Capital Budgeting Techniques Research Paper

Introduction about the topic

Capital budgeting is the process by which companies appraise investment decisions, in particular, by which capital resources are allocated to specific projects. It requires firms to give account for the time value of money and project risk using a variety of more or less formal techniques. The decision to invest in fixed assets is one of the major decisions made by managers.

Investments in fixed assets impact a firm’s operations for a very long time because they involve large capital outlays. As a result, a variety of quantitative and analytical techniques are applied by managers in the selection of projects to enable them to make good decisions in the area¹.

Capital budgeting comprises of a number of techniques based on various concepts emanating from projects and investments such as the concept of incremental cash flows. Accounting rules play a very important role in the basis of some particular techniques.

The management control process requires the services of budgetary planning and control to provide necessary accounting information. