Capital Budgeting Practices in Punjab

8/3/2019 Capital Budgeting Practices in Punjab

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Capital Budgeting Practices in Punjab-based Companies

- Sanjeev Gupta,Faculty,

Apeejay Institute of Management,

Jalandhar,Punjab, India.E-mail: [email protected]

- Roopali Batra

Faculty,Apeejay Institute of Management,

Jalandhar, Punjab, India.E-mail: [email protected]

- Manisha Sharma

Faculty, Apeejay College of Fine Arts,Jalandhar,Punjab, India.

Investment decision, popularly known as capital budgeting decision, is one of the most important

decisions that finance managers have to take. In the current era of globalization and competition,selection of profitable investment opportunities is a must for the survival of any company. A

number of studies have shown that companies employ several capital budgeting techniques whileselecting a project. Based on a primary survey, the present study examines the current status of

capital budgeting and explores the techniques preferred by Punjab-based companies. The studyalso seeks to find whether the factors such as size of capital budget, age of the company and

nature of industry have any influence on the choice of capital budgeting methods. As it is foundthat most of the companies pursue non-discounted methods, the study suggests that they adopt

techniques like Net Present Value (NPV) and Internal Rate of Return (IRR), which could deliverbetter results.

Introduction

Capital budgeting is considered to be one of the most important activities since decisions relatedto capital budgeting have long-term implications for a firm. It is the process of making decisions

on capital expenditure, which is incurred at one point of time whereas their benefits are realizedat different points of time in future. There are several capital budgeting techniques developed to

select the best project. Some techniques are non-discounted methods such as Pay Back Period(PBP) and Accounting Rate of Return (ARR), whereas a few of them are discounted methods

like Net Present Value (NPV) and Internal Rate of Return (IRR).

The present study aims to explore which one of these capital budgeting techniques is used byindustries in New Delhi, and the influence of factors such as size of capital budget, age and

nature of the company, and education and experience of the Chief Executive Officer (CEO).Towards this end, a primary survey was conducted. The survey results have helped to understand


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financial policies of the surveyed companies. Significance of the study stems from the amplescope it provides, first, to certain companies to modify their existing capital budgeting practices

in the light of those adopted by successful companies, and second, to researchers in finance tounderstand the gap between theory and practice so as to re-examine the existing theory.

Review of Prior Studies on Capital Budgeting

Over the past four decades, research in the area of corporate finance has examined various

methods of capital budgeting preferred by industry and how large corporations determine cost ofcapital while taking capital budgeting decisions. It has been noted that majority of the financial

managers and academicians have not been in full agreement as regards the most appropriatecapital budgeting method. The key findings of some of the existing studies in India and abroad

are highlighted here. To begin with, studies conducted elsewhere outside the country has beenreviewed, followed by a review of studies in India.

Foreign Studies

Majority of the earlier studies report Discounted Cash Flow (DCF) models to be the least popularcapital budgeting methods. This is attributed to the lack of financial knowledge and

sophistication as well as the limited use of computer technology in those times. According toMiller (1960), and Pike (1996), the Pay Back Period (PBP) technique is the most preferred

method. Mao (1969) also specifically points to Net Present Value (NPV) method as the leastpopular capital budgeting tool. Later, Klammer (1972) reports a change in preference from Non-

discounted to general Discounted Cash Flow models, and subsequently, the majority ofpublished research on capital budgeting indicate the management preference for the use of

Internal Rate of Return (IRR) over all other capital budgeting methods.

A study of 284 large US corporations by Petty (1975) revealed that 61% of the companies wereusing IRR, 58% were using PBP, 33% used NPV and IRR. Nearly three-fourth of the sample

companies used more than one technique. In another study of the US firms by Schall et al.(1978), it was found that about 86% of the sample firms were using more than one technique and

17% used all the four. The study also revealed that nearly 46% of respondents were using`Weighted Average Cost of Capital' (WACC) as a discount rate. They also concluded that there

was a trend towards using of more sophisticated capital budgeting techniques and this level ofsophistication was positively related to the size of the firms' capital budget and negatively to

firms' beta value in this sample. Block (1997) studied `small business firms' for evaluatingcapital budgeting techniques. His study reveals that Payback period was the most popular

method followed by ARR. For inclusion of risk consideration, `higher required returns' werepreferred by the firms. Further, the dominant purpose for the capital investment project was

replacement and maintenance.

