Capital Budgeting Practices-Thesis[1]

University of Leicester

Centre for Management Studies

MBA (Finance) – October 2008

“Capital Budgeting Practices and Economic Development: A

Comparative Study of Companies in Europe and West Africa”

By

George Ekegey Ekeha Email: [email protected]

March 2007

THIS DISSERTATION IS PRESENTED TO THE CENTRE FOR MANAGEMENT STUDIES, UNIVERSITY OF LEICESTER, UNITED KINGDOM. AND IT IS IN PART FULFILMENTS OF THE COMPLETION OF STUDIES TOWARDS THE AWARDS OF MASTERS OF BUSINESS ADMINISTRATION DEGREE (FINANCE OPTION).

NO PART OF THIS THESIS IS TO BE USED FOR ANY PURPOSES, OTHER THAN ACADEMIC, WITHOUT THE OFFICIAL CONSULTATION WITH THE AUTHOR AND/OR THE UNIVERSITY AUTHORITIES.

GEORGE E EKEHA 1 MBA –OCT. 2007

mailto:[email protected]

TABLE OF CONTENT

LIST OF FIGURES AND TABLES................................................................................ 4

ABSTRACT....................................................................................................................... 5

PREFACE.......................................................................................................................... 7

1.0 INTRODUCTION....................................................................................................... 8

1.1 MOTIVATION OF THE STUDY ...................................................................................... 9

1.2 THE DEBT SERVICING CYCLE OF LESS DEVELOPED COUNTRIES.............................. 10

1.3 THE PROBLEMS AND RESEARCH HYPOTHESIS.......................................................... 11

1.4 ORGANISATION OF THE STUDY ................................................................................. 12

2.0 LITERATURE REVIEW ........................................................................................ 13

2.1 ECONOMIC DEVELOPMENT IN AFRICA ..................................................................... 13

2.2 THE CAPITAL BUDGETING DECISION ....................................................................... 15

2.3 STUDIES ON CAPITAL BUDGETING PRACTICES IN DEVELOPING COUNTRIES ............ 17

3.0 CAPITAL BUDGETING PROCESS AND PROJECT CLASSIFICATIONS... 18

3.1 CLASSIFICATION OF INVESTMENT PROJECTS ............................................................ 18

3.1.1Independent Projects ........................................................................................ 18

3.1.2 Mutually Exclusive Projects ............................................................................ 18

3.1.3 Contingent Projects ......................................................................................... 18

3.2 THE CAPITAL BUDGETING PROCESS .......................................................................... 19

3.2.1 Strategic planning............................................................................................ 20

3.2.2 Identification of investment opportunities ....................................................... 21

3.2.3 Preliminary screening of projects.................................................................... 21

3.2.4 Financial appraisal of projects........................................................................ 22

3.2.5 Qualitative factors in project evaluation ......................................................... 22

3.2.6 The accept/reject decision................................................................................ 23

3.2.7 Project implementation and monitoring .......................................................... 23

3.2.8 Post-implementation audit ............................................................................... 24


4.0 DETERMINANTS OF CAPITAL BUDGETING PRACTICES......................... 24

5.0 SURVEY DESIGN AND METHODOLOGY........................................................ 26

6.0 RESEARCH RESULTS AND ANALYSIS ............................................................ 27

6.1 COMPANY AND CFO CHARACTERISTICS.................................................................. 28

6.2 CAPITAL BUDGETING TECHNIQUES.......................................................................... 30

6.2.1 European CFOs ............................................................................................... 32

6.2.2 West African CFOs .......................................................................................... 33

6.2.3 European versus West African CFOs .............................................................. 34

6.3 COST OF CAPITAL ESTIMATION METHODS ............................................................... 35

6.3.1 European CFOs ............................................................................................... 37



6.4 COST OF EQUITY ESTIMATION METHODS................................................................. 38

6.4.1 European CFOs ............................................................................................... 40



6.5 CAPITAL BUDGETING TECHNIQUES, COST OF CAPITAL AND COST OF EQUITY

ESTIMATIONS: MULTIVARIATE ANALYSIS ..................................................................... 41

6.5.1 The Multivariate Analysis ................................................................................ 42

6.5.2 Capital Budgeting Techniques......................................................................... 44

6.5.3 Cost of Capital Estimation............................................................................... 46

6.5.4 Cost of Equity Estimation ................................................................................ 47

7.0 SUMMARY AND DISCUSSION ............................................................................ 49

LIST OF REFERENCES............................................................................................... 51

RESEARCH QUESTIONNAIRES ............................................................................... 54


LIST OF FIGURES AND TABLES

FIGURE 1: THE CAPITAL BUDGETING PROCESS ............................................. 20

TABLE 1: COMPANY CHARACTERISTICS........................................................... 29

TABLE 2: CAPITAL BUDGETING METHODS USED BY CFOS......................... 31

TABLE 3: MOST FREQUENTLY USED METHODS TO MEASURE THE COST

OF CAPITAL (% OF TOTAL)..................................................................................... 36

TABLE 4: MOST FREQUENTLY USED METHODS TO ESTIMATE THE COST

OF EQUITY (% OF TOTAL) ....................................................................................... 39

TABLE 5: DETERMINANTS OF CAPITAL BUDGETING METHODS:

MULTIVARIATE LOGIT ANALYSIS ....................................................................... 45

TABLE 6: DETERMINANTS OF THE MOST FREQUENTLY USED METHODS

TO MEASURE THE COST OF CAPITAL: MULTIVARIATE LOGIT ANALYSIS

........................................................................................................................................... 47

TABLE 7: DETERMINANTS OF COST OF EQUITY ESTIMATION METHODS:

MULTIVARIATE LOGIT ANALYSIS ....................................................................... 48


ABSTRACT

Over the years, efforts have been made to increase the developmental strides of African

countries. Many projects move from donor countries like the United Kingdom and the

United State into Africa to help improve the lives of the people. However, these efforts

have not been able to redeem Africa from abject poverty and indebtedness to the West.

Various projects that are targeted towards the reduction of poverty are normally

completed with no changes in the lives of the people. These projects, in my opinion, have

not been scrutinised to assess their capabilities of meeting some stated target.

Capital budgeting practices are some of the vital inputs in the decision-making process of

embarking on investment projects. A very good analysis, scrutiny, implementation and

monitoring of such projects could yield the expected results for the stakeholders (people

of the country). According to Dayananda et al (2002), the capital budgeting practices are

used to make investment decisions so as to increase shareholders value. Capital

budgeting is primarily concerned with sizable investments in long-term assets, Brealey &

Myers (2003). These assets may be tangible items such as property, plant or equipment or

intangible ones such as new technology, patents or trademarks. Investments in processes

such as research, design, development and testing – through which new technology and

new products are created – may also be viewed as investments in intangible assets (ibid).

Dayananda et al (2002), argued that irrespective of whether the investments are in

tangible or intangible assets, a capital investment project can be distinguished from

recurrent expenditures by two features. One is that such projects are significantly large.

The other is that they are generally long-lived projects with their benefits or cash flows

spreading over many years. Sizable, long-term investments in tangible or intangible

assets have long-term consequences (ibid). This implies that today’s investment will

determine the overall corporate strategic position over many years. These capital

investments also have a considerable impact on the future cash flows of the organization

and the risk associated with those cash flows. Capital budgeting decisions thus have a

long-range impact on the strategic performance of the organization and are also critical to

its success or failure.


This paper compares the use of capital budgeting techniques by companies in Europe and

West Africa, using data obtained from a survey between 225 European and 120 West

African companies. The main aim is to analyse the use of capital budgeting techniques by

companies in both economic blocs from a comparative perspective to see whether

economic development matters in the choice of which technique to use.

The empirical analysis provides evidence that European CFOs on average use more

sophisticated capital budgeting techniques than their counterparts in West African. At the

same time, however, the results suggest that the differences between European and West

African companies is smaller than might have been expected based upon the differences

in the level of economic development between both economic blocs. At least, this is

evident with respect to the use of methods of estimating the cost of capital and the use of

CAPM as the method of estimating the cost of equity.


PREFACE

The work presented in this thesis was carried out over a period between late 2006 and

early 2007 for the award of MBA (Finance) degree with University of Leicester. During

this time and all my studies period I had help from several different people that I would

like to thank.

First, I would like to thank my lecturer Jeremy French, administrators Hamza and Nikos

at Citi Banking College and Peter Alfano at Centre for Management Studies, University

of Leicester for their support and helpful advice during my period of studies. Secondly, I

would like to thank all the responding CFOs for taking the time to participate in this

study. I would also like to thank my family, my wife Mrs Beauty Ekeha, my mum Agnes

Obri, who was looking after my kids during the period of my studies and all my kids,

Norris Walter, Bright Mawusi, Urielle Jorgbenue and Suzzy Selase for their support

during my studies. Finally, I would like to thank my Administrative Director, Mr. Samuel

Boakye and all members of the Finance Department at Ghana Statistical Services,

Ministry of Finance.

Throughout the period of my studies in the United Kingdom and work with this thesis, I

have gained a lot of knowledge, experience, and insight of good business management in

the area of capital budgeting techniques, and this would also help me contribute to the

future research within this area and other managerial processes both in public and private

sectors.

March 2007

GEORGE EKEGEY EKEHA


1.0 INTRODUCTION

This paper reports the results of a survey with respect to the current practices of capital

budgeting techniques in two different economic blocs at two different levels of economic

development: Europe and West Africa. The main aim of this paper is to analyse the use

of capital budgeting techniques by companies in a comparative perspective to see

whether economic development matters in the choice of techniques. Whereas several

papers in the past have investigated the use of such techniques, this is one of the very few

studies that use such a comparative perspective, comparing a more developed with a

developing economy. This analysis was carried out using standard differences of mean

tests and multivariate regression analysis to see whether there is a so-called “country

effect” on the choice of capital budgeting technique. This means that the research tried to

establish whether capital budgeting practices differ significantly between companies in

the two economic blocs and whether these differences can be explained by differences in

levels of economic development.

Again, only very few papers have addressed the determinants of capital budgeting

practices using these types of analyses, let alone in a comparative economic perspective.

Notable exceptions, among others, are Brounen, et al. (2004) and Payne, et al. (1999).

Yet, both studies analyse the determinants of capital budgeting practices for a number of

developed countries (The Netherlands, Germany, France, Canada, the U.S. and the U.K.).

West Africa and Europe have been chosen for this comparison for the following reasons.

