ........................................................................................... 1
1.2 Statement of the Problem .......................................................................................... 4
1.3 General Objective ...................................................................................................... 5
1.4 Specific Objectives .................................................................................................... 5
1.5 Importance of the Study ............................................................................................ 6
1.5.1 Potential investors .................................................................................................... 6
1.5.2 Company‟s Management ........................................................................................ 6
1.5.3 The Government of Kenya ..................................................................................... 6
1.5.4 Academicians and Researchers .............................................................................. 7
1.6 Scope of the Study..................................................................................................... 7
1.7 Definition of Terms ................................................................................................... 7
1.7.1 Capital budgeting ............................................................................................ 7
1.7.2 Capital budgeting techniques .......................................................................... 7
1.7.3 Cost of capital .................................................................................................. 7
1.7.4 Discount rate .................................................................................................... 7
1.7.5 Discounting ..................................................................................................... 7
1.7.6 Internal rate of return ....................................................................................... 8
1.7.7 Net present value ............................................................................................. 8
1.7.8 Payback period ................................................................................................ 8
1.7.9 Present value .................................................................................................... 8
1.7.10 Profitability index .......................................................................................... 8
1.7.11 Required rate of return .................................................................................. 8
1.8 Chapter Summary ...................................................................................................... 8
CHAPTER TWO ............................................................................................................ 10
2.0 LITERATURE REVIEW ........................................................................................ 10
2.1 Introduction ............................................................................................................. 10
2.2 The Structure of Capital Budgeting Process ........................................................... 10
2.2.1 Identification of Investment Opportunities ................................................... 11
2.2.2 Preliminary Screening of Projects ................................................................. 12
2.2.3 Financial Appraisal of Projects ..................................................................... 12
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2.2.4 Project Implementation and Monitoring ....................................................... 13
2.2.5 Post-Implementation Audit ........................................................................... 14
2.3 Capital Budgeting Techniques ................................................................................ 14
2.3.1 Naive Selection Techniques .......................................................................... 15
2.3.2 Sophisticated/Discounting Cash Flows Approaches ..................................... 17
2.4 Factors Affecting Choice of a Capital Budgeting Technique. ................................ 19
2.4.1 Effect of Inflation on the Choice of Technique. ............................................ 23
2.4.2 Effect of Corporate Taxes on Choice of Technique ...................................... 24
2.5 Risks in Capital Budgeting Techniques .................................................................. 26
2.5.1 Types of Risk ................................................................................................. 28
2.6 Chapter Summary .................................................................................................... 32
CHAPTER THREE ........................................................................................................ 33
3.0 RESEARCH METHODOLOGY ............................................................................ 33
3.1 Introduction ............................................................................................................. 33
3.2 Research Design ...................................................................................................... 33
3.3. Population and Sampling Design ........................................................................... 34
3.4 Data Collection Methods ......................................................................................... 36
3.5. Research Procedures .............................................................................................. 36
3.6 Data Analysis Methods ........................................................................................... 37
3.7. Chapter Summary ................................................................................................... 37
CHAPTER FOUR ........................................................................................................... 38
4.0 RESULTS AND FINDINGS .................................................................................... 38
4.1 Introduction ............................................................................................................. 38
4.2 Questionnaire Return Rate ...................................................................................... 38
4.3 General Information ................................................................................................ 39
4.3.1: Segment of the Firm Listed at the NSE ........................................................ 39
4.3.2: Position in the Firm. ..................................................................................... 40
4.3.3: Years Worked in the Firm. ........................................................................... 40
4.3.4: Educational Level ......................................................................................... 41
4.3.5: Size of the Annual Capital Budget for the Firm. .......................................... 42
4.4 Capital budgeting process ....................................................................................... 42
4.4.1: Agreement levels on Statements relating to the processes of capital
budgeting...................................................................................................... 43
4.4.2: Effect of adherence to capital budgeting process on investment rate. ......... 45
4.5 Capital Budgeting Techniques ................................................................................ 46
4.5.1 Decision on what project to invest in. ........................................................... 47
4. 6 Factors Affecting Choice of Capital Budgeting Technique ................................... 48
4.7 Risks in Capital Budgeting Techniques .................................................................. 49
4.8 Correlation Analysis ................................................................................................ 50
4.9 Chapter Summary .................................................................................................... 51
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CHAPTER FIVE ............................................................................................................ 55
5.0 DISCUSSION, CONCLUSIONS AND RECOMMENDATIONS ....................... 55
5.1 Introduction ............................................................................................................. 55
5.2 Summary ................................................................................................................ 55
5.3 Discussions .............................................................................................................. 57
5.3.1 The Structure of Capital Budgeting Process ................................................. 57
5.3.2 The capital Budgeting Techniques adopted by Companies Listed at the
Nairobi Securities Exchange ........................................................................ 59
5.3.3 Factors Affecting Choice of a Capital Budgeting Technique ....................... 61
5.3.4 The Risks in Capital Budgeting Techniques ................................................. 62
5.4 Conclusion ............................................................................................................... 63
5.4.1 The Structure of Capital Budgeting Process ................................................. 63
5.4.2 The capital budgeting techniques adopted by companies listed at the Nairobi
Securities Exchange ..................................................................................... 64
5.4.3 Factors Affecting Choice of a Capital Budgeting Technique ....................... 65
5.4.4 The Risks in Capital Budgeting Techniques ................................................. 65
5.5 Recommendation ..................................................................................................... 66
5.5.1 Recommendations for Improvement ............................................................. 66
5.5.2 Recommendations for Further Research ....................................................... 67
REFERENCES ................................................................................................................ 68
Appendix I: Questionnaire Cover Letter. ...................................................................... 73
Appendix II: Questionnaire ........................................................................................... 74
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LIST OF TABLES
Table 4.1: Segment of the Firms Listed at the NSE ..................................................................... 39
Table 4. 2: Position Held ............................................................................................................... 40
Table 4.3: Years Worked in the Firm ........................................................................................... 41
Table 4.4: Educational Level ........................................................................................................ 41
Table 4.5: Size of the Annual Capital Budget ............................................................................... 42
Table 4. 6: Availability of a Defined Process during Capital Budgeting ...................................... 42
Table 4. 7: Agreement levels on Statements relating to the Processes of Capital Budgeting ....... 45
Table 4.8: Effect of adherence to capital budgeting process on investment rate .......................... 46
Table 4.9: Capital Budgeting Techniques ..................................................................................... 47
Table 4.10 Reasons for limited application of some techniques ................................................... 47
Table 4.11: Decision on what Project to Invest in ........................................................................ 48
Table 4.12: Factors affecting choice of capital budgeting technique ............................................ 49
Table 4.13: Risks in Capital Budgeting Techniques ..................................................................... 50
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LIST OF FIGURES
Figure 4.1: Response Rate ............................................................................................................ 38
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LIST OF ABBREVIATIONS
CAPEX Capital Expenditure
CB Capital Budgeting
CBK Central Bank of Kenya
DCF Discounted-Cash-Flow
ICO Initial Cash Outlay
IRR Internal Rate of Return
MIRR Modified Internal Rate of Return
NPV Net Present Value
NSE Nairobi Securities Exchange
PBP PayBack Period
PRA Probabilistic Risk Analysis
RR Reinvestment Rate
TDep Depreciation Tax Shield,
WACC Weighted-Average Cost-of-Capital
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CHAPTER ONE
INTRODUCTION
1.1 Background of the Study
Capital budgeting is a form of systematic planning of expenditure in order to achieve
sound investment programs which fulfill management's trusteeship obligations; the care
and effective use of the funds entrusted to them by their shareholders and investors
(Paulo, 2009). Capital budgeting is defined by as the best option and financing decision
for long-term investment proposals in an organization (Mowen, 2009). Brewer, Garrison
and Noreen (2011) further define capital budgeting as an investment analysis done by
managers to determine which investment option among those available has the best return
in future cash flows. Capital budgeting decisions of firms are of strategic importance for
the overall growth of an organization as such decisions commit it‟s limited productive
resources to its production system (Crouhy, Jarrow and Turnbull, 2008). Capital
Budgeting techniques are utilized by most of the organizations to evaluate its investment
projects. Capital budgeting theory lies within the concept of shareholders wealth
maximization which holds that shareholders supply equity capital to a firm in expectation
of receiving a return on their investment in the future (Beraldi, Violi, De Simone,
Costabile, Massabò, and Russo, 2013).
The adoption of the appropriate capital budgeting tools provides managers with both the
processes and techniques required to make decisions that will enhance the organization‟s
resource base while improving its ability to serve its members and evaluate effectiveness
of its investments (Swanson and Fisher, 2008). Following the separation of ownership
and management of the firm, management who have expertise and are involved in the
day-to-day operations of the firm screen the various investment options available to
undertake only those investment options offering optimal returns for the shareholder
(Khamees, Fayoumi and Thuneibat, 2010). A capital investment decision should be based
on the assumption that the objective of an organization‟s manager is to maximize firm
value; the wealth of its shareholders. Therefore, capital investment appraisal and cost of
capital estimation are other major decisions that the financial manager has to make. The
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process of screening alternative investment projects is conducted using various
techniques which have been developed by insight of many practitioners and academics.
Capital budgeting is the technique of administering a capital management program. It
helps the financial manager of a company to decide upon the project which is best
suitable for the firm to invest its funds. In order to maximize shareholders‟ wealth, capital
budgeting decision-making processes are crucial, and ought to be carefully considered
because the investment decision makes sure that the current investment opportunities are
utilized to their best potential, resulting in better future returns for the firm. At any one
given moment, managers in an organization are faced with several investment
opportunities from which to select a few to undertake as resources can allow. An
opportune investment decision can yield very positive results in terms of revenues and
therefore profits but a poorly made and incorrect decision can endanger the very survival
of the business. The worst case is bringing the business to a close which can have adverse
effects on the owners of the organization (Singh, Jain and Yadav, 2012). Therefore
capital budgeting forms a very important part of financial management.
The process of investment appraisal is extensive and detailed hence the need for the
appraiser to have necessary information about certain elements of the proposed project
(Singh et al., 2012). First, the appraiser needs to have information pertaining to the cost
of the investment project. In order to appraise investment projects accurately, appraisers
must have information regarding the total investment required for the project and the
sources of funds to be used such as debt, equity or hybrid. The cost of the project and the
sources of funds are important elements of project appraisal process because they provide
criterion for acceptance or rejection of a selected project. In addition, appraisers need to
know the estimated life and the estimated scrap value of project at the end of its useful
life. Estimated useful life and scrap value of the project are important in computation of
cash flows from the project which are used in appraisal process. The appraisers also need
information on the estimated net cash inflows from and the expected time of receipt of all
cash flows (Beraldi et al., 2013). Projects with same cash flows but coming at different
times may have different effects on the appraisal decision. Appraisers also need to have
information on the estimated residual value of project at the end of its life if applicable.
3
Information on the cost of capital is also important for the appraisers because it has a
bearing on the cost of the whole project. The cost of equity which is the shareholders
expected return and the cost of debt calculated on a weighted basis is the cost of capital
and forms the benchmark in deciding the value creation for current shareholders.
Capital Budgeting techniques are broadly classified into two as either non-discounting
techniques or discounting techniques (Singh et al., 2012). Non discounting capital
budgeting techniques are calculated without considering the time value of money. They
include: Pay Back Period (PBP) method and Average Rate of Return (ARR) method.
The discounting techniques take into consideration the time value of money which
includes: Discounted Pay Back Period, Net Present Value, Internal Rate of Return,
Modified Internal Rate of Return and profitability index (Crouhy, et al., 2008). All
discounted cash flow techniques utilize only incremental cash flows resulting from the
selected alternatives and explicitly consider the time value of money, ignored in non-
discounted cash flow capital budgeting techniques (Singh, et al., 2012).
The Nairobi Securities Exchange was constituted as a voluntary association of stock
brokers registered under the societies Act in 1954 and in 1991 the Nairobi Stock
Exchange was incorporated under the companies Act of Kenya as a company limited
by guarantee and without a share capital (Kithinji and Ngugi, 2008). Resultant
development of the market has seen an addition in the number of stockbrokers,
introduction of investment banks, establishment of custodial institutions and credit
rating agencies and the number of listed companies have increased over time. Securities
traded include, equities, bonds and preference shares (NSE, 2012).
In 1996, the largest share issue in the history of NSE, the privatization of Kenya
Airways, came to the market. In May 2006, NSE formed a demutualization committee
to spearhead the process of demutualization. In September 2006 live trading on the
automated trading systems of the Nairobi Securities Exchange was implemented. In
July 2007 NSE reviewed the Index and announced the companies that would constitute
the NSE Share Index. The review of the NSE 20 share index was aimed at ensuring it is
a true barometer of the market. In 2008, the NSE All Share Index (NASI) was
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introduced as an alternative index (NSE, 2012). Its measure is an overall indicator of
market performance. The Index incorporates all the traded shares of the day. Its
attention is therefore on the overall market capitalization rather than the price
movements of select counters. The Nairobi Securities Exchange marked the first day of
automated trading in government bonds through the Automated Trading System (ATS)
in November 2009. The automated trading in government bonds marked an important
step in the efforts by the NSE and CBK towards creating depth in the capital markets by
providing the liquidity which was necessary (NSE, 2012).
In July 2011, the Nairobi Stock Exchange Limited changed its name to the Nairobi
Securities Exchange Limited. The change of name reflected the strategic plan of the
Nairobi Securities Exchange to evolve into a full service securities exchange which
supports trading, clearing and settlement of equities, debt, derivatives and other
associated instruments. In September 2011 the Nairobi Securities Exchange converted
from a company limited by guarantee to a company limited by shares and adopted a
new Memorandum and Articles of Association reflecting the change. In October 2011,
the Broker Back Office commenced operations. The system has the capability to
facilitate internet trading which improved the integrity of the Exchange trading systems
and facilitates greater access to our securities market (NSE, 2012).
1.2 Statement of the Problem
Capital budgeting decisions are very important for financial managers, since they
determine the choice of investment projects that will affect company value. The success
of the corporate growth in the long run depends upon the effectiveness with which the
management makes capital expenditure decisions. A progressive business firm
continually needs to expand its fixed assets and other resources to be competitive.
Investment in fixed assets is an important indicator of corporate growth. Rate of
investments in the corporate sector depends on the internal growth decisions relating to
various decisions versus replacement, expansion, modernization, introduction of new
product lines and also capability of raising resources for financing growth. In the
dynamic business environment, making capital budgeting decisions are among the most
5
important and multifaceted of all management decisions as it represents major
commitments of company‟s resources and have serious consequences on profitability and
financial stability. The extent, to which the corporation attains financial stability and
profitability over a period of time, while making capital budgeting decisions, needs
evaluation from time to time.
Several studies have been conducted on capital budgeting techniques both internationally
and locally. For instance, Wang (2010) studied capital budgeting practices in India.
Hartwig (2012) did a study to examine what determines the use of capital budgeting
methods using evidence from Swedish listed companies. Locally, Kippra (2010) did a
survey of capital budgeting techniques used by companies listed at the Nairobi stock
exchange and established that most companies employ non-discounted cash flow
techniques to evaluate investment proposals. Though similar, this study was conducted
twelve years ago when the operating environment were not as competitive as today.
Chai (2011) studied the impact of capital budgeting techniques on the financial
performance of courier companies in Kenya. As it can be noted from above discussions,
the existing studies were either done internationally whereby the environment in which
they were conducted were not similar to the ones in Kenya or if they had been done in
Kenya, then either a lot of time had lapsed since then or they were case studies. This
study was different from the previous literature in that it aimed to fill the gap by
providing additional evidence regarding the capital budgeting techniques applied by
major firms in Kenya located in Nairobi.
1.3 General Objective
The general objective of this study was to assess the capital budgeting techniques adopted
by companies listed at the Nairobi Securities Exchange.
1.4 Specific Objectives
1.4.1 To determine the structure of capital budgeting process adopted by companies listed
at the Nairobi Securities Exchange
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1.4.2 To determine the capital budgeting techniques adopted by companies listed at the
Nairobi Securities Exchange
1.4.3 To analyze the factors affecting choice of a capital budgeting technique by
companies listed at the Nairobi Securities Exchange.
1.4.4 To determine the risks in capital budgeting techniques adopted by companies listed
at the Nairobi Securities Exchange.
1.5 Importance of the Study
This study would be important to;
1.5.1 Potential investors
To Potential investors, the results of this research would advise them on the capital
budgeting techniques available for use as well as factors to consider when selecting a
capital budgeting technique to apply. They would also be able to understand how their
firms invest the resources offered to them in order to generate a return which is paid as
dividend.
1.5.2 Company’s Management
The results of this research would provide a comparable base to management of the firms
listed at the Nairobi Securities Exchange on the capital techniques to apply and the
possible results on every application. They would therefore be able to evaluate the capital
budgeting techniques in application as well as know how to structure the process to
ensure optimal return for the investors.
1.5.3 The Government of Kenya
The knowledge on the capital budgeting techniques adopted by major companies would
be of great importance to the government in formulating macro and micro economic
policies especially touching on the operation of companies listed at the NSE. It would
also help them in understanding the choice of techniques in various sectors of the
economy.
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1.5.4 Academicians and Researchers
The results of this study would add to the body of knowledge that is available for use and
application by academicians. The findings would further be used as reference and
stimulate further research in this area as well as act as a background for further
researches.
1.6 Scope of the Study
The geographical scope of this study was Nairobi County. The population scope was 62
companies listed at the NSE as at December 31st 2013. The study targeted Chief Finance
Officers of these firms since they were the ones in charge of financial investment matters
of the firms. The study was conducted within the Month of January and February, 2014.
1.7 Definition of Terms
1.7.1 Capital budgeting
Capital budgeting is the process of analyzing investment opportunities in long-term assets
which are expected to produce benefits for more than one year (Peterson and Fabozzi,
2009).
1.7.2 Capital budgeting techniques
These are quantitative models for analyzing potential capital investment in organizations
(Kee and Robbins, 2009).
1.7.3 Cost of capital
The overall cost to an organization of obtaining investment funds, including the cost of
both debt sources and equity sources (Brewer et al., 2011).
1.7.4 Discount rate
The rate of return that is used to find the present value of a future cash flow (Brewer et
al., 2011).
1.7.5 Discounting
The process of finding the present value of a future cash flow (Petereson and Fabozzi,
2009).
8
1.7.6 Internal rate of return
The rate of discounting at which the net present value of an investment project equals
zero; thus, the internal rate of return represents the interest yield promised by a project
over its useful life (Barrows and Neely, 2012).
1.7.7 Net present value
The difference between the present value of cash inflows and the present value of cash
outflows associated with an investment project (Peterson and Fabozzi, 2009).
1.7.8 Payback period
The length of time that it takes for a project to recover its initial cost out of the cash
receipts that it generates (Koch, Mayper and Wilner, 2009).
1.7.9 Present value
The estimated value now of an amount that will be received in some future period
(Barrows and Neely, 2012).
1.7.10 Profitability index
The ratio of the present value of a project's cash inflows to the investment required
(Petereson and Fabozzi, 2009).
1.7.11 Required rate of return
The minimum rate of return that an investment project must yield to be acceptable (Koch
et al., 2009).
1.8 Chapter Summary
This chapter has discussed the background of the problem and therefore giving a brief
introduction into the capital budgeting techniques and the need to select an appropriate
technique. The statement of the problem to be researched and the purpose of this study
has been given. The significance of the study to different stake holders and scope of the
study have been discussed together with the definition of important terms in the study
within this chapter.
The next chapter which is chapter two would give a literature review of capital budgeting
techniques; it would look at the literature in the area in great detail so as to understand
9
previous works on the same. Chapter three is going to explain the methodology of the
research to be done. It would give the research design which includes the methods that
would be used to obtain information among other details. Chapter four presents the data
collected from the field, its analysis, and finally the interpretation of the findings. The
data is presented in form of tables, charts and graphs. Chapter five gives the discussion
of findings, conclusions and recommendations. It also gives the recommendations for
further studies.
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CHAPTER TWO
LITERATURE REVIEW
2.1 Introduction
This chapter reviews literature on capital budgeting in trying to look at the following
areas, capital budgeting techniques, the importance of capital budgeting to the
organizations, factors affecting choice of a capital budgeting technique and finally look at
literature on the structure of the capital budgeting process. The chapter will end with a
conclusion on the literature review and finally a summary of the chapter will be provided.
2.2 The Structure of Capital Budgeting Process
The capital budgeting process governs the way managers produce and share information
about proposed investments and also determines which decisions are delegated, to whom,
and under what constraints. In many firms, individual managers are assigned capital
spending limits based on proposals generated. Effective investment decision making is
essential to corporate survival and long-term success because it directly impacts future
performance by molding future opportunities and developing competitive advantage by
influencing, among other things, its technology, its processes, its working practices and
its profitability (Peterson and Fabozzi, 2009).
Capital budgeting decisions are guided by corporate strategic plan which provides
direction of where the corporation wants to be and how it intends to get there. A strategic
plan is the grand design of a firm and clearly identifies the business the firm is in and
where it intends to position itself in the future (Angelou, 2009). 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. A firm‟s vision and mission is
encapsulated in its strategic planning framework. Strategy refers to the direction and
scope of an organization over the long term, which achieves advantage for the
organization through its configuration of its resources within a challenging environment
and geared towards meeting the needs of the markets as it fulfils stakeholder expectations
(Angelou, 2009).
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In the capital budgeting process, there are feedback loops at different stages, and the
feedback to „strategic planning‟ at the project evaluation and decision stages is important
to project appraisal processes as it may suggest changes to the future direction of the firm
which may cause changes to the firm‟s strategic plan (Barrows and Neely, 2012). It is
through the strategic plan that an organization‟s activities including investment activities
are directed for optimal performance.
According to Maritan (2008), there are six fundamental phases in the capital budgeting
process that have been identified and these are: Identification of investment
opportunities; Development and evaluation: once investment proposals have been
identified, it is necessary to analyze them thoroughly, collecting relevant and detailed
information for each alternative, and evaluating their profitability and global
attractiveness; Selection: a screening of investment proposals which have passed through
the previous phase might be necessary because of financial or strategic factors. As a
result, some projects might be cancelled or postponed to another planning period;
Authorization: almost all investment projects must be approved before their
implementation; Implementation and control: while the project is being carried out,
follow-up procedures are indispensable to adhere to budgeted costs and deadlines; Post-
auditing: in this phase the outcomes of each project are compared with budget targets in
order to assess forecast accuracy and identify error patterns with a feedback effect on the
whole decision process (Madhani, 2008). The capital budgeting process consists of
several stages as discussed below:
2.2.1 Identification of Investment Opportunities
A profitable investment proposal is not just born; someone has to suggest it. The firm
should ensure that it has searched and identified potentially lucrative investment
opportunities and proposals, because the remainder of the capital budgeting process can
only assure that the best of the proposed investments are evaluated, selected and
implemented (Madhani, 2008). Identification of investment opportunities and generation
of investment project proposals is an important step in the capital budgeting process
because project proposals cannot be generated in isolation but have to be in line with a
firm‟s corporate goals, its vision, mission and long-term strategic plan. It is from the
12
corporate goals, vision, mission and long term strategies that capital investment decisions
are directed (Madhani, 2008). Periodically, the corporate vision and strategy may be
changed if an excellent investment opportunity presents itself.
In some industries, some investments are mandatory for example, those investments
required to satisfy particular regulatory, health and safety requirements (Agarwal,
Barney, Ross and Klein, 2009). This majorly applies for statutory requirements in order
to allow the organization to operate smoothly. Other investments are discretionary and
are generated by growth opportunities, competition, cost-reduction opportunities among
other variables. These investments usually represent the strategic plan of the business
firm and, in turn, these investments can set new directions for the firm‟s strategic plan
(Adler, 2009).
2.2.2 Preliminary Screening of Projects
Many potential projects are normally generated in an organization which is in line with
the corporate strategy of the organization. However, not all these projects progress to the
rigorous project analysis process. As a result, a few investment opportunities are
identified which are then put through a preliminary screening process by management to
isolate the marginal and poor proposals, as it is not worth spending resources to
thoroughly evaluate such proposals (Liljeblom and Vaihekoski, 2011). The preliminary
screening may involve some preliminary quantitative analysis and judgments based on
intuitive feelings and experience.
2.2.3 Financial Appraisal of Projects
Projects going through the preliminary screening phase become candidates for thorough
financial appraisal to ascertain whether they would add value to the firm. This stage is
also called quantitative analysis, economic and financial appraisal, project evaluation, or
simply project analysis (Bastos and Cont, 2009). It is through project analysis that
appraisers are enabled to predict the expected future cash flows of the project. They are
also able to 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
13
cash flows, subject the cash flows to simulation and prepare alternative estimates of the
project‟s net present value (Adler, 2009). Hence, project analysis can involve the
application of forecasting techniques, project evaluation techniques, risk analysis and
mathematical programming techniques for example, linear programming.
While the basic concepts, principles and techniques of project evaluation are the same for
different projects, their application to particular types of projects requires special
knowledge and expertise (Liljeblom and Vaihekoski, 2011). For instance, asset expansion
projects, asset replacement projects, forestry investments, property investments and
international investments have their own special features and peculiarities. Financial
appraisal gives the estimated addition to the organization‟s value in terms of the projects‟
net present values (NPV).If the projects identified within the current strategic framework
of the firm repeatedly have negative NPVs in the analysis stage, these results
communicate to the management to review its strategic plan (Liljeblom and Vaihekoski,
2011). Therefore, the feedback from project analysis to strategic planning plays a crucial
role in the overall capital budgeting process. The results of the quantitative project
analyses greatly influence the project selection or investment decisions. These decisions
therefore, affect the success or failure of the firm and its future.
2.2.4 Project Implementation and Monitoring
Once investment projects have gone through the decision stage they then have to be
implemented by management. During the implementation phase various divisions of the
firm are likely to be involved. A crucial part of project implementation is the constant
monitoring of project progress with a view to identifying potential problems thus
allowing intervention to be done early (Liljeblom and Vaihekoski, 2011). Deviations
from the estimated cash flows need to be monitored on a regular basis with a view to
taking corrective actions when needed.
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2.2.5 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 contribute greatly to
the improvement of current investment decision-making by analyzing the past „rights‟
and „wrongs‟ (Liljeblom and Vaihekoski, 2011). The post-implementation audit can
provide useful feedback to project appraisal or strategy formulation. For instance, export
assessment of the strengths and weaknesses of cash flow forecasting of past projects can
indicate the level
2.3 Capital Budgeting Techniques
Economic resources in an organization are limited while the investment opportunities are
massive which puts managers in a tight spot to ensure that they invest few resources of
the organization optimally (Livdan, Sapriza and Zhang, 2009). Corporate managers need
to allocate resources among competing investment alternatives during the capital
budgeting process. To aid managers do this resource allocations optimally, numerous
methods of financial analysis have been identified by researchers and scholars which
guide their decision to either accept or reject proposed capital expenditures (Adams,
Bourne and Neely, 2009).
These financial methods can be grouped into two basic classes-sophisticated/discounting
cash flows and naive selection/non-discounting techniques. The sophisticated techniques
are those that consider the risk-adjusted discounted net cash flows expected from a
project where they consider the risk, cash flows, and the time value of money while
making a decision (Liljeblom and Vaihekoski, 2011). The net present value, internal rate
of return and profitability index are three widely used sophisticated selection criteria.
However, it might be further argued that truly sophisticated methods require something
more than the straight-forward application of the net present value or internal rate of
return models (Adams et al., 2009). On the contrary, naive methods generally do not use
cash flows, consider present values, or incorporate risk in any systematic manner. The
two commonly used naive selection techniques are the accounting rate of return and the
payback period (Livdan et al., 2009).
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2.3.1 Naive Selection Techniques
2.3.1.1 Payback Period Approach
Payback period is a capital budgeting technique defined as the time period calculated as
number of years in which the initial investment is recovered from the invested project
(Crosson and Needles, 2010). The payback period is one of the earliest and most popular
methods of capital project evaluation, and it has been widely used by many firms. The
essence of the technique is the determination of the time period it takes for the cash
inflow from an investment to pay back its original cost. The investment alternative with
the shortest payback period is considered superior (Horngreen and Harrison, 2008). This
approach computes the length of time required to recover, through the incremental cash
inflow, the amount of investment outlay in a project. The basic idea of this approach is
that investment decisions should be made in accordance with how fast an organization is
able to recoup its capital outlay from a given project (Crosson and Needles, 2010). The
PBP can be used as a decision criterion to select investment proposal. If the PBP is less
than the maximum acceptable payback period, accept the project however, if the PBP is
greater than the maximum acceptable payback period, reject the project. The decision
criterion holds that only projects with shorter period to recover the capital outlay are
accepted first. If the incremental cash inflow from a project is the same in every year, the
payback period becomes the ratio of the cost of the project to the annual cash flow
(Arnold, 2008).