Ken and Cherukuri (1991) concluded that IRR was the number one choice followed by NPV.

Evaluators used multiple evaluation methods. The most widely accepted discount rate wasWACC and for measuring risk, `Sensitivity Analysis' was the most preferred method, followed

by `Increasing the required rate of return', and `Shortening the payback'. Chen's (1995) studyexamined the impact of firm characteristics on use of capital budgeting techniques. The study


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revealed that equipment replacement and expansion of existing business were the most commonaspects of investment. The preference of IRR over NPV was also found in the context of

countries like Hong Kong, Malaysia and Singapore (Cherukuri, 1996). Jog and Srivastava (1995)and Pike (1996) indicate a diminishing recognition of ARR in Canada and the UK. Thus, it is

possible to note that NPV is least preferred to IRR. This is because it is relatively easy to

understand percentage return than an absolute dollar value increase in shareholder wealth.

Indian Studies

In India also, various academicians have carried out research, to study the capital budgeting

practices in the Indian corporate sector. Chandra (1975) selected 20 firms to examine theinfluence of size, industry group and capital intensity on the choice of investment evaluation

techniques. The study revealed that `Pay Back Period' method was mostly used for evaluatingsmall size investment and for evaluating large size investments, the corporates preferred ARR.

To evaluate investments, companies also looked at profit per rupee invested, cost saving per unitof product and investment required to replace a worker.

In a comprehensive study by Porwal (1976), it was found that ARR was preferred over IRR.Companies also preferred Pay Back Period due to the shortage of funds, obsolescence, and easy

calculations. The most preferred rate of discount was WACC. The risk factors that wereconsidered by the companies were `chances of unavailability of inputs', `probability of not

achieving a target return' and `uncertain market potential'. For incorporation of risk, `Shorter PayBack Period' and `Higher cut off rate' were preferred. Further, for rationing, `Priorities' and

`higher rate of return' were the two main aspects for resolving conflicts among differentdepartments.

Pandey (I989) compared the Indian capital budgeting polices with those of the USA and the UK.

He studied the companies by following questionnaire-cum-interview method. `Pay Back Periodmethod' was found to be the most popular, followed by IRR and NPV. One-third of the

companies were found to be using ARR. There were no fixed criteria for acceptance andrejection of the projects. He advocated the idea that investment evaluation criteria should not be

standardized and the characteristics of investment evaluation method must be considered beforeusing it. In computing discount rate, companies specified `Minimum acceptable rate of return'

and also WACC. For considering investment risk, `Sensitivity analysis 'and `Conservativeforecasts' were too equally used.

Sahu (1989) made an attempt to study the trends in fixed investment and its financing. It was

found that routine investments were financed through internal sources of funds, whereas growthinvestment generally utilized the external sources of funds. Purohit et al. (1994) found that the

maintenance and development did not matter for fixed investment, which was financed withinternal sources and external sources. The study found that Pay Back Period and ARR were thepreferred methods, followed by NPV and IRR.

Dhankar (1995) analyzed methods of investment evaluation and methods to examine uncertainty

in 75 manufacturing companies. He observed that 16% of companies were using DCFTechniques and 33% of companies applied traditional methods like `Pay Back' and ARR.


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Further, half of the companies incorporated risk by Àdjusting the Discount Rate' and used`Capital Asset Pricing Model.' In another study by Babu and Sharma (1995), it was found that

three-fourth of companies used DCF technique. The companies used `Cost of capital', `BankRate' and `Term Lending Rate' of financial institution as the rate of discount. `Sensitivity

Analysis' and Àdjustment of Discount Rate' methods were popular for handling risk.

Jain and Kumar (1998) found that companies were making regular investment for replacementand maintenance. One-fourth of the sample companies invested for expansion and

diversification. The most preferred method was `Pay Back Period' followed by NPV and IRR.Preference for Pay Back Period method was due to its simplicity, less cost, less time, and easy

understanding. For hurdle rate, WACC was preferred followed by Àrbitrary rate' and `Marginalcost of additional funds'. The companies, for incorporating risk preferred the `Sensitivity

Analysis' followed by `Higher cut off rate' and `Shorter Pay Back Period.'

Methodology

The study relies on the primary survey conducted. A structured non-disguised questionnaire wasused to collect the data from the 32 companies working in Punjab. The questionnaire comprisedof 12 important questions. These questions were mainly dichotomous, multiple choice and

questions based on the Likert scale.

The primary data were analyzed by applying tabular and Chi-square analysis, using SPSSrigorously. Chi-square was used to test the hypothesis; if the null hypothesis is rejected, it could

be concluded that there is a statistically significant relationship between the variables.

Findings and Discussion

The present study aims to unravel the status of capital budgeting in Punjab and throws light onthe methods preferred by Punjab-based companies while taking investment decisions. In doingso, the study tests if factors such as size of capital budget, age and nature of the company exert

any influence on the choice of methods. Before presenting the results, description of the sampleis given.

Table 1.1: Industry-wise Distribution ofSample

IndustryNo. of

Companies

Cotton Spinning (N1) 2Synthetic Fibers/Silk and

Textiles (N2)5

Electronics (N3) 1

Metal Alloys (N4) 4

General Engineering (N5) 5


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Banking and Insurance (N6) 3

Chemical Dyes and Fertilizers

(N7)2

Others (N8) 10

Total 32

Description of the Sample

The description of 32 companies covered in the study in terms of their nature, age, and

ownership is provided through Table 1.1 to 1.3.

Size of Capital Budget

Although all the companies surveyed are not very large, the size of the annual capital budget did

vary among all the respondents (Table 2A). Out of 32 companies in Punjab, 28.1% of companieshad a capital budget of less than Rs. 10 mn and 37.5% had between Rs. 10-99 mn. Nearly one-

third of respondents had capital budget exceeding Rs. 100 mn. None of the sample companieshad capital budget of over Rs. 1 bn.

Need for Formal Capital Budgeting Analysis

As shown in Table 2B, every respondent required formal capital budgeting, though minimumcapital expenditure varied.

Table 1.2: Age-wise Classification of

CompaniesAge of Company (in

Years)

No. of

Companies

Less than 5 2

9-May 7

19-Oct 8

More than 20 15

Total 32

Table 1.3: Distribution of Sample onthe Basis of Ownership

OwnershipNo. of

Companies

Public 22

Private 8


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Co-operative 2

Total 32

Source: Primary Survey.

Table 2: Capital Budgeting Practices AmongstSample Companies

(A) Size of Capital Budget

Size of Budget (in

Rs.)Frequency Percentage

Less than 10 mn 9 28.1

10-99 mn 12 37.5

100-499 mn 7 21.9

500-999 mn 4 12.5

More than 1 bn 0 0

Total 32 100

(B) Amount of Capital Expenditure Required forFormal Capital Budgeting

Size (in

Rs.)Frequency Percentage

Less than 1 mn 9 28.1

1-9 mn 12 37.5

10-29 mn 9 28.1

30-59 mn 2 6.3

>60 mn 0 0

Never 0 0

Total 32 100

(C) Purpose of Making Investment

Purpose Frequency Percentage

Expansion into

New Business

2 6.3

Expansion of

Existing Business17 53.1

EquipmentReplacement and

Modernization

13 40.6

Total 32 100


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(D) Role of Experience and Education

Response Frequency Percentage

Yes 15 46.9

No 9 28.1

Can't Say 8 25

Total 32 100

(E) Methods for Deciding Cost of Capital

Methods Frequency Percentage

WACC 7 50

Cost of Debts 3 21.6

Past Experience 1 7.1

Expected Growth

Rate2 14.2

CAPM 1 7.1

Total 14 100

(F) Methods of Cut-off Rate or Discount Rate

Measure Frequency Percentage

WACC 5 35.7

Cost of Debt 3 21.4

Cost of New

Equity

2 14.25

Arbitrary 1 7.2

Historical Rate of

Return1 7.2

Cost of RetainedEarnings

2 14.25

Total 14 100

(G) Consideration of Factors Deciding CapitalBudgeting Method

Factors Frequency PercentageFinance Theory 2 6.3

Experience andCompetency

6 18.8

Informal Rule of

Thumb4 12.5


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Importance of theProject

7 21.9

Easy toUnderstand

7 21.9

Familiarity of TopManagement 6 18.8

Total 32 100

(H) Type of Risk Involved in Investment

Factors Frequency Percentage

Having

Fluctuations inExpected Return

12 37.5

Non-recoverable 13 40.6

Changes inEconomic, Social

and PoliticalFactors

6 18.8

Fear of

Obsolescence1 3.1

Total 32 100.0

Purpose of Making Investment

Some of the earlier studies found replacement, modernization and diversification as the mostpopular avenues for investment by Indian and foreign companies (Jain and Kumar, 1998 andBlock, 1997). For the respondent companies of our survey, however, the dominant motivation

for making investment was the expansion of existing business followed by equipmentreplacement and modernization (Table 2C). Only 6.3% of the companies in Punjab showed their

willingness for investment in expansion into new business. This shows that, in Punjabinvestment is mainly done for expansion in the existing business line.

Role of Experience and Education

The education of top management and their past experience is believed by many to affect the

method of investment evaluation. The survey also reveals that 46.9% of the companies believethe same, while 28.1% were against the viewpoint (Table 2D). Thus, majority of the respondentcompanies feel that the education of CEOs and CFOs and their past experience does affect the

choice of the capital budgeting technique to be adopted by the company. Companies with moreeducated and highly qualified personnel prefer more sophisticated techniques like NPV, IRR in

contrast to the non-discounted techniques like Pay Back Period criterionpreferred by the lessqualified ones.


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Methods for Calculating Cost of Capital

The study reveals that less than half of the companies, made use of the time-adjusted ordiscounted capital budgeting models for calculating cost of capital (Table 2E). The study reveals

that nearly one half of the sample companies used the WACC for calculating cost of capital

followed by 21.6% preferring the cost of debt. Only one company preferred the CAPM model.The results of the study are consistent with results of the study conducted by Jog and Srivastava(1995), which found that WACC to be used by 47% of the Canadian firms for calculating cost of

capital. These field results correspond to the theory, which considers WACC to have the superiorbase level for cost of capital determinations.

Determination of `Cut off Point' or `Discount Rate'

Companies have to decide an appropriate discount rate to provide financial justification to thecapital project. However, the consideration of risk and the need to earn sufficient return on

investment make the choice complicated. The companies were asked to mention the criteria used

by them for calculating cut off rate and discount rate in case of time adjusted methods. As seenin Table 2F, the methods of discount rate varied substantially but little over than one third of thesample companies preferred WACC as the discount rate.

Consideration of Factors for Deciding Capital Budgeting Method

There are a number of factors on which capital budgeting decisions depend. As shown in Table

2G, the èasy understandability' and ìmportance of the project' are the main factors influencingselection of capital budgeting method. The èxperience and competency' and `familiarity of top

level management' were considered important by nearly one third of sample companies. Theresults also show that while considering various factors, most of the firms do not follow

academic advice or the prevalent financial theory.

Consideration of Risk in Capital Budgeting Decisions

All business activities involve risk. Risk analysis is used in capital budgeting to find out the

range of variation of results of a proposed project. In the same manner, investments also haverisk associated with them because there are uncertainties about the future demand, sales,

production and so on. All these elements of uncertainty have to be considered while makinginvestment decision. As the Table 2H indicates, only 40.6% of companies consider non-recovery

of invested funds as a major risk factor followed by fluctuations in expected returns. Changes ineconomic, social and political factors are considered as the third important factor of risk. Only 1

company out of 32 showed fear of obsolescence as a risk factor associated with investment.

Methods for Incorporating Risk

In business, just as in real life, projects also face uncertainties as far as estimates of future cash

flows, economic life of the project and even cost of capital are concerned. Risks are involved inmaking investments and different companies consider different methods for incorporating risk.

In order to analyze how the concept of risk differs with the change in the nature of industry, a


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cross tabulation of nature of industry and methods of incorporating risk is done. Table 3 explainsthe relationship between nature of industry and methods of incorporating risk. As the Table 3

shows, `shorter pay back period' is most popular method of handling risk. It was followed by`sensitivity analysis', `high cut off rates' and CAPM model.

Table 3: Two-way Distribution Table of Nature ofIndustry and Methods of Incorporating Risk

(in %)

Methods ofIncorporating

Risk

Industry

Cotton

Spinn-ing

SyntheticFiber

Silks andWoolen &

Textiles

Electronicsand

ElectricalEquipments

Metal

Alloys

Shorter PayBack Period 50.0 40.0 - 75.0

High Cut offRates

- 20.0 - -

Sensitivity

Analysis50.0 20.0 100 25.0

CAPM - 10.0 - -

Total 100 100 100 100

Table 3: Two-way Distribution Table of Nature of

Industry and Methods of Incorporating Risk

(in %)

Methods of

IncorporatingRisk

Industry

GeneralEngin-

eering

Banking/Finance/

Insurance

Chemical

Dyes/Pharma-

ceuticals/Fertilizers

Others Total

Shorter Pay

Back Period60.0 33.3 - 30.0 40.6

High Cut offRates

40.0 33.3 100.0 20.0 25.0

SensitivityAnalysis

- 33.3 - 40.0 28.1

CAPM - - - 10.0 6.3


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Total 100 100 100 100 100

Usage of Multiple Capital Budgeting Techniques

Respondent companies were also asked about usages of multiple capital budgeting methods. Out

of 32 companies, 30 companies responded in favor of using more than one capital budgetingmethod. This study is consistent with the results of Petty (1975), which depicted that 74% of the

companies studied were using more than one method for evaluating investment proposals.

Preferred capital budgeting technique

Previous studies indicate that the IRR and Pay Back Period methods are primarily used by Indian

companies (Pandey, 1989). The present study has gone beyond IRR and Pay Back Period andasked whether firms use all the seven important methods of capital budgeting. Respondents were

asked how frequently they use the different capital budgeting methods on a scale of 1 to 5 (1meaning "never", 5 meaning "Always"). The selection of methods as responded by the

companies are given in Tables 4-6. Table 4 shows that three-fourth of companies do not makeuse of NPV method, suggesting that NPV is not very popular in Punjab. The probable reasons

are difficulties in finding cut off rates and lack of trained personnel. About 80% of the samplecompanies did not follow IRR and Profitably Index methods and so they are not popular either.

The MIRR method has not been introduced in any of the companies in Punjab and no companyhas taken the risk of introducing and using this method due to so many complications and risks

involved, as well as unfamiliarity with the technique.

Table 4 also shows that Pay Back Period method is the most popular method among thecompanies in Punjab. Nearly two-third of the companies make use of ARR method always, often

and sometimes. The ARR method uses accounting profits instead of cash flows and does not

consider the time value of money. These results, thus, show that sample companies still followtraditional non-discounted methods like Pay Back Period and ARR, which do not consider thetime value of money.

Table 4: Two-way Distribution Table of Size of Capital Budget

and Capital Budgeting Tool

(in %)

CapitalBudgeting

Tool

Size of

CapitalBudget

(inRs.)

Always Often Sometimes Rarely Never

NPV Less

than10 mn

22.2 - - - 77.8

10-99mn

8.3 - 33.3 - 58.3


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100-499

mn

- - 14.3 - 85.7

500-

999

mn

- - - - 100

More

than 1bn

- - - - 100

Total 9.4 - 15.6 - 75

IRR Lessthan

10 mn

11.1 - - 22.2 66.7

10-99

mn

- - - 25 75

100-

499mn

- - - - 100

500-999

mn

- - - - 100

Morethan 1

bn

- - - - 100

Total 3.1 - - 15.6 81.3

Discounted

Pay Back*

Less

Than10 mn

11.1 55.6 - - 33.3

10-99

mn- 25 - 8.3 66.7

100-499

mn

- - 42.9 14.3 42.9

500-999

mn

- - 50 - 50

More

than 1bn

- - - - -

Total 3.1 25 15.6 6.3 50


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PayBack Period

Lessthan

10 mn

33.3 - - 33.3 33.3

10-99

mn50 - 16.7 33.3 -

100-499

mn

42.9 - 14.3 28.6 14.3

500-999

mn

50 - - 25 25

More

than 1bn

- - - - -

Total 43.8 - 9.4 31.3 15.6Modified

IRR#

Less

than10 mn

- - - - 100

10-99mn

- - - - 100

100-

499mn

- - - - 100

500-

999mn

- - - - 100

Morethan 1bn

- - - - 100

Total - - - - 100

ARR Lessthan

10 mn

22.9 33.3 22.2 - 22.2

10-99mn 25 33.3 16.7 8.3 16.7

100-499

mn

28.6 - - 42.9 28.6

500-999

25 - 25 25 25


14/20

mn

More

thanbn

- - - - -

Total 25 21.9 15.6 15.6 21.9Profitability

Index

Less

than10 mn

22.2 - 22.2 11.1 44.4

10-99mn

8.3 - - - 91.7

100-

499mn

- - - - 100

500-

999mn

- - - - 100

Morethan 1

bn

- - - - -

Total 9.4 - 6.3 3.1 81.3

Note: * Chi-square significant at 5% level.# No Chi-square could be computed because Modified IRR is

constant.

Table 5: Two-way Distribution Table of Age and CapitalBudgeting Tool (in %)

MethodsAge(in

Years)

Always Often Sometimes Rarely Never

NPV Lessthan 5

50 - - - 50

5- 9 14.3 - - - 85.7

10- 19 12.5 - 25 - 62.5

Morethan

20

- - 20 - 80

Total 9.4 - 15.6 - 75

IRR* Less

than 550 - - - 50


15/20

5-9 - - - 28.6 71.4

10 -19 - - - 25 75

More

than

20

- - - 6.7 93.3

Total 3.1 - - 15.6 81.3

DiscountedPay Back*

Lessthan

- 100 - - -

5-9 14.3 42.9 - - 42.9

10 -19 - 25 - - 75

Morethan

20

- 6.7 33.3 13.3 46.7

Total 3.1 25 15.6 6.3 50Pay BackPeriod

Lessthan 5

50 - - - 50

5-9 28.6 - - - 42.9

10 -19 50 - 50 - -

Morethan

20

46.7 - 6.7 13.3 46.7

Total 43.8 - 15.6 6.3 -34.3

ModifiedIRR#

Lessthan 5

- - - - 100

5-9 - - - - 100

10 -19 - - - - 100

More

than20

- - - - 100

Total - - - - 100

ARR Less

than 550 - 50 - -

5-9 14.3 42.9 14.3 - 28.6

10 -19 25 37.5 25 - 12.5

More

than20

26.7 6.76.7 6.7 33.3 26.7


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Total 25 21.9 15.6 5 21.9

Profitability

Index*

Less

than 550 - 50 - -

5-9 14.3 - 14.3 14.3 57.1

10 -19 12.5 - - - 87.5

More

than20

- - - - 100

Total 9.4 - 6.3 3.1 81.3

Note:* Chi-square significant at 5% level.

#No Chi-square could be computed because Modified IRR isconstant.

Table 6: Two-way Distribution Table of Nature ofIndustry and Capital Budgeting Tool

(in %)

MethodsN1

n=2

N2

n=5

N3

n=1

N4

n=4

N5

n=5

N6

n=3

N7

n=2

N8

n=10

NPV

Always 50% - 100 - - - - 10

Often - - - - - - - -

Sometimes - 40 - 25 20 33.3 - -

Rarely - - - - - - - -

Never 50 60 - 75 80 66.7 100 90

IRR

Always - - - - - - - 10

Often - - - - - - - -

Sometimes - - - - - - - -

Rarely - - - - 20 - - 40

Never 100 100 100 100 80 100 100 50

Discounted Pay Back*

Always 50 - - - - - - -

Often 50 60 100 - - - - 30

Sometimes - - - 50 - - 100 10

Rarely - - - 25 - - - 10

Never - 40 - 25 100 100 - 50


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Profitability Index

Always 50 - 100 - - - - 10

Often - - - - - - - -

Sometimes - - - - - - - 20

Rarely - - - - - - - 10

Never 50 100 - 100 100 100 100 60

Pay Back Period

Always 50 60 100 - 60 66.7 50 30

Often - - - - - - - -

Sometimes - 20 - - 20 - 50 -

Rarely 50 20 - 75 - - - 50

Never - - - 25 20 33.3 - 20

ARR

Always - 20 - 50 20 33.3 - 30

Often 50 40 - 25 20 - - 20

Sometimes 50 20 100 - 20 33.3 - -

Rarely - - - - - 33.4 50 30

Never - 20 - 25 40 - 50 20

MIRR#

Always - - - - - - - -

Often - - - - - - - -

Sometimes - - - - - - - -

Rarely - - - - - - - -

Never 100 100 100 100 100 100 100 100

Note: * Chi-square significant at 5% level.# No Chi-square could be computed because Modified

IRR is constant.For industry description of N code, see Table 1A.

In an open-ended question to find out why companies preferred a method over the other, it wasfound that companies preferred pay back period method because of its simplicity. Few others

favored it on the ground that it is the oldest and even less competent personnel can also handlethis method. Moreover, there is also lack of willingness on the part of the personnel to follow

sophisticated discounted flow methods.

Hypothesis Testing


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Ho1: There is no association between the size of the capital budget and different methods ofcapital budgeting.

To test for this hypothesis, Chi-square test was applied individually between the size of the

capital budget and each method of capital budgeting considered in this study (Table 4). For the

Discounted Pay Back Period method, the Pearson Chi-square test of independence wassignificant at 5% level. This indicates a significant relationship between size of capital budgetand the use of discounted pay back. In case of the rest of the five methods Pearson Chi-square

was insignificant, indicating no association between size of capital budget and these capitalbudgeting tools.

Ho2: There is no association between the age of the company and different methods of capital

budgeting.

Table 5 shows the association between age of the company and capital budgeting tools. It reveals

that as far as Pay Back Period, ARR and NPV methods are concerned there is no significant

association between tools and age. In case of IRR, Discounted Payback and Profitability IndexChi-square were significant at 5% level. Generally, in these cases it can be seen that oldercompanies have least preference for these discounted techniques while the younger companies

go in for these advanced discounted techniques. However, these results are mixed in case of avery important discounted technique, NPV, where no such relation could be established.

Ho3: There is no association between the nature of industry and different methods of capital

budgeting.

The Table 6 depicts the relationship between the nature of industry and the methods of capitalbudgeting. Chi-square value is insignificant for all the methods of capital budgeting except the

discounted Pay Back Period. Discounted Pay Back Period was found significant at 1% level.

Conclusion

The survey reveals that the status of capital budgeting practices in the state of Punjab is still far

from satisfactory. Majority of the sample companies still use non-discounted cash flowtechniques, mostly Payback Period criterion to evaluate any new project. Only a very few

companies use DCF, and among them a very negligible number use NPV techniques to evaluatea new project. Moreover, majority of the sample companies use the WACC approach to calculate

the cost of capital, which is also used as the most preferred discount or cut off rate. For thepurpose of incorporating risk in investment decision `shorter pay back period' is the most

prevalent method. Similarly, majority of the companies feel that CEO education and experienceplay an important role in selecting the capital budgeting technique.

Further, the study did not find any significant association between the size of capital budget and

capital budgeting methods adopted. In fact, evidences suggest that as the size of capital budgetincreases, companies avoid using discounted techniques like NPV. Similarly, though at someinstances it appears that young companies prefer DCF techniques than the older ones, the same is

not true in case of NPV method. Thus, age of the company also does not influence the selection


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of the capital budgeting technique. Similarly no significant relationship could be establishedbetween the nature of industry and investment evaluation techniques.

Therefore it can be concluded that capital budgeting practices in Punjab are still in its nascent

stage. Companies should move from the traditional non-discounted techniques towards the

sophisticated discounted cash flow techniques.

References

1. Babu C P and Sharma A (1995), "Capital Budgeting Practices in Indian Industry-An EmpiricalStudy", ASCI Journal of Management, (September), pp. 34-36.

2. Block S (1997), "Capital Budgeting Techniques Used by Small Business Firms in the 1990s",

Engineering Economist, Vol. 42, pp. 289-297.

3. Chandra P (1975), "Capital Expenditure Budgeting Analysis in Practice", Indian Management,

(July).

4. Chen S (1995), "An Empirical Examination of Capital Budgeting Techniques", EngineeringEconomist, Vol. 40, pp. 220-232.

5. Cherukuri U R (1996), "Capital Budgeting Practices: A Comparative Study of India and Select

South East Asian Countries", ASCI Journal of Management, (March), pp. 30-46.

6. Dhankar R S (1995), "An Appraisal of Capital Budgeting Decision Mechanism in IndianCorporates", Management Review, (July-December), pp. 22-34.

7. Graham J and Harvey C (2002), "How Do CFOs Make Capital Budgeting and CapitalStructure Decisions?", Journal of Applied Corporate Finance, Vol. 15, pp. 8-23.

8. Holmen M (2005), "Capital Budgeting and Political Risk: Empirical Evidence", Unpublished

Manuscript, Uppsala University.

9. Jain P K and Kumar M (1998), "Comparative Capital Budgeting Practices: The IndianContext", Management and Change, (January-June), pp. 151-171.

10. Jog Vijay and Srivastava A K (1995), "Capital Budgeting Practices in Corporate Canada",Financial Practices and Education, Vol. 5, pp. 387-397.

11. Ken L R and Cherukuri U R (1991), "Current Practices in Capital Budgeting: Cost of Capital

and Risk Adjustment", ASCI Journal of Management, Vol. 21, pp. 26-44.

12. Klammer T (1972), "Empirical Evidence of the Adoption of Sophisticated Capital BudgetingTechniques", Journal of Business, Vol. 45, pp. 387-397.

13. Mao J C T (1969), Quantitative Analysis of Financial Decisions, Macmillan: New Delhi.


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14. Miller J H (1960), "A Glimpse at Practice in Calculating and Using Return on Investment",NAA Bulletin (now Management Accounting), (June), pp. 65-76.

15. Pandey I M (1989), "Capital Budgeting Practices of Indian Companies", MDI Management

Journal, Vol. 2.

16. Petty J W (1975), "The Capital Expenditure Decision-Making Process of LargeCorporations", Engineering Economist, Vol. 20, pp. 159-172.

17. Pike R (1996), "A Longitudinal Survey on Capital Budgeting Practices", Journal of BusinessFinance and Accounting, Vol. 23, pp. 79-92.

18. Porwal L S (1976), Capital Budgeting in India, Sultan Chand & Sons: New Delhi.

19. Purohit B N, Lall G S and Panda J (1994), Capital Budgeting in India, Kanishka Publishers

Distributors: Delhi.

20. Sahu P K (1989), Capital Budgeting in Corporate Sector, Discovery Publishing House:

Delhi.

21. Schall L D, Sundem G L and Geijsbeek W R (1978), "Survey and Analysis of CapitalBudgeting Methods", Journal of Finance, Vol. 33, pp. 281-288.

Reference # 01J-2007-02-04-01.

The IUP Journal of Applied Finance Feb 07

http://www.iupindia.in/207/IJAF_CapitalBudgeting57.asp

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Capital Budgeting Practices in Punjab

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