The researcher was a Finance Manager in a government department of one West African

country and considers West African countries as strongly emerging, yet still less-

developed economy in many respects, which has received a lot of attention in the

economic and financial development literature during recent years. Moreover, the

researcher also considers Europe as a typical example of a developed economic bloc and

also most companies in this bloc have various investment interests in Africa. Finally, the

researcher believes that most CFOs in African countries do not utilise the sophisticated

capital budgeting techniques to scrutinise projects very well before selection. This

resulted in various mismanagement and failure to achieve economic heights.


1.1 Motivation of the Study

Capital budgeting involves making investment decisions concerning the financing of

capital projects by organisations. Making a good investment decision is important since

funds are scarce and the investment is expected to add to the value of the organisation

especially in Less Developed Countries (LDCs) and Third World poor nations. Capital

investment decision is thus one of the requirements, if properly applied, that can help

accelerate economic development. All countries of the sub-Saharan Africa expend an

upward of 13.5 billion dollars per annum on foreign debt payment to rich foreign

creditors, World Bank report (2005). Many countries in the third world borrowed huge

sums of money in expectation that interest rates would remain stable. Many African

countries accepted these loans for political and economic stabilization in the post

independence era, however prominent problems such as corruption make these loans

ineffective to save the recipients countries from their economic woes.

For example in Ghana, a governance and corruption survey was commissioned by the World

Bank, which was conducted by the Centre for Democratic Development (CDD – GHANA).

Evidence from the survey showed that public concern about corruption in the country is very high

and that there is a widespread public perception that corruption has had a negative toll on

productivity and efficiency of both the public and private sectors and consequent effects on

popular welfare, CDD Ghana (2000). The Ghana Integrity Initiative (GII), a local chapter of

Transparency International, has also on various occasions undertakes some educational programs

on corruption and good governance through seminars and workshops for various interest groups

in the country. One recent study on administrative costs faced by private investors in 32

developing countries most from Africa reported that it takes up to two or three years to establish a

new business in many developing countries (Morisset and Lumenga Neso: 2002). Their study

found that the most delays occurred in securing land access and obtaining building permits. The

associated administrative costs were found to be positively correlated with estimates of the level

of corruption and negatively correlated with the quality of corporate governance, degree of

openness, and public wages, among others (Morisset and Lumenga Neso: 2002). The authors

finally argued that the level of corruption or the lack of good governance is expected to influence

administrative costs as bureaucrats and politicians are more likely to capture the extra rents (ibid).

In fact, the corrupt practices of most executives in both public and the private sectors of these

developing West African countries have led to increases in debts to their borrower countries with


the intended targets of the loans not met. On the side of the creditors as well, many of these

loans were given in order to gain and or retain the loyalty of those corrupt regimes, which

is the characteristic of African governments.

1.2 The Debt Servicing Cycle of Less Developed Countries

These debt-trapped nations were under-developed and their debt crisis further plunge

them into deeper economic crisis and abject poverty due to excessive borrowing. Most

executives of these developing countries have the selfish tendency of mismanaging the

various project assigned to them. Some managers of the projects are eager to satisfy their

personal needs before thinking of the implementation of whatever projects has been

assigned to them. This leads to poor budgeting, poor monitoring and hence poor

implementation of the project. Governments of the nations have to then borrow more

funds in order to complete and maintain the existing projects. Due to the fact that these

loans were thoughtlessly accepted, and collected by most African governments, they had

neither little implications for development nor benefit for the masses.

Finally the unreliable market prices in the world’s market for agricultural products and

low-technologically manufactured goods, which make it particularly difficult for African

countries to diversify and increase exports to hard currency markets. Thus making it

difficult for them to earn their way out of the debt trap. In my opinion, the developed

countries, like the USA and UK who have been prophesising their lengthy plans to

alleviate Africa from its economic woes must endeavour to ensure some monitoring

system such that the aids will go a long way to improve the investment capacity of the

continent. International markets should also be opened to the African manufacturers in

the said developed countries. Finally, loans must be channelled towards the

transformation of the primary products into products worthy for the international market.

Notwithstanding, however, the researcher believes that these debt-ridden nations in the

Sub-Saharan Africa are expected to make attempts at improving their economic status

themselves through huge research and development leading into economic productivity.

The concerns of the developed nations may be to no avail if these less developed nations


do not take steps that will help relief their situation. The capital investment decision is

thus one of the most critical and crucial decisions that any country or organisation can

take to achieve economic development-thus by adding economic value. Since economic

development depends on the multiplicity of viable corporate organisations and enterprises

in the country, the approach adopted here is to demonstrate how capital budgeting, as an

investment decision can help African countries promote corporate organisational growth

by using acceptable techniques to identify viable projects. In other words, capital

budgeting is an integral part of the corporate plan of an organisation, which reflects the

basic objectives of an organization. The capital investment decision involves large sums

of money and may introduce a drastic change in companies as well as the whole

economy, when it is well scrutinised. For instance, acceptance of a project may

significantly change a company’s operation, profitability and create more jobs within the

country. These changes might also affect investors’ evaluation of a company (Osaze,

1996:40-44).

1.3 The Problems and Research Hypothesis

Most third world countries depend excessively on importation. They do not develop an

enduring technological base that can support the growth of their economies. Their capital

investment decisions are not usually well articulated. This may be due to the fact that

their governments do embark on white elephant projects that gulp huge sums of money

and are useless in terms of utility to the people. The projects often are abandoned halfway

and in some cases, are only executed on papers. The current efforts of some African

governments like those of Ghana and Nigeria, towards privatisation of hitherto

government-owned firms and corporations is an indirect concession to the fact that the

former investment decision pattern of the national government is not wise enough to

alleviate their countries from poverty. In fact, most of the diversified companies have

improved productivity and quality with enormous benefits to their countries. Considering

the matter from the corporate perspective therefore, the researcher believes that capital

budgeting decision is one of the decision-making areas of a financial manager that

involves the commitment of large funds in long-term projects or activities. And these

projects have a huge impact on the county’s economic development.


This study therefore seeks to examine the importance of capital investment decisions; the

basic steps in making capital investment decisions and the techniques used in evaluating

capital investment projects so that the overall country’s economy can grow from the

corporate sector investments. It is also expected to show that the use of sophisticated

techniques by both corporate and governmental CFOs will help in the development

efforts of Africans and other poor nations. The researcher believes that most developed

countries in Europe have achieved highs in today’s competitive international market

because they put money where it adds value. Investments are well scrutinised using

various sophisticated techniques, both qualitative and quantitative, before final decision is

arrived and such projects are well monitored until fully completed. It is my believe also

that most African Countries remain in the low economic growth and poverty zone

because CFOs don’t make use of technical tools to analyse various investment projects,

which have significant impact on the economic development. These differences might be

due to the level of education, technology and economic development between the two

economic blocs. Therefore, the researcher hypothesizes that CFOs of European

companies will use net present value (NPV) and internal rate of returns (IRR) methods

more often than their counterparts in West Africa, whereas the opposite will be true for

the pay back (PB) and accounting rate of returns (ARR) methods.

An additional contribution of this paper to the existing empirical literature on capital

budgeting practices is in terms of the countries for which the researcher had gathered

data. Most previous studies focus on the United States and the United Kingdom and there

are some few studies available for the Netherlands (Herst, Poirters and Spekreijse, 1997;

Brounen, De Jong and Koedijk, 2004). The researcher is also aware of study on “Capital

Budgeting and Economic Development in the Third World Countries” (Elumilade, et al

2006) but there were no comparisons with any developed economy.

1.4 Organisation of the study

The paper is organised in seven different sections, with section one dealing with

introduction, hypothesis and motivations of the study. Section two discusses literature


review on capital budgeting practices and further discussed the capital budgeting process,

classification of investment projects and alternative determinants of capital budgeting

practices in sections three and four. This was followed by a discussion of the design of

the survey in section five. Section six then provides the results of the survey and a

discussion of the empirical analysis of determinants of capital budgeting practices. The

paper ends with a summary and discussion of the results in the final section.

2.0 LITERATURE REVIEW

In this section the researcher tries to outline previous studies relevant to this study. The

section discussed various studies on economic development, capital budgeting among

CFOs from various countries and if there is any comparative study between developed

and developing countries.

2.1 Economic Development in Africa

Economic development in Africa has not been steady. In fact, when compared to the

situation in the Western countries like Europe, the conclusion is that countries of the third

world are either qualified as undeveloped or mildly put underdeveloped. African scholars

have tended to heap the blame on the Europeans; saying that colonialism or neo-

colonialism is the bane of Africa’s economic woes. This notion is referred to by

Onigbinde (2003:21-25), as the “Original Sin Fallacy”. The present economic woe of

underdeveloped countries (UDCs) according to this fallacy is that UDCs’ condition is

original “in relation to a so-called non-achievement, the present condition of the

underdeveloped world is a historical product of capitalist expansion (ibid).

The crisis of underdevelopment in Africa is also captured in the “Africa at the Doorstep

of Twenty-First Century” by Adebayo Adedeji as sited by Onigbinde, 2003. According to

him, African within the world is, …poverty increased in both the rural and urban areas:

real earning fell drastically; unemployment and underemployment rose sharply; hunger

and famine became endemic; dependence on food aid and food imports intensified;

disease, including the added scourge of AIDS, decimated population and became a real

threat to the very process of growth development; and the attendant social evils-rime

delinquency, there is a mess vengeance (Onigbinde, 2003: 78-79) .


The United States Assistance for International Development (USAID), 1988-1992 (cited

from Onigbinde, 2003:79-80), stated among other things that, … approximately 180

million of sub-Saharan Africa’s 500 million people could be classified as poor, of whom

66.7 percent, or 120 million, are desperately poor. By every international measure, be it

per capital income ($330), life expectancy (51 years), or the United Nation’s Index of

Human Development (0.255 compared to 0.317 for South Asia, the next poorest region),

Africa is the poorest region in the world, Onigbinde 2003. The solution to all these

problems lies in the fact that firms are to embark on projects that would give rise to

company’s value which will by extension enhancing the desired economic development

for the country. In the course of achieving these development efforts, the company’s

activities become more complex and corporate management assumes a sound financial

position in the handling of problems and decisions therein.

In his study of “The obstacles to investment in Africa…”, Professor Peter Montiel of the

World Bank concluded among other things that “One set of explanations is based on the

view that investment projects with high economic rates of return are not as plentiful in

Africa as the simple neoclassical growth paradigm would seem to imply. One argument is

that for a variety of reasons, aggregate production functions may be characterized by

lower levels of productivity in Africa than in creditor countries. An alternative or

complementary story is based on generalizing the aggregate production function to

include roles for human capital, public capital, and institutional capital” Montiel (2006).

He continued to say “These effects raise questions about the abundance of investment

opportunities yielding high economic rates of returns in Africa at the present time”,

(ibid). This conclusion suggests that, though not abundant, investment opportunities with

high returns exist in African countries and when applied properly, it could bring

economic growth to Africa. One of the best ways to scrutinise these opportunities is by

using various techniques like the capital budgeting techniques, to access the profit

potentials.


2.2 The Capital Budgeting Decision

Capital budgeting decisions are among the most important decisions the financial

manager of a company has to deal with. Capital budgeting refers to the process of

determining which investment projects result in maximisation of shareholder value,

Dayananda et al, 2002. Generally speaking, there are four main capital budgeting

techniques the manager may use when evaluating an investment project. In fact, there are

other techniques that could have been considered, such as sensitivity analysis, real

options, book rate of return, simulation analysis, etc. (Graham and Harvey, 2001, pp.196-

197). However, the researcher has chosen to focus on the most well known techniques to

keep the study simple. The net present value (NPV) and internal rate of return (IRR)

methods are considered to be discounted cash flow (DCF) methods. The payback period

(PB) and average accounting rate of return (ARR) methods are so-called non-DCF

methods, Brealey and Myers, 2003. From a pure theoretical point of view the NPV is

considered to be the most accurate technique to evaluate projects. Yet, it is also the most

sophisticated of the four, followed by the IRR method. Both non-DCF methods are

considered to be less accurate, of which the PB method is the least sophisticated (ibid).

In the past, several studies of capital budgeting practices have been carried out. Most

studies focus on companies in the U.S. Comparing survey results of capital budgeting

practices in the U.S. over time generally seems to show that the analytical techniques

used by executives have increased in terms of sophistication. For example, in one of the

earliest studies reporting the results of questionnaires on capital budgeting practices,

Klammer (1972) shows that in 1959, based on a sample of 184 large U.S. companies, 19

per cent indicated that they used DCF methods as their primary method to evaluate

projects. The majority of companies used either PB (34 per cent of the total sample) or

ARR methods (34 per cent) as their primary method of evaluation. In 1970, the picture

had changed drastically: DCF methods were used by 57 per cent of the companies; 26 per

cent used ARR and only 12 per cent used PB as their primary method of project

evaluation (ibid). In a later study, Hendricks (1983) reports that in 1981 76 per cent of the

companies in his sample studied used DCF methods as their primary tool. Only 11 per

cent stated they used the PB method as their primary tool. Trahan and Gitman (1995)


show that, based on a 1992 survey of 58 of the Fortune 500 large companies and 26 of

the Forbes 200 best small companies, most companies used DCF methods as their

primary evaluation tool, although these methods were more important for the large

companies (88 per cent for NPV and 91 per cent for IRR) than for the small companies

(65 and 54 per cent for NPV and IRR respectively).

A recent study by Graham and Harvey (2001), a comprehensive survey published on

capital budgeting practices (using answers from a 1999 survey among 392 Chief

Financial Officers (CFOs) of companies in the U.S. and Canada) showed that the NPV

and IRR techniques are the most frequently used capital budgeting techniques. Their

survey reported that 75 per cent of the CFOs always use NPV and 76 per cent always or

almost always use the IRR method. Their survey results also show, however, that even

though over time the use of the PB method has declined as a primary tool for project

evaluation, it remains to be an important secondary instrument CFOs normally use.

According to Hendricks (1983), in his 1981 survey 65 per cent of the companies in his

sample used PB as a secondary measure. Trahan and Gitman (1995) show that in 1992,

72 per cent of the large and 54 per cent of the small companies used PB as one of the

evaluation tools. In the 1999 survey of Graham and Harvey (2001) 57 per cent indicated

they use the PB method as one of their evaluation tools.

The general picture that emerges from the previous short discussion also emerges from

survey studies based on other U.S. as well as U.K., European and Australian companies

(Gitman and Forrester (1977); Schall, et al. (1978); Kim and Farragher (1981); Shao and

Shao (1996); Pike (1996) and Brounen, et al. (2004) ; Freeman and Hobbes (1991) and

Truong, et al. (2005); Herst, et al. (1997) and Brounen, et al. (2004). A comparison of the

results of these survey studies also showed an increasing sophistication with respect to

the use of evaluation techniques over time. At the same time, however, it seems that

companies in European countries report lower rates of the use of DCF techniques as

compared to U.S. companies.


Brounen et al (2004) replicate the Graham and Harvey (2001) survey in four European

countries (U.K., France, Germany and the Netherlands; total sample was 313 companies)

in 2002-2003 and find that for the U.K. companies in their sample 47 per cent states that

NPV is (almost) always used as a tool of evaluating projects, whereas 69 per cent

(almost) always use the PB. For the Netherlands these figures are comparable (70 and 65

per cent, respectively); for France and Germany the figures are even lower (42-50 per

cent and 44-51 per cent, respectively).

2.3 Studies on Capital Budgeting Practices in Developing Countries

A few studies have reported survey evidence on capital budgeting practices in the Asia-

Pacific region. These studies show a somewhat different picture. Wong, et al (1987) used

information from a survey among a large number of companies in Malaysia, Hong Kong,

and Singapore in 1985 and found that in these countries the PB method was the most

popular primary measure for evaluating and ranking projects. For Malaysia this picture

was confirmed in Han (1986). In a recent paper by Kester, et al. (1999), based on

information from surveys of 226 companies in Australia, Hong Kong, Indonesia,

Malaysia, The Philippines and Singapore in 1996- 1997, it was reported that the PB

method was still an important method. Yet, DCF methods seem to have increased in

importance as well. Excluding Australia from the sample of the countries studied, 95 per

cent of the companies in the five Asian countries indicated that they use the PB method

and 88 per cent of them said they use the NPV method when evaluating projects. In terms

of importance (on a scale from 1 to 5, where 1 = unimportant and 5 = very important)

both methods are rated almost equally important (3.5 versus 3.4) (ibid). When comparing

these results to the results of studies for companies in Western economies, these figures

seem to be very high. Comparing the results of the study by Wong, et al. (1987) with

those of Kester, et al. (1999) does seem to suggest that the level of sophistication of

capital budgeting techniques has increased quite rapidly during a period of just one

decade within the developing countries in Asia.


3.0 CAPITAL BUDGETING PROCESS AND PROJECT CLASSIFICATIONS

3.1 Classification of Investment Projects

Investment projects can be classified into three categories on the basis of how they

influence the investment decision process: independent projects, mutually exclusive

projects and contingent projects, Dayananda et al (2002).

3.1.1Independent Projects

An independent project is the one which the acceptance or rejection of does not directly

eliminate other projects from consideration or affect the likelihood of their selection. For

example, management may want to introduce a new product line and at the same time

may want to replace a machine, which is currently producing a different product. These

two projects can be considered independently of each other if there are sufficient

resources to adopt both, provided they meet the firm’s investment criteria (ibid). This

implies that the projects can be evaluated independently and a decision made to accept or

reject them depending upon whether they add value to the firm.

3.1.2 Mutually Exclusive Projects

According to Dayananda et al (2002), two or more projects that cannot be pursued

simultaneously are called mutually exclusive projects – the acceptance of one prevents

the acceptance of the alternative proposal. Therefore, mutually exclusive projects involve

‘either-or’ decisions – alternative proposals cannot be pursued simultaneously. The early

identification of mutually exclusive alternatives is crucial for a logical screening of

investments. Otherwise, a lot of hard work and resources can be wasted if two divisions

independently investigate, develop and initiate projects, which are later recognized to be

mutually exclusive (ibid).

3.1.3 Contingent Projects

Finally, a contingent project is the one which the acceptance or rejection is dependent on

the decision to accept or reject one or more other projects. Contingent projects may be

complementary or substitutes (ibid). For example, the decision to start an agricultural


project in a West African village may be contingent upon a decision to build roads

leading to the project sites. In this case the projects are complementary to each other. The

cash flows of the farming project will be enhanced by the existence of good roads to

transport inputs and outputs to and from the farm and conversely the cash flows

necessary for the road maintenance will be enhanced by the existence of high road taxes

paid by the trucks using the road. In contrast, substitute projects are ones where the

degree of success (or even the success or failure) of one project is increased by the

decision to reject the other project. For example, market research indicates demand

sufficient to justify two restaurants in a shopping complex and the firm is considering one

Chinese and one Thai restaurant. Customers visiting this shopping complex seem to treat

Chinese and Thai food as close substitutes and have a slight preference for Thai food

over Chinese (ibid). Consequently, if the firm establishes both restaurants, the Chinese

restaurant’s cash flows are likely to be adversely affected. This may result in negative net

present value for the Chinese restaurant. In this situation, the success of the Chinese

restaurant project will depend on the decision to reject the Thai restaurant proposal. Since

they are close substitutes, the rejection of one will definitely boost the cash flows of the

other. Contingent projects should be analysed by taking into account the cash flow

interactions of all the projects (ibid).

3.2 The capital budgeting process

This section was adopted from Dayananda et al (2002), they stated that there are several

sequential stages in the process. For typical investment proposals of a large corporation,

the distinctive stages in the capital budgeting process are depicted, in the figure 1 below:


Figure 1: The Capital Budgeting Process

Corporate Goal

Strategic Planning

Investment Opportunities

Preliminary Screening

Financial appraisal, quantitative analysis, project evaluation/analysis

Qualitative factors, judgement & gut

feeling

Accept/reject decision on the projects

Implementation

Facilitation, monitoring, control & review

Continue, expand or abandon project

Post-implementation audit

Source: Capital Budgeting: Financial Appraisal of Investment Projects (Dayananda et al 2002) 3.2.1 Strategic planning

A strategic plan is the grand design of the firm and clearly identifies the business the firm

is in and where it intends to position itself in the future. Strategic planning translates the

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, Daft (2003). A firm’s vision and mission is

encapsulated in its strategic planning framework. There are feedback loops at different

stages, and the feedback to ‘strategic planning’ at the project evaluation and decision

Accept Reject


stages – indicated by upward arrows in Figure 1 – is critically important. This feedback

may suggest changes to the future direction of the firm, which may in effect, cause

changes to the firm’s strategic plan Dayananda et al (2002).

3.2.2 Identification of investment opportunities

According to Dayananda et al (2002), the identification of investment opportunities and

generation of investment project proposals is an important step in the capital budgeting

process. They proposed that the projects have to fit in with a firm’s corporate goals, its

vision, mission and long-term strategic plan. Of course, if an excellent investment

opportunity presents itself the corporate vision and strategy may be changed to

accommodate it. Thus, there is a two-way traffic between strategic planning and

investment opportunities. Deyananda et al (2002) went on to argue that this is very

tactical level of the capital budgeting process because, some investments are mandatory –

for instance, those investments required to satisfy particular regulatory, health and safety

requirements – and they are essential for the firm to remain in business. Other

investments are discretionary and generated by growth opportunities, competition, cost

reduction opportunities and so on (ibid). Some firms have research and development

(R&D) divisions constantly searching for and researching into new products, services and

processes and identifying attractive investment opportunities. Sometimes, excellent

investment suggestions come through informal processes such as employee chats in a

staff room or corridor (ibid).

3.2.3 Preliminary screening of projects

The next stage after identifying various investment opportunities is to do initial

screening. It is obvious that all the identified opportunities cannot go through the rigorous

project analysis process. Therefore, the identified investment opportunities have to be

subjected to a preliminary screening process by management to isolate the marginal and

unsound proposals, because it is not worth spending resources to thoroughly evaluate

such proposals. Dayananda et al (2002) suggested that the preliminary screening may

involve some preliminary quantitative analysis and judgements based on intuitive

feelings and experience.


3.2.4 Financial appraisal of projects

The next stage after the initial screening of identified projects is to go through rigorous

financial appraisal to ascertain if they would add value to the firm. According to

Dayananda et al (2002), this stage is also called quantitative analysis, economic and

financial appraisal, project evaluation, or simply project analysis. This project analysis

may predict the expected future cash flows of the project, analyse 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. Thus, the

project analysis can involve the application of forecasting techniques, project evaluation

techniques, risk analysis and mathematical programming techniques such as linear

programming. The financial appraisal stage will provide the estimated contribution that

the project would make towards the increase of the firm’s value in terms of the projects’

net present values. “If the projects identified within the current strategic framework of the

firm repeatedly produce negative NPVs in the analysis stage, these results send a message

to the management to review its strategic plan” (ibid). It is noteworthy therefore that 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 will therefore

influence the project selection or investment decisions.

3.2.5 Qualitative factors in project evaluation

Dayananda et al (2002), continued that when a project passes through the quantitative

analysis test, it has to be further evaluated taking into consideration some qualitative

factors. Qualitative factors are those which will have an impact on the project, but are

virtually impossible to be evaluated accurately in monetary terms. They suggested the

following factors for consideration:

• the societal impact of an increase or decrease in employee numbers

• the environmental impact of the project

• possible positive or negative governmental political attitudes towards the project

• the strategic consequences of consumption of scarce raw materials


• positive or negative relationships with labour unions about the project

• possible legal difficulties with respect to the use of patents, copyrights and trade

or brand names

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

They argued that some of the items in the above list affect the value of the firm, and some

not. The firm can address these issues during project analysis, by means of discussion and

consultation with the various parties, but these processes will be lengthy, and their

outcomes often unpredictable. This stage will require considerable management

experience and judgemental skill together with high level of think-tack to incorporate the

outcomes of these processes into the project analysis. In some cases, however, those

qualitative factors which affect the project benefits may have such a negative bearing on

the project that an otherwise viable project will have to be abandoned.

3.2.6 The accept/reject decision

Having done the critical quantitative and qualitative analysis, the NPV results from the

quantitative analysis combined with those qualitative factors will form the basis of the

decision support information. The analyst relays this information to management with

appropriate recommendations. Management considers this information and other relevant

prior knowledge using their routine information sources, experience, expertise, ‘gut

feeling’ and, of course, judgement to make a major decision – to accept or reject the

proposed investment project (ibid).

3.2.7 Project implementation and monitoring

Once investment projects have passed through the decision stage they must be

implemented by management without any further delay. During this implementation

phase various divisions of the firm like sales and marketing, production and technical are

likely to be involved. An integral part of project implementation is the constant

monitoring of project progress. This would enable management to identifying potential

bottlenecks thus allowing early intervention. Deviations from the estimated cash flows


need to be monitored on a regular basis so that corrective actions will be taken when

needed.

3.2.8 Post-implementation audit

Dayananda et al suggest that, 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. They said that, “An evaluation of the performance of past

decisions, however, can contribute greatly to the improvement of current investment

decision-making by analysing the past ‘rights’ and ‘wrongs’. The post-implementation

audit can provide useful feedback to project appraisal or strategy formulation. For

example, ex post assessment of the strengths (or accuracies) and weaknesses (or

inaccuracies) of cash flow forecasting of past projects can indicate the level of confidence

(or otherwise) that can be attached to cash flow forecasting of current investment

projects” (ibid). This might also be important because if projects are undertaken within

the framework of the firm’s current strategic plan and they do not prove to be as lucrative

as predicted, the audit information can prompt management to consider a thorough

review of the firm’s current strategic plan.

4.0 DETERMINANTS OF CAPITAL BUDGETING PRACTICES

As was shown in the previous section, over time, financial managers have applied various

methods and procedures to determine which investments are beneficial to the firm. The

choice of the evaluation method may therefore be determined by individual preferences

of the manager and/or by the environment in which decisions have to be made.

While in the literature several factors have been mentioned as determinants of the choice

of capital budgeting practices, in this paper the researcher wants to focus on the role that

is played by the level of economic development in this respect. The review of studies of

capital budgeting practices in the previous section showed that over time, the use of more

sophisticated DCF methods has become more popular. This may be explained by various

factors. First, financial markets have developed over time, making the use of DCF

methods more applicable, convenient and necessary. Due to the development of financial


markets (and especially stock markets) shareholder’s value maximization has gained high

importance, which has pressured CFOs of companies to use DCF methods over other

simpler and less accurate alternatives. Second, training of CFOs has improved over time,

which may have enabled them to better understand and thus use more sophisticated

techniques. Third, financial tools and programmes that help the CFO to determine which

investments are beneficial to the firm have become increasingly sophisticated, which may

also have stimulated the use of more sophisticated techniques. Finally, the increased use

of computer technology and the related reduction in the cost of this technology may have

stimulated the use of more sophisticated techniques.

This researcher believes that these factors are all related to increasing levels of

development. More developed countries generally tend to have more sophisticated

financial markets, Levine (1997) higher levels of human capital, Schultz (1988), Boozer

et al (2003), and higher levels of technology, Evenson (1988). This would also mean that

the level of economic development of a country and the sophistication of the capital

budgeting techniques implemented by CFOs in that country are positively related. In

general terms, therefore, it could be expected that CFOs of companies in more developed

countries use DCF methods significantly more often than do their counterparts in less

developed countries. The opposite may hold for the use of non-DCF methods. It is this

hypothesis that will be investigated in this study, using information from Europe and

West African CFOs with respect to their capital budgeting practices.

Although since the late 1980s some West African countries have seen some impressive

economic growth, over the period, the researcher believes that at the beginning of the

new millennium there was still a wide gap in levels of economic, human and

technological development between West African countries and the developed countries

such as Europe. Whiles the investment in high returns projects will facilitate the

development efforts of these poor nations, the researcher also believes that the use of

sophisticated capital budgeting techniques will help the West African CFOs to identify

the most profitable projects and thereby helping their governments to achieve economic

heights. The high level of economic and technological developments in the developed


countries have facilitated the ability to make use of very sophisticated techniques, which

are more likely to produce more reliable results. Therefore, the researcher hypothesizes

that CFOs of European companies will use NPV and IRR methods more often than do

West African CFOs, whereas the opposite will be true for the PB and ARR methods.

To test the hypothesis the researcher will also take into account other variables that

according to the literature may also explain the use of capital budgeting practices,

Brounen, et al. (2004) and Graham and Harvey (2001). These variables will be included

in the multivariate analysis as control variables. In particular, the researcher included

measures of the size of the firm, the industry to which the firm belongs, and the

educational level and age of the CFO of the firm. Firm size is included because some

papers have argued and indeed found evidence for the fact that larger companies are more

inclined to use more sophisticated capital budgeting techniques (Payne, et al., 1999; Ryan

and Ryan, 2002; Brounen, et al., 2004). One important reason for this may be that larger

companies generally deal with larger projects, which makes the investment in the use of

more sophisticated techniques less costly (Payne, et al., 1999). Based on this argument,

the researcher expects to find a positive relationship between firm size and the use of

DCF methods.

The measure of the educational level of the CFO is included, since it may be expected

that CFOs with higher levels of education will have less problems in understanding and

using more sophisticated capital budgeting techniques. Again, therefore, the researcher

expects a positive relationship between the level of the educational background of the

CFOs of the companies and the use of DCF methods. With respect to measures of the

industry and age of the CFO, there are no specific and priori expectations about the

nature of the relationship.

5.0 SURVEY DESIGN AND METHODOLOGY

The data for the analysis have been obtained by using the results of structured

questionnaires. The questionnaires were sent to 225 Europe and 120 West African listed

and non-listed companies in the period between August 2006 and January 2007. The


questionnaires consisted of a number of multiple choice questions related to capital

budgeting practices of companies, questions specifying firm characteristics, such as size,

foreign sales and industry, as well as questions asking for the age and educational

background of the respondent.

With respect to the questions related to capital budgeting practices the researcher asked

companies to indicate the frequency of the use of different project evaluation techniques

(running from 0 to 4, where 0 = never and 4 = always), the cost of capital estimation

method used most frequently, the use of methods to estimate the cost of equity. To

increase the chances of getting responses from the companies, the researcher decided to

keep the survey as short as possible. In total, I included only fifteen questions. The same

set of questions was sent to European and West African companies. The questions were

all structured in English and were sent by post. To increase the level of response, two

reminders were sent to the companies: the first one was two weeks and the second three

weeks after the original questionnaires were sent, all by email. The questionnaire was to

be completed by the CFO of the company or any person in financial authority. The

researcher received 36 responses, 28 from Europe and 8 from West African companies,

resulting in a response rate of 12 per cent for the European and 6 per cent for the West

African companies sampled. These response rates are somewhat on average to those

found in other studies. For example, Graham and Harvey (2001) report a response rate of

9 per cent; Trahan and Gitman (1995) have a rate of 12 per cent and Brounen, et al.

(2004) reports a rate of 5 per cent. Kester, et al. (1999) shows an average response rate

for the five Asian countries of 15.5 per cent.

6.0 RESEARCH RESULTS AND ANALYSIS

This section first describes and compares the characteristics of European and West

African companies in the sample that was considered to be relevant as determinants of

their capital budgeting practices. Next, it discusses the outcomes related to the answers to

the questions on capital budgeting practices, focusing on the use of different capital

budgeting techniques and methods used to estimate cost of capital and equity. Finally, the

researcher present a univariate and multivariate analysis of the relationship between firm


characteristics and capital budgeting practices for the European and West African

companies in the sample.

6.1 Company and CFO Characteristics

Table 1 shows the information on the characteristics of both the European and West

African companies in the sample. With respect to total sales the table shows that the

European companies on average report higher sales than the West African companies.

While 36 per cent of the European companies have sales of more than 1 billion dollars,

none of the West African companies reports sales in this category. About 55 per cent of

the West African companies have sales of 100 million dollars or above, while the

remainder have sales less than 100 millions dollars. If small companies are classified as

having sales of less than 100 million dollars, medium-sized companies having sales of

between 100-499 million dollars, and large companies having sales of 500 million dollars

or more, then the figures indicate that majority of the European companies responding to

this study fall within the large companies category, whereas the West African companies

responding to the study mainly consist of medium-sized and small-sized companies.


Table 1: Company Characteristics Europe (%) West African (%)

Sales (US$ million): Less than 25 million 18 12 25 – 99 million 12 36 100 – 499 million 25 50 500 – 999 million 12 12 More than 1 billion 36 0 Foreign sales (% of total sales: No foreign sales 4 37 1 – 24% 18 38 25 – 49% 25 25 50 – 99% 53 0 100% 0 0 Industry Manufacturing 53 62 Technology 21 0 Retail and Wholesale 12 12 Transport and Energy 20 26 Financial 4 0 CFO’s Level of Education: Professional (Undergraduate) 12 38 MBA 20 25 Non-MBA Master 42 25 PhD 26 12 Age of CFOs: Less than 40 years 7 0 40 – 49 years 48 62 50 – 59 years 45 37 More than 60 0 0 Source: survey results

Additionally, with respect to the share of foreign sales both samples differ quite

substantially. Whereas 75 per cent of the West African companies report that their

foreign sales are zero or are less than 25 per cent of total sales, about 65 per cent of the

European companies state they have 50 per cent or more foreign sales. Table 1 also

shows that more than 50 per cent of the European and about two thirds of the West

African companies are classified as manufacturing companies. It also provides

information on CFO characteristics. In general, European CFOs seem to have a higher

level of education. Whereas almost 70 per cent of the European CFOs have a non-MBA

master or PhD, this is only 37 per cent for the West Africa CFOs. At the same time, 38

per cent of the West Africa CFOs have an undergraduate degree or professional

qualification as their highest level of education; for the European CFOs this is only 12

per cent. With respect to the age structure CFOs in both countries are rather similar.


6.2 Capital Budgeting Techniques

The first question in the questionnaire relates to the capital budgeting practices of

companies. Similar to Graham and Harvey (2001) and Brounen, et al. (2004), the

researcher asked companies to rate different capital budgeting methods on a 4-point scale

in terms of the frequency with which they are used (where 0 = never and 4 = always).

This provides information with respect to the methods that are being used, and also with

respect to the relative importance of the different methods. The following capital

budgeting techniques are used: two DCF methods (NPV and IRR), two non-DCF

methods (PB and ARR) and other techniques. As was already discussed above, from a

pure theoretical point of view the NPV is the most accurate technique. Yet, it is also the

most sophisticated of the four, followed by the IRR method. Both non-DCF methods are

considered to be less accurate, of which the PB method is the least sophisticated method,

Dayananda et al, 2002.

Table 2 shows the results of the responses from European and West African companies.

First of all, the table shows the percentage of CFOs who indicate that they always or

almost always use a certain capital budgeting method (scores 3 and 4). Next, the table

shows the mean scores for the different methods in both continental blocs. Finally, the

table shows the mean scores for different methods of different categories of companies,

using the characteristics of companies and CFOs discussed in table 1 to categorize

companies in sub-samples.

Before going into the analysis of the differences between the European and West African

CFOs, let me shortly discuss this results and compare them to those of other studies

relevant for this analysis. The row labelled “% 3 and 4 scores” presents the percentage of

companies that indicate they use a certain capital budgeting method always (score = 4) or

almost always (score = 3). The row labelled “mean” gives the mean score of all

companies, using a 0 (never) to 4 (always) scale. The other rows show mean scores of

different categories of companies, based on firm characteristics discussed in table 1. The

figures in italics are t-test statistics based on standard differences of mean test, showing

whether the averages for the different categories of companies are significantly different


from each other. The t-test statistics shown for the mean scores of West Africa report

whether they are significantly different from the mean scores reported for the Europe. (a),

(b), (c) are significance levels of 10, 5 or 1 per cent respectively. Table 2: Capital Budgeting Methods Used by CFOs NPV IRR PB ARR Other

Europe (N = 42) % responding 3 & 4 scores 89 75 79 7 7 Mean Score 3.50 2.98 3.10 0.24 0.17 Total Sales <$500 million

3.27

2.73

3.36

0.09

0.05

≥$500 million 3.75 3.25 2.80 0.40 0.30 2.30(b) 1.32 2.10(b) 1.33 1.56 CFOs Edu. (Master/PhD) Yes

3.55

3.00

3.10

0.10

0.14

No 3.38 0.70

2.92 0.18

3.08 0.09

0.54 1.76(a)

0.23 0.51

Age of CFOs < 50 yrs

3.52

2.78

3.17

0.22

0.09

50 yrs or older 3.47 0.22

3.21 1.07

3.00 0.61

0.26 0,19

0.26 1.06

Industry: Manufacturing

3.52

3.14

3.00

0.05

0.24

Others 3.48 0.22

2.81 0.83

3.19 0.68

0.43 1.66(b)

0.10 0.86

Foreign Sales: < 50% of sales

3.55

3.15

3.40

0.20

0.00

≥50% of sales 3.45 0.43

2.82 0.82

2.82 2.17(b)

0.27 0.31

0.32 1.98(a)

West Africa (N = 8) % responding 3 & 4 scores 50 87 75 12 0 Mean Score 2.51

4.43(c) 3.38

1.82(a) 3.16 0.35

1.00 3.92(c)

0.02 1.73(a)

Total Sales <$100 million

2.12

3.29

3.00

0.82

0.00

≥$100 million 2.75 1.65(a)

3.43 0.64

3.25 1.22

1.11 0.90

0.04 0.78

CFOs Edu. (Master/PhD) Yes

2.95

3.45

3.00

0.70

0.00

No 2.16 2.15(b)

3.32 0.63

3.28 1.40

1.24 1.81(a)

0.04 0.89


3.13

3.48

3.00

1.00

0.04

50 yrs or older 1.86 3.82(c)

3.27 1.01

3.32 1.61

1.00 0.00

0.00 0.86


2.43

3.43

3.10

1.03

0.03

Others 2.67 0.58

3.27 0.77

3.27 0.78

0.93 0.31

0.00 0.70

Foreign Sales: Yes

2.97

3.42

3.03

1.03

0.00

No 1.50 4.21(c)

3.29 0.60

3.43 1.88(a)

0.93 0.31

0.07 1.51


6.2.1 European CFOs

Table 2 shows that the NPV method is the most popular method among the European

CFOs. 89 per cent of the respondents indicated they use this method (almost) always, and

its mean score is 3.50, which is 0.40 above the second most popular method (the PB

method). The IRR and PB method are quite comparable in terms of their mean scores and

percentage of CFOs who say they use these methods (almost) always. The ARR method

is clearly the least popular: its mean score is 0.24 and only 7 per cent of the CFOs in the

sample stated that they use this method (almost) always.

If these results for the European CFOs are compared with those found in Brounen, et al.

(2004), it seems that this finding has significantly higher percentages and mean scores for

most of the methods reported in the survey. Brounen, et al. show that 70, 56 and 65 per

cent of companies (almost) always use the NPV, IRR or PB method respectively, and

they report mean scores of 2.76, 2.36 and 2.53, respectively. The differences between

their findings and this study may be due to the fact that in their sample there are more

smaller companies: almost 40 per cent of their companies have total sales between 25 and

102 million dollars, whereas in this study I have no respondent of the companies in this

size category. In contrast, in this study 36 per cent of the companies have sales of more

than 1 billion dollars, whereas in the sample of the study by Brounen, et al. only 20 per

cent of the companies is in this size category.

Table 2 also shows the results of a standard difference of mean test of the mean scores of

the NPV, IRR, PB and ARR method for the five different categories of companies listed

in table 1 (size, educational level of the CFO, age of the CFO, industrial sector and

percentage foreign sales of total sales). The results of these tests show that for larger

companies the mean score for the NPV method is significantly higher (at the 5 per cent

level) than for smaller companies. The opposite is true for the PB method. With respect

to the PB method, the table also shows that companies with lower foreign sales have

significantly higher mean score than companies with higher foreign sales. The other


mean tests report either insignificant t-values or values that are only significant at the 10

per cent level. These results are comparable to similar tests results presented in Brounen,

et al., who also find that larger companies have significantly higher mean scores for the

NPV method. They, however, do not find significant differences for any of the other

methods for any of the categories of companies they use in their study.

6.2.2 West African CFOs

Table 2 shows that the IRR and the PB method are the most frequently used methods.

87 and 75 per cent of the CFOs in the sample stated that they use these methods (almost)

always. The NPV method is used much less: only 50 per cent of the CFOs report they use

this method (almost) always. Looking at the mean scores the IRR and PB method are

comparable with 3.38 and 3.16 mean score respectively, whereas the NPV method’s

score falls behind with only 2.51. In the researcher’s opinion, the use of IRR scored very

high in these countries because of the unstable nature of inflation and interest rates in

those countries. As was true for the European companies sampled, the ARR method is the

least popular. The mean score for this method is 1.00 and only 12 per cent of the West

African CFOs in this sample say they use this method (almost) always. The researcher is

unable to compare the results for West Africa with those found in other studies, simply

because the researcher couldn’t find any literature on capital budgeting practices in West

Africa. Probably the best comparison to make here is by looking at the outcomes of a

survey of capital budgeting practices for five Asian countries carried out by Kester, et al.

(1999). This is based on the assumption that one can look at most of these countries as

developing countries as compare to their fellow West African counterpart.

As already mentioned in section 2, Kester et al (1999) found that 95 per cent of the Asian

companies in their sample indicate they use the PB method, whereas 88 per cent report

they use the NPV method. The mean scores for both methods are 3.5 and 3.4 (on a scale

of 5), respectively. Although it is difficult to make a simple comparison between the

outcomes of the survey by Kester, et al and this study results, since the questions in their

survey were slightly different from the ones used here, these figures nevertheless seem to

suggest that CFOs in West Africa use the NPV method on a much less regular basis than


their colleagues in other developing countries like those in Asia. The results of the

standard differences of mean test of the mean scores of the NPV, IRR, PB and ARR

method for the five different categories of companies and CFOs show that, for the higher

educated and younger CFOs the mean score for the NPV method is significantly higher

than for the lower educated and older CFOs. Also, companies with foreign sales have a

significantly higher mean score for the NPV method than companies with no foreign

sales. The mean score of the NPV method of the larger companies is higher than for the

smaller companies, yet the t-value is only just significant at the 10 per cent level. The

other mean tests report either insignificant t-values or values that are only significant at

the 10 per cent level. Kester, et al. do not report mean scores of different categories of

companies, so it is very impossible to make any comparisons.

6.2.3 European versus West African CFOs

First, European CFOs seem to use the NPV method more often than their colleagues in

West Africa. Whereas 89 per cent of the European CFOs indicate they (almost) always

use this method, this is only true for 50 per cent of the West African CFOs. Instead, the

IRR method is used more by West African CFOs than by European CFOs (87 versus 75

per cent). The differences with respect to the use of the NPV and IRR method in the

Europe and West Africa are confirmed when looking at the mean scores. In Europe the

mean score for the NPV method is 3.50 whereas in West Africa it is 2.51. For the IRR

method, mean scores are 2.98 and 3.38, respectively. The differences of the mean scores

with respect to the use of the NPV and IRR method between European and West African

CFOs are statistically significant, as shown in table 2 (see the t-values in italics presented

in the row below the mean scores for West Africa). Note, however, that for the IRR

method the difference is only significant at the 10 per cent level. Although the PB method

seems to be more popular among European CFOs responding to this study (79 per cent of

the European CFOs indicate they (almost) always use this method, against 75 per cent for

the West African CFOs), the difference between the mean scores of West Africa versus

the Europe is not statistically significant. Finally, the ARR method is not used very much

in both West Africa and the Europe; yet the analysis shows that the mean score for the

West African CFOs is significantly higher than the score for their European counterparts


(1.00 versus 0.24). The above discussion seems to suggest that the European CFOs are

using the most sophisticated capital budgeting method (i.e. NPV) on a significantly more

regular basis than their West African colleagues do. Instead, West African CFOs use the

less sophisticated ARR method significantly more than the European CFOs. This result

seems to partly confirm the research hypothesis that, based on the fact that there is quite

some difference in the level of economic development of the two continental blocs, on

average European CFOs will use more sophisticated capital budgeting methods than their

West African colleagues.

6.3 Cost of Capital Estimation Methods

The next important question in the questionnaire focuses on the methods that are used to

estimate the cost of capital. Estimating the cost of capital is necessary when a firm

applies discounting techniques like the NPV or IRR method. The researcher asked

companies to indicate which method they use most frequently when estimating the cost

of capital. In particular, CFOs are asked to make a choice out of the following set of

possible methods, i.e. the project dependent (risk-adjusted) cost of capital (PDCC), the

weighted average cost of capital (WACC), the cost of debt and other methods. Whereas

the PDCC and WACC are the more sophisticated methods, the cost of debt is clearly the

least sophisticated of the three methods. In fact, using the cost of debt for capital

budgeting purposes is in most cases not appropriate. Yet, since in many cases projects are

financed by newly issued debt, using the cost of debt is tempting, and also because of the

ease with which it can be calculated.

Table 3 presents the results of the responses from European and West African companies.

In particular, it presents the percentage of companies that indicates that a certain method

of cost of capital estimation is the one they use most frequently. The researcher again

used the characteristics of companies and CFOs discussed in table 1 to categorize

companies in sub-samples. The percentages given in this table refer to the share of CFOs

in each of the categories, using DCFs methods, who indicated that certain discount rate is

the one they use most frequently. Total percentages for different categories of companies

may add up to more or less than 100 per cent due to rounding errors.


Table 3: Most Frequently Used Methods to Measure the Cost of Capital (% of total) Project dependent

(risk-adjusted) cost of capital

(PDCC)

Weighted Average Cost of Capital

(WACC)

Cost of debt (CD)

Other Methods

Europe (N = 28) % of total companies

10.7 67.9 14.3 7.1


14.3

64.3

21.4

0.0

≥$500 million 5.0 70.0 5.0 20.0


13.8

62.1

10.3

13.8

No 0.0 76.9 23.1 0.0


13.0

56.5

21.7

8.7

50 yrs or older 5.3 78.9 5.3 10.5


14.3

71.4

14.3

0.0

Others 4.8 61.9 14.3 19.0 Foreign Sales: < 50% of sales

10.0

65.0

20.0

5.0

≥50% of sales 9.1 68.2 9.1 13.6

West Africa (N = 8) % of total companies 12.5 50 25 12.5 Total Sales <$100 million

5.9

47.1

47.1

0.0

≥$100 million 21.4 57.1 17.9 3.6


15.0

70.0

15.0

0.00

No 16.0 40.0 40.0 4.0


21.7

69.6

4.3

4.3

50 yrs or older 9.1 36.4 54.5 0


13.3

43.3

40.0

3.3

Others 20.0 73.3 6.7 0.0

Foreign Sales: Yes

19.4

54.8

25.8

0.0

No 7.1 50.0 35.7 7.1


6.3.1 European CFOs

The results in table 3 show that 67.9 per cent of the European companies state that they

use the WACC for discounting purposes. Only 10.7 per cent of the companies use a

project dependent (risk-adjusted) cost of capital. In addition, table 3 shows that a

relatively large number of European companies (14.3 per cent) use the simple cost of

debt as the discount rate. When looking at the results for different sub-samples of

companies, a couple of points are noteworthy. Small companies use the cost of debt more

often than large companies do: 21.4 versus 5.0 per cent. In addition, CFOs with higher

levels of education make less use of the cost of debt than less educated CFOs. Less

educated European CFOs do not use a project dependent (risk-adjusted) cost of capital at

all, while 13.8 per cent of the higher educated CFOs indicate that they use this one the

most frequently.


Of the West African companies, 50 per cent indicate that they use the WACC most

frequently, 25 per cent mention the cost of debt, while 12.5 per cent state that they use the

project dependent cost of capital most often. Compared to the European companies, West

African companies appear to use the cost of debt more often. In addition, like European

CFOs, West African CFOs with higher levels of education use the cost of debt less often

than their less educated colleagues. Moreover, small West African companies use the cost

of debt more often than larger companies. This result is consistent with those for the

European companies in this sample. In contrast to their European counterparts, however,

older West African CFOs are more inclined to use the cost of debt. The level of CFO

education does not seem to influence the use of the project dependent (risk-adjusted) cost

of capital.


In all, when looking at the methods used to measure the cost of capital, the outcomes

presented in table 3 suggest that the main differences between West Africa and Europe

are with respect to the use of the cost of debt. In West Africa, the cost of debt is used

more often than in Europe. Based upon the difference in the level of economic


development between the two continental blocs, this may be expected, since the cost of

debt is a relatively simple method of calculating the cost of capital. Moreover, most

companies in West Africa are significantly small in size as compare to those in the

European countries, hence the use of the simpler methods.

6.4 Cost of Equity Estimation Methods

The researcher finally asked companies to indicate which methods they use to estimate

the cost of equity. Estimating the cost of equity is necessary when a firm applies

discounting techniques like the NPV or IRR method. The cost of equity is an input for

calculating the project dependent (risk-adjusted) cost of capital and the WACC. The

researcher asked companies to indicate which methods they use most frequently when

estimating the cost of equity. In particular, companies were asked to indicate whether

they make cost of equity estimations, and if they do, what type of method they use most.

Although there are several possible methods available, the survey results showed that

companies basically use two (in the Europe) or three (in West Africa) different methods

on a regular basis. The following methods were mentioned by the respondents: average

historical returns on common stock, Capital Pricing Asset Model (CAPM), no estimation

done, and other methods (e.g. dividend discount type of models). Of these methods, the

CAPM can be seen as the most sophisticated model.

Table 4 presents the results of the responses from European and West African companies.

In particular, it presents the percentage of companies that indicates that a certain method

of cost of equity estimation is the one they use most frequently. The researcher again

used the characteristics of companies and CFOs discussed in table 1 to categorize

companies in sub-samples. The percentages between brackets in columns 3, 4 and 5 refer

to the share of companies that indicate they do estimate the cost of equity. So, for

instance if all the European companies in this sample stated they do estimate the cost of

equity, 52 per cent uses the CAPM.


Table 4: Most Frequently Used Methods to Estimate the Cost of Equity (% of total) No

Estimation done

Average historical returns on common

stock

Capital Asset Pricing Model

(CAPM)

Other Methods

Europe (N = 28) % of total companies

35.7 0.0 33.3 (52.0) 31.0 (48.0)


31.8

0.0

27.3(40.0)

40.9(60.0)

≥$500 million 40.0 0.0 40.0 (66.7) 20.0 (33.3)


34.5

0.0

24.1 (36.8)

41.4

No 38.5 0.0 53.8 (87.5) 7.7 (12.5)


43.5

0.0

30.4 (53.8)

26.1 (46.2)

50 yrs or older 26.3 0.0 36.8 (50.0) 36.8 (50.0)


19.1

0.0

42.9 (53.0)

38.1 (47.0)

Others 52.4 0.0 42.9 (50.0) 23.8 (50.0) Foreign Sales: < 50% of sales

30.0

0.0

35.0 (50.0)

35.0 (50.0)

≥50% of sales 40.9 0.0 31.8 (53.8) 27.3 (46.2)

West Africa (N = 8)

% of total companies 64.4 4.4 (12.7) 24.4 (68.5) 6.7 (18.8) Total Sales <$100 million

76.5

0.0

17.6 (74.9)

5.9 (25.1)

≥$100 million 57.1 7.1 (16.7) 28.6 (66.7) 7.1 (16.7)


55.0

5.0 (11.1)

35.0 (77.8)

5.0 (11.1)

No 72.0 4.0 (14.3) 16.0 (57.1) 8.0 (28.6)


43.5

4.4 (7.8)

39.1 (69.2)

13.0 (23.0)

50 yrs or older 86.4 4.6 (33.8) 9.1 (66.2) 0.0


66.7

3.3 (9.9)

20.0 (60.1)

10.0 (30.0)

Others 60.0 6.7 (16.7) 33.3 (83.3) 0.0

Foreign Sales: Yes

51.6

6.5 (13.3)

32.3 (66.7)

9.7 (20.0)

No 92.9 0.0 7.1 (100.0) 0.0


6.4.1 European CFOs

The results in table 4 show that almost 36 per cent of the European companies in this

study stated that in most cases they do not estimate the cost of equity. Of the companies

that do regularly estimate the cost of equity, roughly half of them stated that they use the

CAPM in most cases. When looking at the results for different sub-samples of

companies, the table shows that 80 per cent of the manufacturing companies stated they

do regularly estimate the cost of equity, a percentage that is much higher than that of the

total sample of European companies. When splitting up the companies into two groups

based on the age of the CFO, the table shows that companies with younger CFOs seem to

be much less regularly making cost of equity estimations than companies with older

CFOs (26 versus 44 per cent).

If we turn to the outcomes for those companies that do make frequent estimations of the

cost of equity, the table shows that CFOs of smaller companies less frequently use

CAPM as compared to their colleagues of larger companies. Moreover, CFOs with lower

levels of education use the CAPM more often than highly educated CFOs do. Given the

fact that CAPM is the most sophisticated method, the results with respect to the

educational level of the CFO may be somewhat surprising and cannot easily be

explained. For this, one might have to know more about what the respondents will

include in the category “other methods”, since it turns out to be about 41 and 8 per cent

for higher and lower level of educated CFOs respectively, but unfortunately this

information is lacking in this questionnaire. One plausible explanation may be that other

methods used by European companies consist of methods such as dividend discount

models, which belong to the more sophisticated DCF-methods. For the other sub-

samples, there is no big difference in the use of methods between different types of

companies or CFOs.


With respect to the West African companies in the sample, table 4 shows that the

percentage of companies stating that they do not regularly make cost of equity

estimations is much higher than for Europe: almost 65 per cent for West Africa versus 36


per cent for Europe. The table also shows that there are quite some differences for several

of the sub-samples on the issue of whether or not estimations of the cost of equity are

made on a regular basis. In particular, smaller companies, companies with no foreign

sales, and companies with CFOs who are older or have lower levels of education make

cost of equity estimations (much) less frequently. Of the companies that do regularly

estimate the cost of equity, almost 70 per cent stated that they use CAPM in most cases,

whereas 13 per cent say that they use average historical returns on common stock as their

estimation method. Looking at different sub-samples, the table suggests that higher

educated CFOs use the CAPM much more frequently than CFOs with lower levels of

education (78 percent versus 57 per cent). Moreover, older CFOs seem to use average

historical returns quite often as their method of estimating cost of equity (34 per cent).

These outcomes for sub-samples are more or less in line with what has been hypothesized

above.


To conclude the analysis in this sub-section, the outcomes presented in table 4 show that

there seems to be quite some difference with respect to the use of techniques between

Europe and West Africa. In particular, the results from the questionnaire seem to

establish that the European CFOs are more inclined to use more sophisticated methods to

estimate cost of equity. This outcome is in line with what may be expected based on the

differences in the level of economic development between the two economies. It also

seems to confirm what was already found before in table 2, that European CFOs use

discounting techniques, and in particularly the NPV method, significantly more often

than West African CFOs do. This probably explains the higher percentage of European

CFOs reporting they make use of cost of equity estimations as compared to their West

African colleagues.

6.5 Capital Budgeting Techniques, Cost of Capital and Cost of Equity Estimations:

Multivariate Analysis

The discussion in the previous sub-sections was based on comparing averages. Although

the discussion provided some interesting results on the differences in the use of capital


budgeting methods between Europe and West Africa, in this section, the researcher wants

to go one step further by performing multivariate regression analysis. In particular, the

researcher wants to investigate whether the use of different capital budgeting techniques

and different methods of estimating the cost of capital is determined by a so-called

country effect, i.e. to ask ourselves whether it matters if the company is European or

West African when it decides on using a capital budgeting, cost of capital, and/or cost of

equity estimation method. When investigating this country effect, the researcher made a

consideration for other factors, such as market size, cultural and political environment,

that may influence the choice of capital budgeting, cost of capital, and/or cost of equity

estimation methods.

6.5.1 The Multivariate Analysis

The multivariate analysis is set up as follows. The researcher estimated two different

versions of three different models. The first version of the first model establishes to what

extent the choice of a specific type of capital budgeting method is determined by the

country effect. In the second version of this model, a number of control variables are

added to see if the country effect still holds when adding other possible determinants of

the choice of the capital budgeting method. The first version of the second model

investigates whether the choice of a specific cost of capital estimation method is

determined by the country effect, whereas in the second version of this model I again

introduce a number of control variables to see if the country effect still holds even after

controlling for other possible determinants of the choice of the cost of capital estimation

method. The first version of the third model investigates whether the choice of a specific

cost of equity estimation method is determined by the country effect, whereas in the

second version of this third model I again introduce a number of control variables to see

if the country effect still holds even after controlling for other possible determinants of

the choice of the cost of equity estimation method.

With respect to the first model I tried to investigate the determinants of three different

capital budgeting methods, i.e. the NPV, IRR and ARR method. The PB method has been

left out, since the results in table 2 showed that for this method there was no significant


difference in the mean scores between European and West African companies. The

category of “other methods” has been left out due to the fact that only a very few number

of companies in both Europe and West Africa indicated they used other capital budgeting

methods. With respect to the second model I analyse the determinants of the decision to

make estimations of the project dependent (risk-adjusted) cost of capital, the WACC, as

well as of the cost of debt. The category ‘other methods’ is left out, since the results in

table 3 show that the percentage of both European and West African companies that

using other methods is very low. With respect to the third model I analyse the

determinants of the decision not to make estimations of the cost of equity, as well as of

the CAPM and ‘other methods’. The control variables included are the same for all model

specifications. Thus measures of size, level of education of the CFO, age of the CFO and

type of Industry.

The dependent variables are binary dummy variables. In table 5, the dependent variables

are created as follows: NPV = 1 if the score for a company for the NPV method is 3 or 4,

it is 0 if the score of a company is less than 3; IRR = 1 if the score for a company for the

IRR method is 3 or 4, it is 0 if the score of a company is less than 3; ARR = 1 if the score

for a company for the ARR method is 1 or higher, it is 0 if the score of a company is 0.

The dependent variables used in table 6 are defined as follows: PDCC = 1 if a company

indicates that in most cases it uses a project dependent (risk-adjusted) cost of capital, it is

0 if this is not the case; WACC = 1 if a company indicates it uses the weighted average

cost of capital on a regular basis to estimate the cost of capital, it is 0 if this is not the

case; CD = 1 if a company indicates it uses the cost of debt as an estimate for the cost of

capital on regular basis, it is 0 if this is not the case. Finally, the dependent variables used

in table 7 are defined as follows: NOCC = 1 if a company indicates that in most cases it

does not make estimates of the cost of equity, it is 0 if it does make estimations of the

cost of equity on a regular basis; CAPM = 1 if a company indicates it uses the CAPM on

regular basis to estimate the cost of equity, it is 0 if this is not the case; Other = 1 if a

company indicates it uses another, not explicitly identified model to estimate the cost of

equity, it is 0 if this is not the case. The researcher have excluded the share of foreign

sales to total sales as one of the control variables, since with respect to this variable the


West African and European companies cannot really be compared in the context of a

multivariate analysis. For the West African companies in the sample 30 per cent does not

have foreign sales and another 40 per cent has foreign sales less than 25 per cent. Instead,

half of European companies in the sample have foreign sales of more than 50 per cent of

their total sales.

The independent variables are also binary variables. I used the following variable

specifications: West Africa = 1 if the company is a West African company, it is 0 if the

company is European, this variable is used to measure the country effect; Size = 1 if an

European company has total sales of less than 500 million dollars or if a West African

company has total sales of less than 100 million dollars, it is 0 if a European (West

African) company has total sales of 500 (100) million dollars or more; Education = 1 if

the CFO of the company has a PhD or Master degree, it is 0 if (s)he has an undergraduate

degree; AGE = 1 if the CFO of the company is 50 years or older, it is 0 if (s)he is

younger; Industry = 1 if the company is manufacturing company, it is 0 if it is not. The

figures in brackets are t-test statistics and (a), (b), (c) are significant levels of 10, 5 and 1

respectively. All estimations are carried out using the logit estimation method, Hosmer,

D.W. and Lemeshow, S (1989) and Long S J (1997). The results of the multivariate logit

analysis are presented in tables 5, 6 and 7.

6.5.2 Capital Budgeting Techniques

Table 5 shows the results for the determinants of the use of the different capital budgeting

techniques. The results provide the following picture. First, for the NPV method the

country effect is negative and statistically significant (see column [1]). This result can be

interpreted as supportive evidence for the fact that West African companies use the NPV

method significantly less often than European companies do. This finding supports the

hypothesis on the relationship between the level of development and the choice of the

capital budgeting technique as discussed in section 1.3 of this paper. This result holds

even if I include control variables for size, CFO education and age, and type of industry

(column [2]). Moreover, the results show that the choice for the NPV method is also

determined by the size of the company and the age of the CFO; both variables have a


negative and statistically significant coefficient. This means that smaller companies and

companies with older CFOs use the NPV method less often than larger companies and

companies with younger CFOs do. Based on the discussion in section 4 of this paper, the

outcomes with respect to the size variable are as expected.

Table 5: Determinants of Capital Budgeting Methods: Multivariate Logit Analysis NPV NPV IRR IRR ARR ARR [1]

[2] [3] [4] [5] [6]

Constant 2.001(c) (4.20)

2.957(c) (3.35)

1.036(c) (2.95)

1.585(b) (1.88)

-2.001(c) (-4.20)

0.028 (0.04)

West Africa -2.046(c) (-3.64)

-2.324(c) (-3.61)

1.043(a) (1.77)

0.807 (1.32)

2.315(c) (4.10)

2.350(c) (3.68)

Size -1.172(b) (-2.010)

-0.593 (-1.00)

-0.883 (-1.55)

Education 0.525 (0.93)

-0.523 (-0.83)

-1.626(c) (-2.61)

Age -1.212(b) (-2.15)

-0.293 (-0.50)

-0674 (-1.15)

Industry 0.155 (0.27)

0.595 (1.02)

-0.948 (1.53)

Number of Observations

36 36 36 36 36 36

Secondly, table 5 shows that the country effect for the IRR method is positive and

significant, which indicates that the IRR method is used more often by West African

companies than by European companies (column [3]). Note, however, that the coefficient

is only significant at the 10 per cent confidence level. If the control variables are

introduced in the model, the country effect is still positive, yet it becomes insignificant

(column [4]). This suggests that the choice for the IRR method may not really be

different between European and West African companies. This finding is perhaps

somewhat surprising in the light of the hypothesis on the relationship between the level of

development and the choice of the capital budgeting technique as discussed in section 4,

based on which it might have been expected that European companies are more regular

users of DCF methods than West African companies. On the other hand, combined with

the findings with respect to the use of the NPV method, these findings may make sense. It

might be the case that in recent years European companies have been substituting the IRR


method for the NPV method. Consequently the use of the IRR method by European

companies has decreased.

Finally, table 5 shows that the country effect is positive for the ARR method, indicating

that West African companies are using this method significantly more often than

European companies do (column [5]), a result that still holds after introducing the control

variables (column [6]). This result seems to be in line with the hypothesis that has been

formulated on the relationship between the level of economic development and the use of

capital budgeting techniques. Of the control variables, only the education variable is

statistically significant and it has the expected negative sign, meaning that higher

educated CFOs will use the ARR method significantly less, which is consistent with what

is expected.

6.5.3 Cost of Capital Estimation

Table 6 presents the results for the determinants of the use of the different methods of

estimating the cost of capital. For the PDCC and WACC there were no statistically

significant coefficients for the country effect variable, indicating that for these two

methods of estimating cost of capital there is no difference in use between European and

West African CFOs. Although the country effect is positive and statistically significant at

the 10 per cent level in the bivariate model for the cost of debt estimation method

(column [9]), this effect becomes statistically insignificant after the control variables

were added (column [10]). In the extended, multivariate model, the size variable is

positive and statistically significant at the 1 per cent level. Moreover the age variable is

also positive and statistically significant at the 5 per cent level. The result for the size

variable is in line with what may be expected based on the discussion in section 4.


Table 6: Determinants of the Most Frequently Used Methods to Measure the Cost of Capital: Multivariate Logit Analysis

Project dependent

(risk-adjusted) Cost of Capital (PDCC)

Weighted Average Cost of Capita

(WACC)

Cost of Debt (CD)

Cost of Debt (CD)

[7] [8] [9] [10] Constant -2.251(c)

(-4.28) 0.693(a) (2.12)

-1.172(b) (-4.06)

-3.766(c) (-3.61)

West Africa 0.560 (0.84)

-0.560 (-1.26)

0.891(a) (1.62)

0.746 (1.13)

Size 1.886(c) (2.75)

Education -0.974 (-1.52)

Age 1.298(b) (2.02)

Industry 1.213(a) (1.72)


36 36 36 36

6.5.4 Cost of Equity Estimation

Table 7 presents the results for the determinants of the use of the different methods of

estimating the cost of equity. The results can be summarized as follows. First, the country

effect is positive and statistically significant in the model explaining when companies do

not regularly make cost of capital estimations (column [11]), which means that West

African companies do make such estimations on a less regular basis than their European

counterparts. This result holds even after the control variables were added (column [12]).

This outcome seems to be in line with the results presented in table 5, showing that

European companies do use the NPV method significantly more often than West African

companies do.


Table 7: Determinants of Cost of Equity Estimation Methods: Multivariate Logit Analysis

No Cost of

Capital Estimation (NOCC)

No Cost of Capital

Estimation (NOCC

Capital Asset Pricing Mode

(CAPM)

Capital Asset Pricing Mode

(CAPM)

Others Others

[11]

[12] [13] [14] [15] [16]

Constant -0.588(a) (-1.83)

-0.386 (-0.57)

-0.693(b) (-2.12)

0.203 (0.28)

-0.802(b) (-2.40)

-2.90(c) (-2.87)

West Africa 1.182(c) (2.64)

1.283(c) (2.60)

-0.435 (-0.91)

-0.664 (-1.26)

-1837(c) (-2.68)

-1.662(b) (-2.30)

Size 0.308 (0.64)

-0.765 (-1.45)

0.900 (1.40)

Education -0.464 (-0.95)

-0.348 (-0.66)

1.325(a) (1.80)

Age 0.581 (1.23)

-0.798 (-1.55)

0.290 (0.46)

Industry -0.700 (-1.43)

0.135 (0.267)

0.897 (1.36)


36 36 36 36 36 36

Secondly, the country effect is negative but not statistically significant in the models

explaining the use of the CAPM (columns [13] and [14]). Thus, there seems to be no

difference between European and West African companies with respect to the frequency

with which they use the CAPM to estimate cost of capital. Third, table 7 shows that the

country effect is negative and significant for the ‘other methods’, suggesting that West

African companies use other methods less regularly than European companies do

(column [15]). This result remains after adding the control variables (column [16]). If

‘other methods’ can be interpreted as being dividend discount models – which belong to

the sophisticated DCF-methods – then this finding supports the hypothesis on the

relationship between the level of development and the choice of the cost of equity

estimation methods presented in section 4. Since detailed information about the contents

of the other methods category is lacking, this conclusion remains to be only tentative. The

table also shows that the education variable is positive and statistically significant,

confirming the idea that more developed countries make use of estimation methods that

are positively related to the level of education of the CFO.


7.0 SUMMARY AND DISCUSSION

In this paper, it was argued that the use of capital budgeting practices might be related to

the level of economic development. The researcher has given a number of arguments to

support this argument. First, financial markets have developed over time, making the use

of DCF methods more applicable, convenient and necessary. Due to the development of

financial markets (and especially stock markets) shareholder maximization has gained its

importance, which has pressured CFOs of companies to use DCF methods over other,

more simple and less accurate alternatives. Secondly, training of CFOs has improved

over time, which may have enabled them to better understand and therefore use more

sophisticated techniques. Thirdly, tools and packages that help the CFO to determine

which investments are beneficial to the company have become increasingly sophisticated,

which may also have stimulated the use of more sophisticated techniques. Finally, the

increased use of computer technology and the related reduction in the cost of technology

may have stimulated the use of more sophisticated techniques.

This paper has investigated this hypothesis using information on the use of capital

budgeting techniques by companies in the Europe and West Africa. This information was

obtained from a survey among 28 European and 8 West African companies, who

responded to the questionnaires sent to 345 companies. This minimum response was, in

my opinion, due to the limited time allowed for the return of the questionnaires and some

financial constrains. With this information, the researcher carried out the analysis using

standard differences of mean tests and multivariate regression analysis to see whether the

level of economic development matters for the use of capital budgeting practices. I

focused on whether there was a so-called “country effect”, i.e. whether capital budgeting

practices differed significantly between European and West African companies and

whether these differences can be explained by differences in levels of economic

development. The researcher was not aware of any other study in the literature that has

looked at this issue.

The main findings of the analysis can be summarized as follows. First, European CFOs

use the NPV method significantly more often than their West African colleagues do.


Second, West African CFOs use the ARR method significantly more than European

CFOs do. Third, CFOs of West African companies less often make cost of equity

estimations as compared to European CFOs. These results may be explained by the fact

that there is still a gap with respect to the level of economic, financial, human and

technological development between the two continental blocs. At the same time,

however, the study also found that the use of the IRR method does not seem to differ

significantly between European and West African companies. The same is true for the

estimation of the cost of capital and the use of CAPM as a method of estimating the cost

of equity. The latter three results do not lend support to the central hypothesis of this

paper.

Therefore, the researcher will restrain himself from drawing too strong conclusions with

respect to the importance of the “country effect” as an explanation for differences in

capital budgeting practices between the European and West African companies.

However, the researcher still believes that there are some levels of economic factors

among the determinants of the choice of capital budgeting practices.

It is therefore proposed that further research into this issue is required and that more and

larger data sets should be created, in terms of the number of companies and individual

company observations, as well as in terms of the selected countries included in the

research.


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4. Daft, R, 2003, “Management”, Sixth Edition, Thomson Southwestern, Ohio,

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Budgeting: Financial Appraisal of Investment Projects” Cambridge University

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Ghana Governance and Corruption Survey: Evidence from Household,

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York: Wiley

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RESEARCH QUESTIONNAIRES

These questionnaires are for the purpose of academic attainment in Masters of Business

Administration (MBA) in Finance. The researcher intends to find out the use of capital

budgeting methods among the developed and developing countries. It is also intended to

establish if there be any relationship between level of economic, financial, human and

technological development and the choice of capital budgeting methods. No part of any

information provided in these questionnaires will be shared or used for any purpose other

than as stated above. The researcher will therefore be very glad if the person answering

these questionnaires is the Chief Finance Officer (CFO) or in authority of financial

matters within the organisation. Thank you for your participation towards this study.

1. What is your position in the company? CFO Financial Manager

Financial Director Others (Please state) ………………………

2. Which of the following does your age fall? Less than 40 40 – 49

50 – 59 60 or above

3. What is your highest level of education? PhD MBA

Non-MBA Masters Undergraduate/Professional

4. What industry does your company belong? Manufacturing Financial

Technology Transport & Energy Retail & Wholesale

5. What is the total volume of annual turnover in dollars? Less than 25 million

25 – 99 million 100 – 499 million 500 – 999 million

More than 1 billion

6. What percentage of the total sales is made outside the home country of your

company? 100% 50 – 99% 25 – 49% 1 – 25%

No foreign sales

7. Do you use any capital budgeting method to assess projects when making

investment decisions? Yes No


8. If yes, which method(s) do you use? (Please select all that apply) Net Present

Value (NPV) Internal Rate of Return (IRR) Pay Back (PB)

Accounting Rate of Return (ARR) Others

9. On the scale of 0 – 4 , with 4 being the method(s) used always and 0 being never,

how would you rate the frequency of use for the selected methods above? NPV 0

1 2 3 4 ; IRR 0 1 2 3 4 ; PB 0 1 2

3 4 ; ARR 0 1 2 3 4 ; Others 0 1 2 3

4

10. Do you use any technical method to measure the cost of capital of projects when

making investment decisions? Yes No

11. If yes, which method(s) do you use? (Please select all that apply) Project

dependent cost of capital (PDCC) Weighted average cost of capital

(WACC) Cost of debt (CD) Others

12. On the scale of 0 – 4, with 4 being the method(s) used always and 0 being never,

how would you rate the frequency of use for the selected methods above? PDCC

0 1 2 3 4 ; WACC 0 1 2 3 4 ; CD 0 1

2 3 4 ; Others 0 1 2 3 4

13. Do you use any technical method to estimate the cost of equity of projects when

making investment decisions? Yes No

14. If yes, which method(s) do you use? (Please select all that apply) Capital asset

pricing methods (CAPM) Average historical returns on common stock No

estimate done Others

15. On the scale of 0 – 4, with 4 being the method(s) used always and 0 being never,

how would you rate the frequency of use for the selected methods above? CAPM

0 1 2 3 4 ; Average historical returns on common stock 0 1

2 3 4 ; Others 0 1 2 3 4

Thank you for your time and invaluable contribution to this study.


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