This technique can be used to compare actual pay back with a standard pay back set up
by the management in terms of the maximum period during which the initial investment
must be recovered (Horngreen and Harrison, 2008). The standard PBP is determined by
management subjectively on the basis of a number of factors such as the type of project,
the perceived risk of the project etc. PBP can be even used for ranking mutually exclusive
projects. The projects may be ranked according to the length of PBP and the project with
the shortest PBP will be selected (Graham and Harvey, 2010).
Payback period has several advantages. It is simple to compute, easy to understand, and
provides a good measure of the risk involved in a given investment proposal. However, it
can lead to the wrong investment decision as a result of several disadvantages (Horngreen
16
and Harrison, 2008). It does not consider the time value of money and does not
distinguish between alternatives having different economic lives. Its biggest disadvantage
is that it does not consider events occurring after the end of the payback period. To ignore
the cash flows that occur after the payback period is not a very desirable characteristic in
a selection criterion (Horngreen and Harrison, 2008).
The criticisms of payback methods are therefore valid, but these are criticisms that
generally predate the advent of new technology, and examples of their being used as the
sole appraisal technique are, in practice, rare (Horngreen and Harrison, 2008). The
argument usually given for their use is that they are a simple approach to safeguarding
against undue risk, as projects with a short payback are likely to be less risky. Too much
stress on their use can thus indeed operate against proposals for new technology (Cheffi,
Rao and Beldi, 2010).
2.3.1.2 Accounting/Average Rate-of-Return Approach
The rate of return on the investment is defined as the average annual accounting net
income from the investment divided by the total cost of the investment or by the average
cost of the investment (McLaney, 2009). The average cost of the investment is derived
by averaging the beginning investment and the end of life value, or salvage value. This
technique is more defensible than payback in that it attempts to calculate a rate of return
rather than concentrate on the time necessary to recapture the original investment
(Horngreen and Harrison, 2008).
It also includes the proceeds after payback period and it allows ranking of capital project
alternatives according to their respective returns. However, this method has
disadvantages because it fails to take into consideration the time value of money and the
possibility of reinvesting this money. It may also be disadvantageous because it can be
calculated differently, on the basis of total investment or average investment (Horngreen
and Harrison, 2008).
17
2.3.2 Sophisticated/Discounting Cash Flows Approaches
2.3.2.1 Discounted Payback Approach
As from the explanation, the simple payback approach described can be criticized
because it implicitly values recoveries of specific sums received within the payback
period the same regardless of when during the period they occur (Horngreen and
Harrison, 2008). The discounted payback approach seeks to resolve this fault by giving
greater weight to earlier recoveries. The discounted formula rests upon an assumption
that the prospect of getting a shilling one year later is worth more than the prospect of
getting that shilling two years later (Khamees, Al-Fayoumi and Al-Thuneibat, 2010).
Application of the method requires prior knowledge of how time affects the value of
prospective shillings. The discounted payback period is the time span required to recover
an original outlay of funds for a project from the inflows remaining after the investor has
been compensated at the required rate for waiting (Arnold, 2008).
2.3.2.2 The Net Present Value
Net present value is one of the most important discounted cash flow techniques. For this
method the following steps are used: Estimate the expected cost of each project, which
represents the initial outlay of the project. Estimate the amounts and the timing of the
expected net cash inflows from each project. Determine an appropriate discount rate or
cost of capital for the project. This discount rate depends partly on the riskiness of the
project, defined in terms of the likelihood of variability of cash inflows from the project.
Find the present values of the expected net cash inflows for each project (Khamees, et al.,
2010). For each project, subtract the estimated initial cost from the present value of net
cash inflows. The resulting figures are the net present values of each project. If the net
present value is a positive number, the project is a candidate for further consideration. If
negative, the project should be rejected. The project alternative with the highest positive
net present value should be selected (Horngreen and Harrison, 2008).
The (NPV) of an investment is therefore an estimate of the market price of the stream of
net cash flows from the investment. If the NPV is positive, the investment will increase
the stockholder's wealth, the opposite is also true (Johnson, 2008). Therefore, based on
18
the net present value of projects, the capital budgeting decision a company faces is to
select the portfolio of projects that does not exceed a certain budget, but at the same time
creates maximum value (Fernandez, and Campo, 2011).
2.3.2.3 Internal Rate of Return
Generally, the rate-of-return approach involves arraying potential projects in the order of
their promised percentage rates of return and then applying some predetermined company
capital expenditure policy to divide the array into acceptable and non-acceptable projects.
The determination of the rate of return for a project involves finding the percentage
discount rate which exactly equates the present value of the cash inflows expected during
the life of the project with the outlay required to produce the inflows. The use of cash
inflows rather than net earnings is emphasized (Fernandez and Campo, 2011).
Internal rate of return technique is regarded as one of the most advanced and efficient
methods of capital project evaluation. While the net present value technique requires the
use of an external rate; the cost of capital, the internal rate technique attempts to find the
rate that is internal to the project (Khamees, et al., 2010). This internal rate is that which
makes the net present value of a project equal to zero. In other words, the internal rate is
that which makes the present value of cash inflows equal to the initial cost of the project.
The decision rules here are: if the internal rate of a project is greater than the cost of
capital, the project is accepted; if the internal rate is less than the cost of capital, the
project should be rejected. The project with the highest internal rate is given the top
ranking (Khamees, et al., 2010).
2.3.2.4 Profitability index
Profitability Index (PI) is another measure used to determine capital budgeting decisions
made by an organization. It is similar to the technique of calculating the present value of
the cash flows generated from the project (Droms and Wright, 2010). PI can also be
defined as the ratio of the benefits or cash inflows from a project calculated in present
value terms to the costs incurred while undergoing the project also measured in the terms
of present values.
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2.3.2.5 Modified Internal Rate of return
Modified internal rate of return (MIRR) is a similar technique to IRR. Technically, MIRR
is the IRR for a project with an identical level of investment and NPV to that being
considered but with a single terminal payment (Droms and Wright, 2010). MIRR is
invariably lower than IRR and it makes a more realistic assumption about the
reinvestment rate. The biggest problem with IRR is that the Reinvestment Rate of interim
cash flows is same as the IRR itself (Crosson and Needles, 2010). However, in real world
situations however, a company may not have the opportunity to get the same IRR as
before. IRR of each new project is likely to differ and hence the manager must find a way
to incorporate that change instead of just assuming the same RR (Reinvestment Rate) as
IRR (Khamees, et al., 2010).
The Modified Internal Rate of Return (MIRR) provides the flexibility of modifying the
RR as desired (Liljeblom & Vaihekoski, 2011). Appraising managers may find it difficult
to forecast RRs down the investment horizon and hence a safe assumption would be to
set it equal to the Cost of Capital, below which, incremental projects will result in „Value
Destruction‟ (Khamees, et al., 2010). MIRR delinks the Reinvestment Rate from IRR
thereby giving the manager an option to choose a different/more realistic rate (usually
Cost of Capital) thereby giving a more reliable conclusion (Liljeblom and Vaihekoski,
2011).
2.4 Factors Affecting Choice of a Capital Budgeting Technique.
Capital budgeting ranks among the key managerial actions in modem corporations and
much of the debate revolves around determining appropriate rates of return for accepting
investment projects (Arnold, 2008). In order to understand the investment behavior of
different firms, one is supposed to consider both the process at which external capital is
availed to firms and the process by which raised capital is allocated to investment
projects within the organization (Khamees, et al., 2010). It is important to note that
relatively little research has been focused on the internal allocation process and its
relationship to the organization of the firm. However, modern finance theory pre-scribes
allocating capital according to the net present value (NPV) rule (Bastos and Cont, 2009).
20
According to Livdan et al., (2009) implementation of sophisticated capital budgeting
methods may be one of many means for coping with acute resource scarcity. In times of
economic stress, firms do some restructuring by instituting cost reduction procedures,
tighter and more careful budgeting, among others. The adoption of new criteria for
capital budgeting could be one of these cost reduction procedures (Bastos & Cont, 2009).
The results of their analysis indicated a decline in the returns of the experimental firms
compared to the control firms before they revised their capital budgeting policy (Livdan
et al., 2009). Additional support for this is provided by the fact that approximately 60
percent of the experimental firms implemented sophisticated capital budgeting techniques
in a period when there was a reduction in the gross level of investment for capital
expenditures
Another factor that may affect the choice of capital budgeting technique is the company's
reward structure. Companies that reward their employees on the basis of long-term
incentive plans may experience more benefits from sophisticated selection techniques
than companies that reward using a short-term reward plan (Livdan, et al.,2009).
In the words of Bastos and Cont (2009), firms have discovered that projects typically do
not turn out as well as they estimated they would. They correct for this by using capital
budgeting procedures that are more conservative than net present value as well as by
frequently using relatively conservative estimating procedures. Firms may also scale back
projects' estimated cash flows (Adler, 2009).
It is also important to note that DCF techniques, like any other capital budgeting
techniques, depend critically on the projections of cash flows and any analyst who would
like to do so can generate for you within reason the NPV or IRR desired (McLaney,
2009).In addition, it is often difficult if not impossible to assess accurately in practice the
rate of discount that will be consistent with the riskiness of the cash flow stream being
discounted, or that reflects accurately the rate at which such cash flows will be reinvested
(Petereson and Fabozzi, 2009). Therefore DCF rates are useful mainly for making tactical
capital allocations rather than for making strategic choices (Aggarwal, 2009).
21
Business examples also often demonstrate that less refined measurement techniques are
unreliable and result in the wrong ranking of projects. This implies that the use of less
refined techniques is the most important weakness in the investment decision making
process (Petereson and Fabozzi, 2009). Further it presumes that the utilization of more
refined techniques will improve decision making and corporate profitability. Investment
decision making could be improved significantly if the emphasis were placed on asking
the appropriate strategic questions and providing better assumptions rather than on
increasing the sophistication of measurement techniques. While this suggested change in
emphasis does not mean that refined evaluation techniques should be discarded, it does
mean that their adoption may not provide the desired improvement in corporate
profitability (Adler, 2009). This leads organizations to choose the more refined
techniques.
Bae, Park, and Wagner (2008) agree that IRR along with NPV have been widely used by
business firms in evaluating capital projects. However, high IRRs at the project do not
guarantee that the firm‟s value is maximized. Furthermore, the linkage of IRRs to
business unit performance and corporate performance is unclear. IRR is useful at the
project level but is not sufficient to evaluate shareholder value at the product, brand, or
business unit levels (Khamees, et al., 2010). Economic value added (EVA) provides the
linkage needed. EVA measures economic profit compared to accounting profit and is
calculated as the difference between net operating profit after taxes and total capital costs
of debt and equity. A positive EVA suggests that shareholder value is added (Neely &
Adams, 2009)
It has been argued that project rationing was one of the key factors in investment decision
making. The problem of determining which projects to approve may be alleviated by:
eliminating the constraints on the corporation such as limited capital or raw materials or
limited management or engineering talent or improving the quality of the assumptions
(Meier, Christofides and Salkin, 2011). The latter point suggests that the projects may not
be as desirable as the single point estimates might indicate. In the short run, there may be
little that the corporation can do to eliminate the constraints but even so, significant steps
22
can be taken to improve the quality of the assumptions (Brookbanks, Gandy and
Pourquery, 2011).
Once the corporate strategy has been defined and communicated, the capital expenditure
prepared must determine the key factors affecting the profitability of the project, justify
the assumptions that have been chosen for those factors and communicate the relevant
information to top management (Brookbanks et al, 2011). By giving the assumptions on
key factors good visibility, the corporation increases the opportunity for questioning poor
assumptions and investigating alternatives.
There is little value in refining an analysis that does not consider the most appropriate
alternative and does not utilize sound assumptions. Management should spend its time
improving the quality of the assumptions and assuring that all of the strategic questions
have been asked, rather than implementing and using more refined evaluation techniques.
The selection of better assumptions can be facilitated through making the assumptions
more visible and asking the right strategic questions. In most capital expenditure
analyses, the major assumptions are either not provided or they are buried in the
supporting detail. More attention should be directed toward improved use of sensitivity
analysis and the communication of its results to top management (Mowen and Hansen,
2009). This would enable executives to direct their review of projects to areas that are
key to profitability and enable them to demand more detailed justification of crucial
assumptions.
The main justification for using the accounting rate of return method is because top
management believes that reported profits have an impact on how financial markets
evaluate a company (Harris and Raviv, 2010). This is further reinforced in many
companies by linking management rewards to short-term financial accounting measures.
Thus a project‟s impact on the financial accounting measures used by financial markets
would appear to be a factor that is taken into account within the decision making process
(Mowen and Hansen, 2009).
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2.4.1 Effect of Inflation on the Choice of Technique.
Significant increases in the general price level for goods and services necessitate
modification of traditional capital budgeting procedures to avoid inefficient allocation of
capital. A chronic inflationary environment diminishes the purchasing power of the
monetary unit, causing large divergences between nominal and real future cash flows
(Wang, Zhen and Tang, 2010). Thus, since rational decision makers presumably are
interested in real returns, they should explicitly include the impact of inflation on
investment projects when making capital budgeting decisions (Wang, et al., 2010).
Once one recognizes the uneven effects of inflation on various cash flows and thereby on
the firm value, one also needs to recognize that risks associated with the various flows of
the firm are not equivalent (Mowen and Hansen, 2009). Of course, a capital project
would provide a complete hedge against inflation when the total risk associated with
inflation has no impact on the capital project.
Failure to consider the impact of inflation tends to produce suboptimal decisions for
several reasons. For example, cash-flow estimates must embody anticipated inflation if
the discount rate contains an element attributable to inflation (Graham and Harvey,
2010). Ignoring this adjustment would result in either an upward or a downward appraisal
bias depending on the relative responsiveness to inflation of the cash inflows and
outflows. Even if cash expenses and revenues from an investment project were fully
responsive to inflation, depreciation tax-shields would suffer diminution of real value
since conventional accounting procedures base depreciation computations on historical
cost (Allen, 2009).
Further, any variability in inflation rates will only magnify the variability of real cash
flows and thereby the risk of the more capital intensive firm. Thus, while the real cost of
capital may be identical for two firms under a given inflation rate assumption, their real
cost estimates may differ under another inflation rate (Allen, 2009). Simply adjusting K
by the expected change in the inflation rate is then unlikely to yield the correct, market-
determined cost of capital for the firm; indeed, the naive process would likely result in
24
the misspecification of project value, in inappropriate rankings, and in apparent capital
surpluses or shortages for the firm.
Inflation rates will undoubtedly vary from period to period throughout the life of a capital
investment. Explicitly adjusting the discount rate for inflation requires that the effects of
inflation on cash flows also be accounted for in the model to prevent biased NPV results
.Efforts to incorporate a volatile inflationary environment in capital expenditure analysis
have typically led to a prescription such as discount nominal cash flows by nominal rates
and real flows by real rates (Harris and Raviv, 2010). While this statement is logically
consistent and intuitively appealing, it glosses over thorny conceptual issues in devising
implementation procedures for capital budgeting decisions (Brookbanks et al., 2011).
Studies dealing with the impact of inflation on capital budgeting decisions have stressed
the need for logically consistent treatment, usually within the context of the discounted
cash flow formula. Of special concern has been the equivalence of the real and nominal
formulations of the discounted cash flow method (Mehta, Curley and Fung, 2011).
From a pedagogic viewpoint, it makes sense to perceive inflation as a neutral process
with little or no lasting effects on relative prices and resource allocation. However,
scholars in both economics and finance disciplines have come to recognize the uneven
impact of inflation on the financial market benchmarks; the real rate and the market rate
of return. In turn, changes in these benchmarks typically lead to a change in the required
rate of real return or a disproportionate change in the nominal rate of return for the
project in question (Brookbanks et al., 2011).
2.4.2 Effect of Corporate Taxes on Choice of Technique
The introduction of corporate taxes further exacerbates the problem of inconsistency in
the conventional capital expenditure procedures. The depreciation tax shield, TDep, is,
for instance, a fixed, nominally defined cash flow whose real value varies with inflation.
If two firms are identical in all respects except for their capital intensities, the firm with a
larger capital/labor ratio will have a larger proportion of aggregate cash flow through its
depreciation tax shield, TDep; therefore, this firm will require greater efforts to hedge
against inflation than the other firm (Brookbanks et al., 2011).
25
Suboptimal decisions may also result from over-looking the synergistic reduction of real
returns due to taxation and inflation. For example; with no inflation, a 50% tax bracket,
and a before-tax return of 4%, real after-tax return equals 2%; if an inflation rate of 4% is
introduced, before-tax return must be increased to 12% to completely offset the combined
effects of taxation and inflation. Simply adding 4% to the before-tax return to counteract
the 4% inflation is insufficient, and would cause a 2% reduction in real return because
taxes are paid on nominal income, not real income (Truong, Partington and Peat, 2008).
Although it is difficult to specify a priori the influence of inflation on a firm's cost of
capital in a simple, intuitive fashion, it is vitally important to avoid the misspecification
of the conventionally derived cost of capital measures in order to arrive at sound capital
expenditure decisions (Singh et al., 2012). The significance of the adjustments will
generally depend on the interrelationships among anticipated inflation, the nominal
interest rate, and the individual firm's ability to adjust to changes in inflation as reflected
in its profitability. Moreover, because the adjustment in the nominal discount rate would
not be proportional to the changes in inflation rate expectations, as is conventionally
suggested in the finance literature, a consistent transformation from nominal to real
analysis would not be so straight forward as convention suggests. For implementation
purposes, a real analysis is a derivative process whose validity requires in the first place a
correct specification of nominal flows and the discount rate (Paulo, 2010).
A capital expenditure decision typically involves consideration of two separate but
related markets. Estimates of cash flows revolve around the goods or real market,
whereas the discount rate is connected with the financial market. In turn, the speed of
adjustment to the inflation expectation change varies in the two markets, whereby the
financial market adjusts much more quickly than the goods market (Singh et al.,2012).
Thus the estimates of cash flows require careful scrutiny with respect to leads and lags in
the receipt and disbursement streams. At the same time, difficulties encountered in
correctly specifying the discount rate are exacerbated by the absence of a constant,
economy-wide real rate in an inflationary environment (Paulo, 2010).
26
As noted by Singh et al. (2012), the next major improvement in capital budgeting practice
will not be in the choice of computational technique. Firms are taking the time value of
money into consideration. But corporations will be making decisions using capital
budgeting calculations supplemented by any relevant qualitative and strategic
considerations (Singh et al., 2012). Also, capital budgeting decisions are affected by the
performance compensation system. These considerations are likely to be more important
than marginal improvements in the calculations. Finally, it appears that the adoption of
sophisticated selection techniques may be one of many policies firms pursue in the face
of economic stress. This switch in capital budgeting selection procedures may, in
combination with other policies, bring about economic recovery (Swanson and Fisher,
2008).
2.5 Risks in Capital Budgeting Techniques
Risk is the degree of uncertainty (Graham and Harvey, 2010). Optimum Capital Structure
is believed to be a theoretical concept as practitioners believe that following a „Target
Structure‟ is nearly impossible as market conditions will not allow one to keep it stable
unless the firm is at a „Matured stage‟, where expansion needs are limited and capital
management becomes far simpler .High growth companies are driven by Capex and the
funding mix is not as important as getting the right amount while for matured companies
the priority reverses. Many professionals believe “Raise money when you can, and not
when you should”. However, if debt is raised without really being required at a certain
time it will increase the risk and hence the Cost of Equity (Chong, Jennings and Phillips,
2012). Modern theory suggests that Optimum Capital Structure should be based not on
interest tax shields but rather the risk specific to the firm and industry on a long term
basis (Graham and Harvey, 2010).
Capital budgeting techniques deal with estimation of cash flows from anticipated
projects. Uncertainties exist when the outcome of an event is not known for certain, and
when dealing with assets whose cash flows are expected to extend beyond one year,
certainly, there‟s element of risk in that situation. Risk is inevitable to the capital
investment projects because of the uncertain future period in which cash flows are
27
expected to come in from the projects (Fernandez and Del Campo, 2011). The various
risks include cash flows not being paid in time as agreed, the risk of the investee
company collapsing and also the management sinking the invested funds in risky
projects. By incorporating risk in capital budgeting, investors can minimize losses and
ensure successful organizational performance in future (Harris and Raviv, 2010).
According to surveys, most companies use discounted-cash-flow (DCF) methods to
evaluate capital budgeting decisions. DCF methods typically assume that a project‟s
initial cash outlay (ICO) is known with certainty (Truong, et al., (2008). However, many
types of initial outlays have substantial uncertainty, especially those involving the
construction of a new facility. In addition, this risk affects not only the ICO, but it also
affects subsequent depreciation tax shields. A proper capital budgeting analysis should
incorporate all of the additional risk that is due to an uncertain ICO. Unfortunately, the
typical “contingency” approach employed by many corporations does not satisfactorily
address ICO risk. Sensitivity analysis is an effective way to address ICO risk, but the
finance literature often overlooks the adjustments needed to satisfactorily address ICO
risk within a sensitivity analysis. Companies adjust the estimated initial cash outlay by
adding a “contingencies” amount to the original cost estimate (Graham and Harvey,
2010).
The literature for assessing risk includes the certainty equivalent approach, the risk
adjusted discount rate approach and sensitivity analysis. A “certainty equivalent” is the
certain amount that one would be willing to take in lieu of a risky cash flow (Graham and
Harvey, 2010). With respect to ICO risk, one could, in theory, estimate the certainty
equivalent cash outflow for each uncertain (risky) ICO component, based on the expected
cash flow and its risk, and use this certainty equivalent rather than the estimated ICO
when estimating the project‟s NPV. This is very similar to the common practice
described above of increasing the ICO by a contingencies account, where the adjusted
ICO is essentially a certainty equivalent (Harries and Raviv, 2010).
28
2.5.1 Types of Risk
Risk may be defined as that state of uncertainty or doubt in the face of a situation and
which may have both beneficial and adverse consequences (Brookbanks et al., 2011).
Uncertainty is the state of having limited knowledge where it is impossible to exactly
describe existing state or future outcome and handled through risk management efforts
such as insurance. Uncertainty is not measurable and cannot be quantified (Allen, 2009)
Risk can be categorized as pure or static risk and speculative or dynamic risks (Fernandez
and Campo 2011), Pure or static risk is a situation in which there are only the possibilities
of loss or no loss, as opposed to loss or profit in speculative risk. The only outcome of
pure risks is adverse in case of a loss or neutral in case of no loss. It is never beneficial.
Such risks include premature death, occupational disability, and damage to property and
so on. These risks can be militated against through insurance (Fernandez and Campo
2011).
Pure risks therefore generic risks which are external to an organization or beyond the
organizations control such as fire and other environmental hazards. These typically result
in a disruption in organizations activities thus the goal of any organization in managing
pure risk types rest on the elimination or mitigation of impact. Speculative risk is a
situation in which either profit or loss is possible. These situations are usually situations
involving betting on a horse race, entering a new business venture, borrowing additional
capital for expansion and so on. These are the risks that are inherent in conducting
business and the outcome may be beneficial or result in a loss. Speculative risk is
uninsurable (Fernandez and Campo, 2011).
Speculative risk is therefore a double edged sword comprising of risks that arise out of
the activities of an organization. It is inherent to the type of organization. The upside to
speculative risks exists in a way such that if managed well they allow for the
improvement in profits or achieving organizational objectives and at the same time avoid
any downside risks that it entails (Waring and Glendon, 2008). Speculative risks branch
out into many classes of risk. One useful way of categorizing risks is to identify risks
from an organizational perspective. This view classifies risks into business risks and non
29
business risks (Glasserman, 2008). The energy sector is exposed to a wide array of risk as
expounded below.
2.5.1.1 Financial Risk
Financial risk is a general term for multiple types of risk associated with financing,
including financial transactions that include company loans in risk of default. Financial
risk is an assessment of the possibility that a given investment will fail to bring return and
may result in a loss of the original investment. It is any risk that is related to the form of
financing and emanates from the possibility that a given investment may fail or change in
its ability to return principal and income (Pandey, 2009). Financial risk is most evident in
the Financial Services sector. Volatile interest rate changes affect organizations that
borrow or lend money and at the same time deal in foreign currencies or receive
payments in foreign currency (Chong et al., 2012).
Examples of financial risk include: price risk, market risk, interest rate risk, currency risk,
liquidity risk, credit risk, inflation risk, default risk, execution risk, cash flow risk, re-
investment risk, extension risk, timing risk, prepayment risk, equity risk, accounting risk,
business risk, political risk and pure risk (Allen, 2009).
2.5.1.2 Credit Risk
Credit risk, is also referred to as default risk, is the risk associated with a borrower going
into default (not making payments as promised). Investor losses include lost principal and
interest, decreased cash flow, and increased collection costs. An investor can also assume
credit risk through direct or indirect use of leverage (Glasserman, 2008).
2.5.1.3 Liquidity Risk
This is the risk that a certain security or asset cannot be traded quickly enough in the
market to prevent loss or make a profit. There are two types of liquidity risk: asset
liquidity and funding liquidity. Asset liquidity risk is the risk that an asset cannot be sold
due to lack of liquidity in the market. Funding liquidity is the risk that liabilities cannot
be settled when they fall due, or can only be met at an uneconomic price (Allen, 2009).
30
2.5.1.4 Inflation Risk
Inflation risk is also known as purchasing power risk. It is the risk that the value of assets
or income will decrease as inflation shrinks the purchasing power of a currency due to the
rising cost of goods and services (Chong et al., 2012).
2.5.1.5 Market Risk
The four standard market risk factors are: equity risk, interest rate risk, currency risk and
commodity risk. Equity risk is the risk that stock prices in general will plummet or the
implied volatility will change. Interest rate risk is the risk that interest rates will change.
For an organization that has taken up a loan facility, its costs may be increased if the
interest rate goes up. Currency risk is the risk that foreign exchange rates or the implied
volatility will change, which may adversely affect the value of an asset held in that
currency. Commodity risk is the risk that the prices of basic commodities will increase
(Horcher, 2010).
2.5.1.6 Default Risk
This is also referred to as legal risk, fraud risk or counterparty risk. It is the risk
associated with the possibility of other parties not meeting their contractual obligations or
that the issuer will default to pay the investor their income and principal. It is the event in
which companies or individuals will be unable to make the required payments on their
debt obligations. To mitigate the impact of default risk, lenders often charge rates of
return that correspond to the debtor‟s level of default risk; the higher the risk, the higher
the return required (Allen, 2009).
2.5.1.7 Political Risk
Political risk refers to the complications that businesses and governments may face as a
result of what are commonly referred to as political decisions or any political change that
alters the expected outcome and value of a given economic action by changing the
probability of achieving business objectives. Political risk faced by firms can be defined
as the risk of a strategic, financial or personnel loss for a firm due to nonmarket factors
31
such as fiscal policy, labor laws, acts of terrorism, coups and civil war (Bremmer, 2008)
In Kenya this usually happens during election period. As a result many investors shy
away from new investments and instead wait until the country has resumed normal
operations.
2.5.1.8 Operational Risk
Operational risks are those risks arising from an organization's internal activities. It
focuses on people, processes and the systems they operate. According to Basel II
regulations, operational risk is the risk of loss resulting from inadequate or failed internal
processes, people or systems, or from external events. Such risks include failures of IT
and MIS systems, inadequate processes and internal controls, people and systems, etc.
Personnel can cause operational risks by way of errors or omissions, fraud, lack of
training and expertise. Lapses in internal controls arise out of weak policies and
procedures to govern work processes or simply lacking checks and balance mechanisms
such as supervisory control and management oversight (Whitfield, 2008).
2.5.1.9 Strategic Risk
Strategic risk is the current and prospective impact on earnings or capital arising from
adverse business decisions, improper implementation of decisions, or lack of
responsiveness to industry changes. This type of risk has a wide scope and coverage.
They include those risks which arise from fundamental decisions that directors take
concerning an organization‟s objectives. Strategic risk refers to the situation whereby the
organization fails in all of its endeavors as encapsulated in its vision, mission and
objectives. Strategic risk is the conduit between pure and speculative risks such that
failure to manage the strategic risks could seriously threaten an organizations business
and viability (Waring and Glendon, 2008). Strategic risks can be subdivided into business
risks which are derived from decisions made by the board of directors involving a
product or services; and non-business risks which are risks that do not derive from the
products or services supplied, for example risks associated with long term sources of
finance.
32
2.5.1.10 Reputational Risk
Reputational risk is the current and prospective impact on earnings and enterprise value
arising from negative stakeholder opinion. It is therefore the loss of value of a brand or
the ability of an organization to persuade (Harries and Raviv, 2010). Reputational risk
arises due to directs and indirect activities of an organization. A direct activity for
example would be if the organization‟s products are defective, it would result in the
customers choosing not to purchase the product. An indirect activity on the other hand
would be where the conduct of an organization‟s staff affects the reputation of the
organization. It is therefore the risk of loss resulting from damages to a firm‟s reputation,
or lost revenue or destruction of shareholder value when an organization has been
accused of wrong doing.
2.6 Chapter Summary
This chapter has given a review on the literature on capital budgeting regarding, the
capital budgeting process, capital budgeting techniques, the factors affecting choice of
capital technique and the various risks involved in capital budgeting decisions. The
capital budgeting process governs the way managers produce and share information
about proposed investments and also determines which decisions are delegated, to whom,
and under what constraints. Chapter three provides research methodology which outlines
the methods used to collect that data, research design and how data was analyzed.
Chapter four provides the findings of the research while chapter five presents summary,
conclusions and recommendations.
33
CHAPTER THREE
3.0 RESEARCH METHODOLOGY
3.1 Introduction
This chapter gives the methodology that will be used in the study. It includes subsections
in this order: Research Design, Population and Sampling Design, Data Collection
Methods, Research Procedures, Data Analysis Methods and then finally, the chapter
summary is given.
3.2 Research Design
This study applied a descriptive research design. Descriptive research is concerned with
finding out the what, where and how of a phenomenon. The research design and
methodology entailed collecting data useful in analysis and coming up with relevant
recommendations and conclusions. This research design was appropriate because as
pointed out by Saunders, Lewis and Thornhill (2009), it forms a basis for sound theory
and also contributes to formulation of relevant policy for intervention. This study
involved an investigating into the commonly adopted capital budgeting techniques among
companies listed in the NSE.
Descriptive studies are important such as that undertaken using attitude and opinion
questionnaires and questionnaires on organizational practices, will enable one to identify
and describe the variability in different phenomena (Saunders et al., (2009). The findings
of this study provide a basis for giving the way forward on the choice and the benefits of
the use of certain capital budgeting techniques that are available. The data obtained was
standardized, to allow easy comparison. The dependent variable was financial
performance while the independent variables included structure of capital budgeting,
capital budgeting techniques, and risk.
34
3.3. Population and Sampling Design
3.3.1 Population
Target population in statistics is the specific population about which information is
desired. According to Thorpe (2008), a population is a well defined or set of people,
services, elements, events, group of things or households that are being investigated. The
target population comprised all the companies listed at the Nairobi Securities Exchange
as at December 31st, 2013. Therefore, the population of this study was 62 listed firms.
These were classified into ten categories using the segment classifications as shown in
the Table 3.1 below:
Table 3.1: Population Distribution
Segment Number of firms Percent
Agriculture 7 11%
Automobiles and Accessories 4 7%
Banking and Finance 11 18%
Commercial and services 9 15%
Construction and Allied 5 8%
Energy and Petroleum 5 8%
Insurance 6 10%
Investment 3 5%
Manufacturing and Allied 9 15%
Telecommunication and Technology 2 3%
Total 62 100%
Source: NSE (2014)
3.3.2. Sampling Design
Sampling ensures that some elements of a population are selected as riding representative
of the population.
35
3.3.2.1 Sampling Frame
According to Saunders, et al., (2009) a sampling frame is a list of elements from which
the sample is actually drawn and closely related to the population. In this study, the
sampling frame was drawn from the segment classifications as per the Nairobi Securities
Exchange. This was used so as to ensure that the sampling frame was current, complete
and relevant for the attainment of the study objective.
3.3.2.2 Sampling Technique
The study grouped the population into ten strata based on the segments of classification
as per the NSE. From each stratum of the companies, the study used simple random
sampling to select 70% of the population. Mugenda and Mugenda (2008) stipulated that a
sample of at least thirty elements is adequate for generalization of the findings to the
whole population. However, for this study, since to ensure that the number of those firms
responding is more at least 30, the study selected 70% of the population for inclusion in
the study. A simple random sampling technique was used to select firms to be included
into the survey.
3.3.2.3. Sample size
Thorpe, Smith and Jackson (2008) said that a sample refers to a subset of those entities
that decisions relate to. He poised that, the sample must be carefully selected to be
representative of the population and the researcher also needs to ensure that the
subdivisions entailed in the analysis are accurately catered for. A sample size of 42 firms
was selected from the total population. The researcher plans to interview the chief
Finance Officers of these firms as shown in the table below:
36
Table 3.2: Sample Size Distribution
Segment Number of
firms
Sample
Percentage
Sample Size
Agriculture 7 70% 5
Automobiles and Accessories 4 70% 3
Banking and Finance 11 70% 8
Commercial and services 9 70% 6
Construction and Allied 5 70% 4
Energy and Petroleum 5 70% 4
Insurance 6 70% 4
Investment 3 70% 2
Manufacturing and Allied 9 70% 6
Telecommunication and Technology 2 70% 1
Total 62 42
3.4 Data Collection Methods
This research collected primary data using questionnaires. The questionnaires included
both open and closed ended in line with the objectives of the study. A five point likert
scale was used for closed ended questions. The questionnaires contained two sections
each. The first section sought to establish the respondent firms‟ demographic data while
the second section sought to establish the respondents‟ opinions on the four objectives of
the study in this study. The four objectives included: the structure of capital budgeting
process; the capital budgeting techniques adopted by companies; the factors affecting
choice of a capital budgeting technique; and the risks in capital budgeting techniques
adopted by companies.
3.5. Research Procedures
A pilot test was conducted covering five Chief Finance Officers of five listed firms to
enable the researcher determine the respondents‟ burden in filling the questionnaire and
the appropriateness of the questionnaires in collecting the required data. The
questionnaires was reviewed and revised accordingly to take care of the issues noted
during the pilot survey.
37
The questionnaires were distributed to the sample companies by the researcher using a
drop and pick later method to reduce disruptions on the respondents‟ routines. Personal
administration was chosen upon so as to ensure high response rate. Respondent
anonymity was assured by giving questionnaires unique numbers which only the
researcher understood their meaning. Only the researcher understood the codes on the
questionnaires hence ensuring respondent confidentiality. A clear explanation was given
to respondents as to how they were to benefit from the research. All these were aimed at
ensuring a high response rate.
3.6 Data Analysis Methods
Before processing the responses, data preparation was done on the completed
questionnaires by editing, coding, entering and cleaning the data. Data collected was
analyzed using descriptive statistics. The descriptive statistical tools helped in describing
the data and determining the respondents‟ degree of agreement with the various
statements under each objective. To ensure that the data collected from the field make
meaning, the researcher analyzed the data using mean and standard deviation, frequencies
and percentages. The data analysis tool was Statistical package for Social Sciences
(SPSS) and Microsoft Excel to generate quantitative reports. The analyzed data is
presented in the form of tables and figures.
3.7. Chapter Summary
Chapter 3 enumerated the research methodology and design. It has given a detailed
analysis of the research design, population and the sampling process that will be used in
collecting the research data. Stratified sampling technique was used and the population to
be studied was divided into ten strata. This was done to ensure the results are more
representative and also give all segments a chance to participate in the study. Data
analysis was done using the Statistical Package for Social Sciences.
The next chapter focuses on data analysis and findings of the research. These were
obtained from the collected data in the filled out questionnaires.
38
CHAPTER FOUR
4.0 RESULTS AND FINDINGS
4.1 Introduction
The purpose of this research was to assess the capital budgeting techniques adopted by
companies listed at the Nairobi Securities Exchange. This chapter presents analysis and
findings of the study as set out in the research objectives and methodology. The results
are presented on capital budgeting techniques adopted by companies listed at the Nairobi
Securities Exchange.
4.2 Questionnaire Return Rate
The study sampled 42 firms from the target population in collecting data with regard to
the capital budgeting techniques adopted by companies listed at the Nairobi Securities
Exchange. Out of the 42 questionnaires distributed, 29 were filled and returned giving a
response rate of 69%. This response rate was good and representative and conforms to
Mugenda (2008) stipulation that a response rate of 50% is adequate for analysis and
reporting; a rate of 60% is good and a response rate of 70% and over is excellent. The
questionnaires that were not returned were due to reasons like, the respondents were not
available to fill them in at that time and with persistence follow-ups there were no
positive responses from them. The response rate demonstrates a willingness of the
respondents to participate in the study. The questionnaire return rate results are shown in
the Figure 4.1 below.
Figure 4.1: Response Rate
39
4.3 General Information
The study targeted companies listed at the Nairobi Securities Exchange. As such the
results on demographic characteristics of these companies and the persons who filled in
the questionnaires were investigated in the first section of the questionnaire. Findings are
presented in this section under segment listed in, position of the responding officer,
period worked with the firm, highest educational level attained and the size of the annual
capital budget. These are presented below.
4.3.1: Segment of the Firm Listed at the NSE
The study posted a question requesting the respondents to indicate the segment their firm
were listed in at the NSE. From the Table 4.1, 13.8% of the firms were listed in the
agriculture segment, 20.7% in the banking and finance, 10.3% in both the commercial
and services and energy and petroleum, 6.9% in the investment segment, 3.4% in the
telecommunication and technology segment, 10.3% in both the construction and allied
and insurance and 6.9% in the manufacturing and allied segment. From the findings, the
firms that responded were listed in all the segments represented at the NSE thus making
the findings more representatives of all firms and segments at the NSE. However, the
banking and finance segment had the highest percentage of 20.7% while the
telecommunication and technology had the lowest percentage of 3.4%. The findings are
as shown in the table below:
Table 4.1: Segment of the firms listed at the NSE
Segment Frequency Percentage
Agriculture 4 13.8%
Banking and finance 6 20.7%
Commercial an services 3 10.3%
Energy and petroleum 3 10.3%
Investment 2 6.9%
Automobiles and accessories 2 6.9%
Telecommunication and technology 1 3.4%
Construction and allied 3 10.3%
Insurance 3 10.3%
Manufacturing and allied 2 6.9%
Total 29 100.0%
40
4.3.2: Position in the Firm.
The study further inquired into the position held by the officers responding in the study.
From the findings, majority of the respondents (72%) worked as Chief Finance Officer
while 17% worked as investments managers. 11% held other positions in the organization
including accountants, and portfolio managers. These findings indicate that the
respondents were more reliable as they had financial management background which is
important in capital budgeting process in an organization.
The findings were as listed in the Table 4.2:
Table 4. 2: Position in the Firm
Position Frequency Percentage
Chief Finance Officer 21 72%
Investments Manager 5 17%
Other 3 11%
Total 29 100%
4.3.3: Years Worked in the Firm.
The study requesting the respondents to indicate the period they had worked with their
respective firms. From the findings, majority of the respondents, 45% had worked with
the current organizations for a period of 11 to 15 years followed by 24% who had worked
for 6 to 10 years. 17% of the respondents had worked with their current organizations for
a period of over 16 years while 14% had worked with their current organizations for
below 5 years. These findings show that the respondents had worked with their respective
organizations for a long period of time to understand the capital budgeting procedures
and how they functioned. This means that the data is more reliable as they clearly
understood the capital budgeting processes and methods adopted by their respective
firms. The findings were as in the Table 4.3:
41
Table 4.3: Years worked in the firm
Years Frequency Percentage
below 5 4 14%
6 to 10 7 24%
11 to 15 13 45%
above 16 5 17%
Total 29 100%
4.3.4: Educational Level
The study posted further asked the respondents to indicate their highest educational level
attained. The findings, majority (66%) of the respondents had acquired masters as their
highest educational level, 14% had undergraduates‟ degree, 10% had attained PhD while
only 3% had diploma as their highest educational level. There were also a 2% of the
respondents who had attained other educational levels including ACCA, CISA and CPA
K. These findings indicate that the respondents were well learned on financial
management aspects including capital budgeting processes and methods hence well
suited to provide data for this study. The findings were as in the table 4.4:
Table 4.4: Educational Level
Educational level Frequency Percentage
PhD 3 10%
Masters 19 66%
Undergraduate 4 14%
College/diploma 1 3%
Other 2 7%
Total 29 100%
42
4.3.5: Size of the Annual Capital Budget for the Firm.
The respondents were asked to indicate the approximate size of the annual capital budget
in their respective firms in Ksh. From the findings in the table 4.5, 10.3% of the firms
had an approximate annual capital budget of up to 100 million, 31.0% had an
approximate annual capital budget of between 101 to 500 million shillings and 20.7%
had an approximate annual budget of above 1 billion shillings. From the findings, it can
be noted that majority (37.9%) of the firms had an approximate value of 501 to 1 billion
shillings as an approximate annual capital budget. The findings were as in indicated in
the table 4.5:
Table 4.5: Size of the Annual Capital Budget
Budget Frequency Percentage
Up to 100 million 3 10.3%
101 to 500 million 9 31.0%
501 to 1 billion 11 37.9%
above 1 billion 6 20.7%
Total 29 100.0%
4.4 Capital budgeting process
The respondents were required to indicate whether there was a defined process to be
followed during capital budgeting in their organization. The findings showed that all
firms had a defined process for their organization to follow during capital budgeting. This
is illustrated by 100% agreement among the respondents of their being a defined process
for capital budgeting processes. The findings were as shown in the table 4.6:
Table 4.6: Availability of a Defined Process during Capital Budgeting
Response Frequency Percentage
Yes 29 100%
No 0 0%
Total 29 100%
43
4.4.1: Agreement levels on Statements relating to the processes of capital budgeting
Several statements were availed to the respondents regarding the process of capital
budgeting processes in the respective firms. A five point likert scale ranging from 1-5
was availed where 1= not at all, 2= to a little extent, 3= moderate extent, 4= great extent
and 5= very great extent. The respondents were than required to rank their level of
agreement on each statement using this scale. To facilitate the analysis, the study
computed the means and standard deviations. From the findings in table 4.7, the findings
showed that majority of the respondents agreed to a great extent to the statement that
capital budgeting decisions in the organization were guided by corporate strategic plan,
with a mean score of 4.3 with a standard deviation of 0.7. Strategic plans provide the
vision and mission of what the organization aims to achieve and how it aims to achieve
them. Therefore it is important that all activities and especially investment activities are
guided by the strategic plan.
The study further sought to establish the extent of adherence to some proposed activities
within the capital budgeting process among the organizations listed at the NSE. From the
findings, the respondents agreed to a very great extent to the adherence that all projects
were authorized prior to their kick off as supported by a mean score of 4.5 with a
standard deviation on 0.7. This is important in making sure that there is order in the
operations of the concerned companies.
The respondents were further required to indicate their level of agreement on whether a
variety of investment opportunities were identified in advance in the organization. From
the findings, the mean score of 3.8 with a standard deviation of 1.0 was computed
indicating that majority of the respondents agreed. This means that the organizations
identified several investment opportunities for evaluation in order to determine which
ones bear high returns for the company.
The study further sought to establish whether the organizations collected relevant and
detailed information on each investment opportunity presented to them. The findings
gave a mean score of 4.0 with a standard deviation of 1.1. These findings indicate that the
respondents agreed that their organizations collected relevant and detailed information on
each investment opportunity prior to the appraisal process.
44
The respondents were also requested to indicate whether the organization analyzed
investment opportunities thoroughly to establish their worthiness to the organization. The
findings gave a mean score of 3.5 with a standard deviation of 1.0 meaning that the
organizations clearly analyzed the investment opportunities to establish their alignment to
the strategic plan of the organization.
On whether the organizations evaluated the profitability of each investment opportunity,
the computed mean was 4.3 with a standard deviation on 0.9. This mean indicates that the
organizations evaluated the profitability of each investment opportunity to establish its
worthiness to the organization prior to taking it on.
The study also set to establish whether organizations set budgets for each investment
project to be undertaken. The mean score of 4.2 with a standard deviation of 0.9 with a
were attained meaning that the firms established budgets for each investment opportunity.
This is important to allow for project evaluation and establish whether the appraisal
methods were accurate or not. This would be achieved through evaluation. The
respondents were required to further indicate whether their organizations evaluated the
fitness of the investment opportunities against the corporate strategic plan. From the
findings, the respondents agreed as supported by a mean score of 3.9 with a standard
deviation of 0.7. After implementation, the organization compares the actual costs with
budgeted costs to establish the variance, as supported with a mean score of 3.9 with a
standard deviation of 1.1 and the organization carries down the information learned from
one investment opportunities to the next investment opportunity, with a mean score of 3.5
with a standard deviation of 1.6.
Overall, the respondents agreed to a moderate extent of adherence to the process that all
projects not meeting the set thresholds were abandoned, as supported by a mean score of
2.9 with the standard deviation of 1.6 as well as the process of holding regular reviews to
assess the progress of the selected projects implementation, with a mean score of 3.3179.
These findings are well illustrated in the Table 4.7.
45
Table 4. 7: Agreement levels on Statements relating to the processes of capital
budgeting
mean standard
deviation
Capital budgeting decisions in our organization are guided by
corporate strategic plan
4.3 0.7
A variety of investment opportunities are identified in advance
in the organization
3.8 1.0
We collect relevant and detailed information on each
investment opportunity
4.0 1.1
We analyze investment opportunities thoroughly to establish
their worthiness to the organization
3.5 1.0
We evaluate the profitability of each investment opportunity 4.3 0.9
We set budgets for each investment project to be undertaken 4.2 0.9
We evaluate the fitness of the investment opportunities against
the corporate strategic plan
3.9 0.9
All projects have to be authorized prior to their kick off 4.5 0.7
All projects not meeting the set thresholds are abandoned 2.9 1.6
We hold regular reviews to assess the progress of the selected
projects implementation
3.3 1.0
After implementation, actual costs are compared with budgeted
costs to establish the variance
3.9 1.1
Information learned from one investment opportunities is
carried down to the next investment opportunity
3.5 1.6
4.4.2: Effect of adherence to capital budgeting process on investment rate.
The study further sought to find out the extent to which adherence of capital budgeting
process affected the rate of investment in the organization. From the research findings, all
the respondents agreed that adherence to capital budgeting process does affect the rate of
investment in the organization. From the findings in the table 4.8, majority of the
respondents 44.8% agreed to a great extent that the adherence to capital budgeting
process affect the rate of investment in the organization, 41.4%, to a very great extent,
10.3% to moderate extent and 3.4% to a little extent. The results are as in the table 4.8:
46
Table 4.8: Effect of adherence to capital budgeting process on investment rate
Extent Frequency Percentage
Very great extent 12 41.4%
Great extent 13 44.8%
Moderate extent 3 10.3%
To a little extent 1 3.4%
To no extent 0 0.0%
Total 29 100.0%
4.5 Capital Budgeting Techniques
The research study sought to find out the capital budgeting techniques that the
respondents utilizes in their organization. The researcher proposed a list of the budgeting
techniques from which the respondents were required to indicate the extent to which they
utilized them in their organization. From the findings, all the proposed capital budgeting
techniques were utilized in the organization. However, some were used more than others.
From the table 4.8, the most utilized capital budgeting method was internal rate of return
as supported by the highest frequency of 26 (89%) of the respondents, followed by net
present value technique at 25 (86.2%) of the respondents. Profitability index technique
was third at 22 (75.9%) of the respondents, Present- Value technique used by 72.4%,
Discounted Payback technique utilized by 58.6%, Accounting/Average Rate-of-Return
technique utilized by 41.4% and Modified Internal Rate of Return (MIRR) technique
was least utilized by only 20.7% of the respondents. From the findings, many
organizations utilized internal rate of return and net present value while the least utilized
techniques were MIRR and payback methods. These findings are shown in the Table 4.9:
47
Table 4.9: Capital Budgeting Techniques
Technique Frequency Percentage
Payback Period Method 13 44.8%
Accounting/Average Rate-of-Return 12 41.4%
Discounted Payback 17 58.6%
Present- Value 21 72.4%
Net Present Value 25 86.2%
Internal Rate of Return 26 89.7%
Profitability index 22 75.9%
Modified Internal Rate of Return MIRR) 6 20.7%
The study further sought to establish from the respondents the reasons as to why some of
the techniques were not utilized in their organizations or were least used. From the
findings, the respondents identified failure to take into account time value of money as
they key reason for not applying some techniques followed by lack of familiarity with the
technique at 23%, Cumbersome computations involved at 17% and other reasons at 3%.
These findings indicate that different techniques are not applied by some organizations
because of some reasons. These findings were as shown in the Table 4.10:
Table 4.10 Reasons for Limited Application of some Techniques
Reason Frequency Percentage
Lack of familiarity 7 23%
Failure to take into account time value of money 23 77%
Cumbersome computations involved 5 17%
Limited staff, time and experience 3 10%
Other 1 3%
4.5.1 Decision on what project to invest in.
The research study sought to find out from the respondents how their organizations
decided on what projects to invest in. The findings showed that the firm mostly uses
capital budgeting techniques analysis, (89.7%), to decide on the project to invest in and
only 10.3% of the subjective judgment. Further, the findings revealed that there were
48
other ways in which the firm uses to decide on what projects to invest in other than the
three specified in the questionnaire. These included the object that the firm needed to
achieve by using that project for example, the need for market penetration as well as the
boosting sales. Another decision criteria specified by the respondents was complementing
productivity of the firm. Some projects were undertaken even when they did not meet the
set criteria just for the purpose of achieving other objectives in the organization for
example, need for diversification, fight competition as well as increasing the customers‟
satisfaction. The findings were as shown in the Table 4.11:
Table 4.11: Decision on what Project to Invest in
frequency percentage
Referrals 0 0.0%
subjective judgment 3 10.3%
capital budgeting techniques analysis 26 89.7%
Total 29 100.0%
4. 6 Factors Affecting Choice of Capital Budgeting Technique
The study sought to establish the extent to which some of the proposed factors affected
the choice of capital budgeting technique among the organizations listed at the NSE.
From the findings in table 4.12, certainty of the cash flow, with a mean score of 4.7, was
the factor that affected the choice of capital budgeting technique to a very large extent.
The size of the firm, with a mean score of 4.1, level of inflation, with a mean score of 3.7,
levels of interest rates, with a mean score of 4.2, the state of the economy, with a mean
score of 4.4, prevailing corporate taxes in the economy, with a mean score of 3.7,
limitation of the strategic plan of the organization, with a mean score of 4.03, amount of
capital available for investment, with a mean score of 4.3, environmental impact of the
project, with a mean score of 3.5, as well as the profitability levels of the project, with a
mean score of 4. 3, were factors which affected the capital budgeting technique to great
extent. Other factors such as levels of risks involved in the project, with a mean score of
3.2, affected the capital budgeting technique to a moderate extent. The finding also
49
revealed that government regulations on the sector, affected the capital budgeting
technique only to little extent, with a mean score of 2.1.
These findings shows that all the factors proposed affected the choice of capital
budgeting technique. It is also clear from the research findings that in general, the
proposed factors affected the choice of capital budgeting technique to a great extent; with
an average mean score of 3.9. These findings of the research were as shown in the Table
4.12:
Table 4.12: Factors Affecting Choice of Capital Budgeting Technique
Factor mean standard deviation
Size of your firm 4.1 0.1
Certainty of the cash flows 4.7 0.9
Level of inflation 3.7 0.5
Levels of interest rates 4.2 1.0
State of the economy – boom/recession 4.4 1.0
Corporate taxes prevailing in the economy 3.7 0.3
Government regulations on the sector 2.1 1.0
Limitation of the strategic plan of the organization 4.0 0.6
Amount of capital available for investment 4.2 0.2
Levels of risks involved in the project 3.2 1.1
Environmental impact of the project 3.5 1.0
Profitability levels of the project 4. 3 1.2
Total 46.2 9.0
Average 3.9 0.7
4.7 Risks in Capital Budgeting Techniques
The study sought to find out the extent to which some of the risks involved in the capital
budgeting technique were encountered in the organization listed at the NSE. A list of
several risks was provided on which the respondents were required to indicate their level
of agreement in experiencing them in their organizations. From the research finding, high
50
inflation affecting interest rates ranked the greatest risk with a mean score of 3.5 with a
standard deviation of 0.0. Other risks such as cash flow not flowing in as anticipated had
a mean score of 2.1, collapse of the investee company a mean score of 1.7, management
investing the invested funds in risky projects a mean of 2.4 and fluctuating cost of capital
used in computations a mean score of 2.0. These findings that the proposed risks in
general were encountered only to a little extent with an average mean score of 2.4. These
findings are as listed in the Table 4.13.
Table 4.13: Risks in Capital Budgeting Techniques
Risk mean standard deviation
Cash flow not being paid in time as anticipated 2.1 0.7
Collapse of the investee company 1.7 0.9
Management sinking the invested funds in risky projects 2.4 1.0
High inflations which affects interest rates 3.5 0.0
Fluctuating cost of capital used in computations 2.0 0.4
Total 11.8 3.0
Average 2.4 0.6
4.8 Correlation Analysis
The researcher conducted a correlation analysis so as to assess the capital budgeting
techniques adopted by companies listed and how they affected the financial performance.
The data presented before on financial performance, structure of capital budgeting
process; capital budgeting techniques; factors affecting choice of a capital budgeting
technique; and the risks in capital budgeting techniques were computed into single
variables per variable by obtaining the averages of each variable. Pearson‟s correlations
analysis was then conducted at 95% confidence interval and 5% confidence level 2-
tailed. The table above indicates the correlation matrix between the factors (structure of
capital budgeting process; capital budgeting techniques; factors affecting choice of a
capital budgeting technique; and the risks in capital budgeting techniques) and financial
performance of the organizations. According to the table, there is a positive relationship
between financial performance and structure of capital budgeting process, capital
budgeting techniques; factors affecting choice of a capital budgeting technique; and the
risks in capital budgeting techniques 0.638, 0.764, 0.622 and 0.529 respectively. The
51
positive relationship indicates that there is a correlation between the variables and
financial performance of firms. This infers that capital budgeting techniques has the
highest effect on financial performance, followed by structure of capital budgeting
process, then factors affecting choice of a capital budgeting technique while the risks in
capital budgeting techniques having the lowest effect on the financial performance of
firms listed at the NSE.
Table 4. 14: Correlation Matrix
Capital
budgeting
structure of
capital
budgeting
process
capital
budgeting
techniques
factors
affecting
choice of a
capital
budgeting
technique
the risks
in capital
budgeting
technique
s
Capital
budgeting
Pearson
Correlation 1
Sig. (2-
tailed) .
structure of
capital
budgeting
process
Pearson
Correlation .638 1
Sig. (2-
tailed) .029 .
capital
budgeting
techniques
Pearson
Correlation .764 .523 1
Sig. (2-
tailed) .017 .016 .
factors
affecting
choice of a
capital
budgeting
technique
Pearson
Correlation .622 .743 .597 1
Sig. (2-
tailed) .031 .012 .028 .
the risks in
capital
budgeting
techniques
Pearson
Correlation .529 .533 .720 .531 1
Sig. (2-
tailed) .047 .009 .002 .014 .
4.9 Chapter Summary
The study sampled 42 firms from the target population in collecting data with regard to
the capital budgeting techniques adopted by companies listed at the Nairobi Securities
Exchange. Out of the 42 questionnaires distributed, 29 were filled and returned giving a
response rate of 69%. On segmentation, 13.8% of the firms were listed in the agriculture
segment, 20.7% in the banking and finance, 10.3% in both the commercial and services
52
and energy and petroleum, 6.9% in the investment segment, 3.4% in the
telecommunication and technology segment, 10.3% in both the construction and allied
and insurance and 6.9% in the manufacturing and allied segment. Majority of the
respondents (72%) worked as Chief Finance Officer while 17% worked as investments
managers. 11% held other positions in the organization including accountants, and
portfolio managers. Majority of the respondents, 45% had worked with the current
organizations for a period of 11 to 15 years followed by 24% who had worked for 6 to 10
years. 17% of the respondents had worked with their current organizations for a period of
over 16 years while 14% had worked with their current organizations for below 5 years.
On the education level of the respondents, (66%) had acquired masters as their highest
educational level, 14% had undergraduates‟ degree, 10% had attained PhD while only 3%
had diploma as their highest educational level. On annual capital budget figures, 10.3%
of the firms had an approximate annual capital budget of up to 100 million, 31.0% had an
approximate annual capital budget of between 101 to 500 million shillings and 20.7%
had an approximate annual budget of above 1 billion shillings. The findings showed that
all firms had a defined process for their organization to follow during capital budgeting.
On the processes of capital budgeting, the findings showed that majority of the
respondents agreed to a great extent to the statement that capital budgeting decisions in
the organization were guided by corporate strategic plan, with a mean score of 4.3 with a
standard deviation of 0.7. The respondents agreed to a very great extent to the adherence
that all projects were authorized prior to their kick off as supported by a mean score of
4.5 with a standard deviation on 0.7. On whether a variety of investment opportunities
were identified in advance in the organization, the mean score was 3.8 with a standard
deviation of 1.0 indicating that majority of the respondents agreed. The organizations
collected relevant and detailed information on each investment opportunity presented to
them as supported by a mean score of 4.0 with a standard deviation of 1.1. The
organization analyzed investment opportunities thoroughly to establish their worthiness
to the organization as supported by a mean score of 3.5 with a standard deviation of 1.0
meaning that the organizations clearly analyzed the investment opportunities to establish
their alignment to the strategic plan of the organization. On whether the organizations
53
evaluated the profitability of each investment opportunity, the computed mean was 4.3
with a standard deviation on 0.9. Organizations set budgets for each investment project to
be undertaken. On whether their organizations evaluated the fitness of the investment
opportunities against the corporate strategic plan, the respondents agreed as supported by
a mean score of 3.9 with a standard deviation of 0.7. After implementation, the
organization compares the actual costs with budgeted costs to establish the variance, as
supported with a mean score of 3.9 with a standard deviation of 1.1 and the organization
carries down the information learned from one investment opportunities to the next
investment opportunity, with a mean score of 3.5 with a standard deviation of 1.6.
Overall, the respondents agreed to a moderate extent of adherence to the process that all
projects not meeting the set thresholds were abandoned, as supported by a mean score of
2.9 with the standard deviation of 1.6 as well as the process of holding regular reviews to
assess the progress of the selected projects implementation, with a mean score of 3.3179.
On the capital budgeting techniques that the respondents utilize in their organization.
From the findings, all the proposed capital budgeting techniques were utilized in the
organization. However, some were used more than others. From the table 4.8, the most
utilized capital budgeting method was internal rate of return as supported by the highest
frequency of 26 (89%) of the respondents, followed by net present value technique at 25
(86.2%) of the respondents. Profitability index technique was third at 22 (75.9%) of the
respondents, Present- Value technique used by 72.4%, Discounted Payback technique
utilized by 58.6%, Accounting/Average Rate-of-Return technique utilized by 41.4% and
Modified Internal Rate of Return (MIRR) technique was least utilized by only 20.7% of
the respondents. The reasons as to why some of the techniques were not utilized in their
organizations or were least used included failure to take into account time value of money
as they key reason for not applying some techniques followed by lack of familiarity with
the technique at 23%, Cumbersome computations involved at 17% and other reasons at
3%. These findings indicate that different techniques are not applied by some
organizations because of some reasons.
54
On the factors affected the choice of capital budgeting technique among the organizations
listed at the NSE, certainty of the cash flow, with a mean score of 4.6965, was the factor
that affected the choice of capital budgeting technique to a very large extent. The size of
the firm, with a mean score of 4.1123, level of inflation, with a mean score of 3.6757,
levels of interest rates, with a mean score of 4.2125, the state of the economy, with a
mean score of 4.4437, prevailing corporate taxes in the economy, with a mean score of
3.6900, limitation of the strategic plan of the organization, with a mean score of 4.0397,
amount of capital available for investment, with a mean score of 4.2945, environmental
impact of the project, with a mean score of 3.5376, as well as the profitability levels of
the project, with a mean score of 4.2943, were factors which affected the capital
budgeting technique to great extent. Other factors such as levels of risks involved in the
project, with a mean score of 3.1598, affected the capital budgeting technique to a
moderate extent. The finding also revealed that government regulations on the sector,
affected the capital budgeting technique only to little extent, with a mean score of 2.1163.
On the risks involved in the capital budgeting technique were encountered in the
organization listed at the NSE, high inflation affecting interest rates ranked the greatest
risk with a mean score of 3.5 with a standard deviation of 0.01. Other risks such as cash
flow not flowing in as anticipated had a mean score of 2.1, collapse of the investee
company a mean score of 1.6922, management investing the invested funds in risky
projects a mean of 2.4 and fluctuating cost of capital used in computations a mean score
of 2.0 These findings that the proposed risks in general were encountered only to a little
extent with an average mean score of 2.4.
55
CHAPTER FIVE
DISCUSSION, CONCLUSIONS AND RECOMMENDATIONS
5.1 Introduction
The chapter presents a summary and discussions of the research findings on the
assessment of capital budgeting techniques adopted by companies listed at the Nairobi
Securities Exchange. It further gives the conclusions Based on the findings in chapter
four and recommendations on what the firms listed at the NSE can do to improve capital
budgeting processes. The suggestion for further research is also discussed. From the
analysis and data collected, the following discussions, conclusions and recommendations
are made. The recommendations are based on the objectives of the study.
5.2 Summary
The researcher set out to assess the capital budgeting techniques adopted by companies
listed at the Nairobi Securities Exchange. The study focused on 4 key research objectives:
determine the structure of capital budgeting process; determine the capital budgeting
techniques adopted by companies listed at the Nairobi Securities Exchange; analyze the
factors affecting choice of a capital budgeting technique and determine the risks in capital
budgeting techniques adopted by companies listed at the Nairobi Securities Exchange.
The population of interest comprised of all firms listed at the Nairobi Securities
Exchange. Customer population was 62 firms listed at the NSE. A representative sample
of 42 firms was selected sing stratified sampling method where the firms were classified
according to the segment classification. Simple random sampling technique was used to
select the sample firms in order to give each element of the population an equal chance of
being included in the study.
A questionnaire was used to collect the data. The questionnaire made use of both open
and closed ended questions. To ease the respondents‟ burden, a five point likert scale was
used. The questionnaires were tested through a pilot survey on five chief finance officers
in Small and Medium Enterprises. The questionnaires were administered to respondents
in person to ensure high response rate. The collected questionnaires were inspected for
completeness, coded and entered into SPSS for analysis. Descriptive statistics including
56
mean and standard deviations were computed. The data was presented in the form of
tables and figures.
The study established that the companies had a clearly defined process governing the
capital budgeting processes. Capital budgeting decisions in the organization were guided
by corporate strategic plan. Strategic plans provide the vision and mission of what the
organization aims to achieve and how it aims to achieve them. Adherence to
authorization process prior to project kick off ensured that only value adding projects
were undertaken. This is important in making sure that there is order in the operations of
the concerned companies. The study also established that organizations set budgets for
each investment project to be undertaken to allow for project evaluation and establish
whether the appraisal methods were accurate or not.
On the capital budgeting technique, the study established that all the proposed capital
budgeting techniques were utilized in the organization. The most utilized capital
budgeting method was internal rate of return followed by net present value technique.
Profitability index technique was third while Present- Value technique was fourth. Other
techniques utilized included discounted Payback technique, Accounting/Average Rate-of-
Return technique and Modified Internal Rate of Return (MIRR) technique. For those least
utilized, the respondents identified failure to take into account time value of money as
they key reason for not applying some techniques followed by lack of familiarity with the
technique and Cumbersome computations involved.
On the factors affecting the choice of capital budgeting technique among the
organizations listed at the NSE, certainty of the cash flow affected the choice of capital
budgeting technique, The size of the firm, the state of the economy, prevailing corporate
taxes in the economy, limitation of the strategic plan of the organization, amount of
capital available for investment, environmental impact of the project and profitability
levels of the project. Government regulations on the sector, affected the capital budgeting
technique to little extent.
On the risks in capital budgeting techniques, high inflation affecting interest rates ranked
the greatest risk, other risks such as cash flow not flowing in as anticipated. Collapse of
57
the investee company, management investing the invested funds in risky projects, and
fluctuating cost of capital used in computations, re encountered only to a little extent with
an average were encountered by the firms.
5.3 Discussions
5.3.1 The Structure of Capital Budgeting Process
From chapter four, the study established that the companies had a clearly defined process
governing the capital budgeting processes. Capital budgeting decisions were guided by
corporate strategic plan. Strategic plans provide the vision and mission of what the
organization aims to achieve and how it aims to achieve them. These findings are
consistent with the findings of Liljeblom and Vaihekoski (2011) who established that the
capital budgeting process governs the way managers produce and share information
about proposed investments and also determines which decisions are delegated, to whom,
and under what constraints.
Peterson and Fabozzi (2009) argued that effective investment decision making is
essential to corporate survival and long-term success because it directly impacts future
performance by molding future opportunities and developing competitive advantage by
influencing, among other things, its technology, its processes, its working practices and
its profitability. Through capital budgeting processes, the organizations ensured that
appraisal of investment project was transparent and maximizes the value of their firms.
Truong et al., (2008) confirm usage of project appraisal techniques in accordance to the
strategic plan by arguing that capital budgeting decisions are guided by corporate
strategic plan which provides direction of where the corporation wants to be and how it
intends to get there. Madhani (2008) also argues that it is from the corporate goals,
vision, mission and long term strategies that capital investment decisions are directed.
The study further established that the firms used a variety of investment opportunities
which were identified in advance for evaluation in order to determine which ones bear
high returns for the company. Truong, et al. (2008) argue that a profitable investment
proposal is not just born; someone has to suggest it. The firms need to ensure that it has
searched and identified potentially lucrative investment opportunities and proposals,
58
because the remainder of the capital budgeting process can only assure that the best of the
proposed investments are evaluated, selected and implemented.
The study further established that the organizations collected relevant and detailed
information on each investment opportunity presented to them. Bastos (2009) called this
stage quantitative analysis, economic and financial appraisal, project evaluation, or
simply project analysis. Organizations collected relevant and detailed information on
each investment opportunity prior to the appraisal process. It is through project analysis
that appraisers are able to 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 (Adler, 2009).
The study further established that the firms adhered to authorization process prior to
project kick off of a project to ensure that only value adding projects were undertaken.
These findings are in line with those of Adams et al., (2012) that feedback from project
analysis to strategic planning plays an important role in the overall capital budgeting
process. The results of the quantitative project analyses heavily influence the project
selection or investment decisions. This is important in making sure that there is order in
the operations of the concerned companies.
The organization analyzed investment opportunities thoroughly to establish their
worthiness to the organization and their alignment to the strategic plan of the
organization. It is through project analysis that appraisers are able to 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. To establish its worthiness to the
organization prior to taking it on, the organizations evaluated the profitability of each
investment opportunity.
59
The study also established that organizations set budgets for each investment project to
be undertaken to allow for project evaluation and establish whether the appraisal methods
were accurate or not. According to Liljeblom and Vaihekoski (2009), 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‟ and „wrongs.
The organizations evaluated the fitness of the investment opportunities against the
corporate strategic plan. After implementation, the organization compares the actual costs
with budgeted costs to establish the variance and carry down the information learned
from one investment opportunities to the next investment opportunity evaluation. The
study established that adherence of capital budgeting process affected the rate of
investment in the organization.
5.3.2 The capital Budgeting Techniques adopted by Companies Listed at the Nairobi
Securities Exchange
On the effects of capital budgeting techniques adopted by companies listed at the Nairobi
Securities Exchange, the study established that all the proposed capital budgeting
techniques were utilized in the organization.
The most utilized capital budgeting method was internal rate of return followed by net
present value technique. According to Khamees et al., (2010), internal rate of return
technique is regarded as one of the most advanced and efficient methods of capital
project evaluation. Profitability index technique was third while Present- Value technique
was fourth. Other techniques utilized included discounted Payback technique,
Accounting/Average Rate-of-Return technique and Modified Internal Rate of Return
(MIRR) technique. Liljeblom and Vaihekoski (2009) argued that the sophisticated
techniques are those that consider the risk-adjusted discounted net cash flows expected
from a project where they consider the risk, cash flows, and the time value of money
while making a decision. These findings are consistent with the argument of Adams et
al., (2012) that the net present value, internal rate of return and profitability index are
three widely used sophisticated selection criteria. From the findings of the study, it was
established that the most used technique was internal rate of return. However, it might be
60
further argued that truly sophisticated methods require something more than the straight-
forward application of the net present value or internal rate of return models.
From the findings, MIRR was the least used technique of appraisal. Liljeblom and
Vaihekoski (2009), MIRR is the IRR for a project with an identical level of investment
and NPV to that being considered but with a single terminal payment. MIRR is invariably
lower than IRR and it makes a more realistic assumption about the reinvestment rate. The
biggest problem with IRR is that the Reinvestment Rate of interim cash flows is same as
the IRR itself (Swanson and Fisher, 2008). Appraising managers may find it difficult to
forecast RRs down the investment horizon and hence a safe assumption would be to set it
equal to the Cost of Capital, below which, incremental projects will result in „Value
Destruction‟ (Khamees et al., 2010). MIRR delinks the Reinvestment Rate from IRR
thereby giving the manager an option to choose a different/more realistic rate (usually
Cost of Capital) thereby giving a more reliable conclusion (Liljeblom and Vaihekoski,
2011).
The study further established that the decisions on what projects to invest in were done
using capital budgeting techniques and subjective judgment. According to Adams et al.,
(2012) corporate managers need to allocate resources among competing investment
alternatives during the capital budgeting process. To aid managers do this resource
allocations optimally, numerous methods of financial analysis have been identified by
researchers and scholars which guide their decision to either accept or reject proposed
capital expenditures. Capital budgeting techniques have been used by managers to
evaluate investment projects for organizations.
Some projects not meeting the evaluation criteria were however undertaken for other
reasons and purposes. These reasons included the need for market penetration as well as
the boosting sales, complementing productivity of the firm, or the purpose of achieving
other objectives in the organization for example, need for diversification, fight
competition as well as increasing the customers‟ satisfaction. These findings are
consistent with those of Allen (2009) that if the projects identified within the current
strategic framework of the firm repeatedly produce negative NPVs in the analysis stage,
61
these results communicate to the management to review its strategic plan. Thus, the
feedback from project analysis to strategic planning plays an important role in the overall
capital budgeting process. The results of the quantitative project analyses heavily
influence the project selection or investment decisions. These decisions clearly affect the
success or failure of the firm and its future direction
5.3.3 Factors Affecting Choice of a Capital Budgeting Technique
On the factors affecting the choice of capital budgeting technique among the
organizations listed at the NSE, certainty of the cash flow affected the choice of capital
budgeting technique. According to Liljeblom and Vaihekoski (2011), deviations from the
estimated cash flows need to be monitored on a regular basis with a view to taking
corrective actions when needed.
Project cash flows may also be affected by the levels of inflation existing in an economy.
A chronic inflationary environment diminishes the purchasing power of the monetary
unit, causing large divergences between nominal and real future cash flows
(Bhattachcryya, 2011). Thus, since rational decision makers presumably are interested in
real returns, they should explicitly include the impact of inflation on investment projects
when making capital budgeting decisions (Bhattachcryya, 2011).
Inflation rates will undoubtedly vary from period to period throughout the life of a capital
investment. Explicitly adjusting the discount rate for inflation requires that the effects of
inflation on cash flows also be accounted for in the model to prevent biased NPV results
(Harries and Raviv, 2010).
The size of the firm, the state of the economy, prevailing corporate taxes in the economy,
According to Thorpe, Smith and Jackson (2008), the introduction of corporate taxes
further exacerbates the problem of inconsistency in the conventional capital expenditure
procedures. Suboptimal decisions may also result from over-looking the synergistic
reduction of real returns due to taxation and inflation (Bhattachcryya, 2011).
62
Capital budgeting decisions were also affected by the limitation of the strategic plan of
the organization. Arnold (2008) notes that capital budgeting decisions are guided by
corporate strategic plan which provides direction of where the corporation wants to be
and how it intends to get there. 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.
The amount of capital available for investment, environmental impact of the project and
profitability levels of the project together with government regulations on the sector,
affected the capital budgeting technique to little extent.
5.3.4 The Risks in Capital Budgeting Techniques
On the risks in capital budgeting techniques, high inflation affecting interest rates which
was ranked the greatest risk. According to Johnson (2008) once one recognizes the
uneven effects of inflation on various cash flows and thereby on the firm value, one also
needs to recognize that risks associated with the various flows of the firm are not
equivalent either. Failure to consider the impact of inflation tends to produce suboptimal
decisions for several reasons. Ignoring this adjustment would result in either an upward
or a downward appraisal bias depending on the relative responsiveness to inflation of the
cash inflows and outflows. Even if cash expenses and revenues from an investment
project were fully responsive to inflation, depreciation tax-shields would suffer
diminution of real value since conventional accounting procedures base depreciation
computations on historical cost (Johnson, 2008).
Inflation risk is the risk that the value of assets or income will decrease as inflation
shrinks the purchasing power of a currency due to the rising cost of goods and services
(Chong et al., 2012).
Other risks identified in the study included cash flow not flowing in as anticipated.
According to (Chong et al., 2012) Capital budgeting techniques deal with estimation of
cash flows from anticipated projects. Uncertainties exist when the outcome of an event is
63
not known for certain, and when dealing with assets whose cash flows are expected to
extend beyond one year, certainly, there‟s element of risk in that situation. Risk is
inevitable to the capital investment projects because of the uncertain future period in
which cash flows are expected to come in from the projects.
The various risks include cash flows not being paid in time as agreed, the risk of the
investee company collapsing and also the management sinking the invested funds in risky
projects. By incorporating risk in capital budgeting, investors can minimize losses and
ensure successful organizational performance in future (Chong, Jennings, and Phillips,
2012). Financial risk is is any risk that is related to the form of financing and emanates
from the possibility that a given investment may fail or change in its ability to return
principal and income .Financial risk is most evident in the Financial Services sector.
Volatile interest rate changes affect organizations that borrow or lend money and at the
same time deal in foreign currencies or receive payments in foreign currency (Chong et
al., 2012).
Another risk involved fluctuating cost of capital used in computations. According to
(Thorpe et al., 2008) any variability in inflation rates will only magnify the variability of
real cash flows and thereby the risk of the more capital intensive firm. Thus, while the
real cost of capital may be identical for two firms under a given inflation rate assumption,
their real cost estimates may differ under another inflation rate.
Simply adjusting K by the expected change in the inflation rate is then unlikely to yield
the correct, market-determined cost of capital for the firm; indeed, the naive process
would likely result in the misspecification of project value, in inappropriate rankings, and
in apparent capital surpluses or shortages for the firm (Chong et al.,2012)
5.4 Conclusion
5.4.1 The Structure of Capital Budgeting Process
The study set to determine the structure of capital budgeting process adopted by
companies listed at the Nairobi Securities Exchange, The study established that the
companies had a clearly defined process governing the capital budgeting. Capital
64
budgeting decisions in the organization were guided by corporate strategic plan. Strategic
plans provide the vision and mission of what the organization aims to achieve and how it
aims to achieve them. Adherence to authorization process prior to project kick off
ensured that only value adding projects were undertaken. A variety of investment
opportunities were identified in advance in the organization which means that the
organizations identified several investment opportunities for evaluation in order to
determine which ones bore high returns for the company. The organizations collected
relevant and detailed information on each investment opportunity presented to them.
The organization analyzed investment opportunities thoroughly to establish their
worthiness to the organization and their alignment to the strategic plan of the
organization. The organizations evaluated the profitability of each investment
opportunity. Organizations set budgets for each investment project to be undertaken so
as to allow for project evaluation and establish whether the appraisal methods were
accurate or not. Organizations evaluated the fitness of the investment opportunities
against the corporate strategic plan. After implementation, the organization compares the
actual costs with budgeted costs to establish the variance and carry down the information
learned from one investment opportunities to the next investment opportunity evaluation
5.4.2 The capital budgeting techniques adopted by companies listed at the Nairobi
Securities Exchange
The study set to determine the capital budgeting techniques adopted by companies listed
at the Nairobi Securities Exchange. The study established that all the proposed capital
budgeting techniques were utilized in the organization. The most utilized capital
budgeting method was internal rate of return followed by net present value technique.
Profitability index technique was third while Present- Value technique was fourth. Other
techniques utilized included discounted Payback technique, Accounting/Average Rate-of-
Return technique and Modified Internal Rate of Return (MIRR) technique. For those least
utilized, the respondents identified failure to take into account time value of money as
they key reason for not applying some techniques followed by lack of familiarity with the
technique and Cumbersome computations involved.
65
Some projects not meeting the evaluation criteria were however undertaken for other
reasons and purposes. These reasons included the need for market penetration as well as
the boosting sales, complementing productivity of the firm, or the purpose of achieving
other objectives in the organization for example, need for diversification, fight
competition as well as increasing the customers‟ satisfaction
5.4.3 Factors Affecting Choice of a Capital Budgeting Technique
The study set to analyze the factors affecting choice of a capital budgeting technique by
companies listed at the Nairobi Securities Exchange. The findings indicated that certainty
of the cash flow affected the choice of capital budgeting technique to a great extent.
Other factors affecting the choice of capital budgeting techniques included: the size of the
firm, the state of the economy, prevailing corporate taxes in the economy, limitation of
the strategic plan of the organization, amount of capital available for investment,
environmental impact of the project and profitability levels of the project. Finally,
government regulations on the sector, affected the capital budgeting technique to little
extent.
5.4.4 The Risks in Capital Budgeting Techniques
The study set to determine the risks in capital budgeting techniques adopted by
companies listed at the Nairobi Securities Exchange. On the risks in capital budgeting
techniques, the study identified high inflation to affect interest rates which was ranked the
greatest risk, followed by other risks such as cash flow not flowing in as anticipated.
Other risks included collapse of the investee company, management investing the
invested funds in risky projects and fluctuating cost of capital used in computations.
66
5.5 Recommendation
5.5.1 Recommendations for Improvement
5.5.1.1 The Structure of Capital Budgeting Process
The study recommended that capital budgeting is a key process in an organization‟s
development plan which needs to be handled with strict care because of the impact it has
on the future of the organization. Through capital budgeting processes, the scarce
resources of an organization are committed into projects hoping that the projects will earn
substantial return for the shareholders. The study established that companies listed at the
NSE had a well laid down capital budgeting procedures. No capital project was
undertaken without undergoing the due course of the capital budgeting process.
5.5.1.2 The capital budgeting techniques adopted by companies listed at the Nairobi
Securities Exchange
The study established that all the capital budgeting techniques were applied among the
firms listed at the NSE. However, internal rate of return and net present value methods
were dominant among the firms. This was largely because it took into account the time
value of money and was easy to compute. However, there are different scenarios when
some projects are undertaken even if they did not meet the set criteria. This was majorly
for some foreseen reason like an organization intending to diversify its risks. This study
therefore recommends that project appraisal managers borrow from experience to
improve the predictability of Future cash flows and reduce the effects of uncertainty.
5.5.1.3 Factors Affecting Choice of a Capital Budgeting Technique
The study established that capital budgeting process among the firms listed at the NSE
was affected by a number of factors. These included high inflation affecting interest rates
ranked the greatest risk, other risks such as cash flow not flowing in as anticipated.
Collapse of the investee company, management investing the invested funds in risky
projects, and fluctuating cost of capital used in computations, re encountered only to a
little extent with an average were encountered by the firms. In order to reduce the effects
67
of these factors, the study recommends that capital budgeting appraisers collect as much
information as possible concerning the investment project, macro-economic changes that
are likely to affect the operating environment so as to come up with appropriate inflation
adjusted cost of capital used in appraising projects.
5.5.1.4 The Risks in Capital Budgeting Techniques
The study established that high inflation affected interest rates which in turn affected the
inflationary rate used in the computation of cost of capital of the firms. Other risks such
as cash flow not flowing in as anticipated made it difficult to realize some of the
anticipated returns from a project. Collapse of the investee company, management
investing the invested funds in risky projects, and fluctuating cost of capital. In order to
reduce the effects of these risks, the study recommends that capital budgeting process
incorporate risk management officers who would advice the team on ways of minimizing
such risks.
5.5.2 Recommendations for Further Research
The study recommends that, a similar study be done targeting all the Small and Medium
Enterprises so as to be able to get a clear picture of capital budgeting techniques applied
in Kenya among small and large enterprises. This will help generalize the finding on all
firms in Kenya.
This study also recommends that future studies review the effects of capital budgeting on
the financial performance of firms. This will help establish the relationship between
capital budgeting and financial performance of firms listed at the NSE.
68
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APPENDICES
Appendix I: Questionnaire Cover Letter.
UNITED STATES INTERNATIONAL UNIVERSITY
RE: Survey Questionnaire
Dear Respondent,
I am a post- graduate student studying for a Masters in Business Administration degree at
the United States International University. The objective of my study is TO ASSESS
THE CAPITAL BUDGETING TECHNIQUES ADOPTED BY COMPANIES
LISTED AT THE NAIROBI SECURITIES EXCHANGE.
You are part of the selected sample of respondents whose views I seek on the above-
mentioned matter. Your honest answers will be completely anonymous, but your views,
in combination with those of others are extremely important in this research. All the
information you provide will be treated with strict confidentiality and used for the
purpose of completing this study only. Please answer the questions as accurately as
possible. Tick the appropriate answer for each question and answer all questions
please.
I guarantee that all information will be handled with the Strict Confidentiality.
Thank you for your cooperation
Dorothy Kiget.
74
Appendix II: Questionnaire
CAPITAL BUDGETING TECHNIQUES ADOPTED BY COMPANIES: A CASE
OF COMPANIES LISTED AT THE NAIROBI SECURITIES EXCHANGE
Date ________________________________________________
Please take a few minutes to complete this questionnaire. Your honest answers will be
completely anonymous, but your views, in combination with those of others are
extremely important in this research. Kindly answer all questions.
PART A: Demographic Information
(Please tick one box for each of the questions 1-7)
1. Name of the firm (optional) _______________________________________
2. In what segment if the firm listed at the NSE?
Agriculture Automobiles and Accessories
Banking and Finance Telecommunication and Technology
Commercial and services Construction and Allied
Energy and Petroleum Insurance
Investment Manufacturing and Allied
3. What position do you hold in your firm?
Chief Finance Officer Investments Manager
Other Please specify
4. How many years have you worked with this firm?
Below 5 years 6-10 Years 11-15 years
Above 16 years
5. What is the highest educational level that you have attained?
PhD Masters Undergraduate
College/Diploma
Other (Kindly Specify)
_______________________________________________________________
75
6. What is the approximate size of the annual capital budget of your firm in Kshs?
Up to 100 million
101-500 million
501-1 Billion
Above 1 million
PART B: CAPITAL BUDGETING PROCESS
9. Does your organization have a defined process to be followed during capital
budgeting?
Yes No
10. Below is a list of activities within the capital budgeting process. To what extent are
these processes adhered to in your organization? Use a scale of 1-5 where 1= not at
all, 2= to a little extent, 3= moderate extent, 4= great extent and 5= very great extent.
1 2 3 4 5
Capital budgeting decisions in our organization are guided
by corporate strategic plan
A variety of investment opportunities are identified in
advance in the organization
We collect relevant and detailed information on each
investment opportunity
We analyze investment opportunities thoroughly to
establish their worthiness to the organization
We evaluate the profitability of each investment
opportunity
We set budgets for each investment project to be
undertaken
We evaluate the fitness of the investment opportunities
against the corporate strategic plan
All projects have to be authorized prior to their kick off
76
All projects not meeting the set thresholds are abandoned
We hold regular reviews to assess the progress of the
selected projects implementation
After implementation, actual costs are compared with
budgeted costs to establish the variance
Information learned from one investment opportunities is
carried down to the next investment opportunity
11. To what extent has adherence to capital budgeting process affected the rate of
investments in your organization?
Very great extent
Great extent
Moderate extent
To a little extent,
To no extent,
PART C: CAPITAL BUDGETING TECHNIQUES
12. Below is a list of capital budgeting techniques. Kindly select the ones utilized in your
organization.
Payback Period Method
Accounting/Average Rate-of-Return
Discounted Payback
Present- Value
Net Present Value
Internal Rate of Return
Profitability index
Modified Internal Rate of Return (MIRR)
Other (Please specify)
_______________________________________________________________
77
13. For the ones not selected in Question 12 above, why doesn‟t your firm use these
capital budgeting techniques?
Lack of familiarity
Failure to take into account time value of money
Cumbersome computations involved
Limited staff, time and experience
Other (Kindly specify)
_____________________________________________________________
________________________________
14. How does your firm decide on what projects to invest in? (Please tick one box)
Referrals
Subjective judgement
Capital budgeting techniques analysis
Other methods (please specify)
1.
2.
PART D: FACTORS AFFECTING CHOICE OF CAPITAL BUDGETING
TECHNIQUE
15. Below are some factors that affect the choice of capital budgeting technique. Please
indicate the extent to which each has affected capital budgeting in your organization.
78
Use a scale of 1-5 where 1= not at all, 2= to a little extent, 3= moderate extent, 4=
great extent and 5= very great extent
1 2 3 4 5
Size of your firm
Certainty of the cash flows
Level of inflation
Levels of interest rates
State of the economy – boom/recession
Corporate taxes prevailing in the economy
Government regulations on the sector
Limitation of the strategic plan of the organization
Amount of capital available for investment
Levels of risks involved in the project
Environmental impact of the project
Profitability levels of the project
16. Kindly indicate any other factors affecting choice of capital budgeting technique in
your firm
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
17. To what extent have these factors in general affected capital budgeting decisions in
your organization?
Very great extent
Great extent
Moderate extent
To a little extent,
79
To no extent,
PART E: RISKS IN CAPITAL BUDGETING TECHNIQUES
18. Below is a list of some of the risks involved in capital budgeting techniques. Kindly
indicate the extent to which each has been encountered in your organization.
1 2 3 4 5
Cash flow not being paid in time as anticipated
Collapse of the investee company
Management sinking the invested funds in risky projects
High inflations which affects interest rates
Fluctuating cost of capital used in computations
To what extent do these risks affect capital budgeting decision in your company?
Very great extent
Great extent
Moderate extent
To a little extent
To no extent
Thank you once again for your co-operation and time.
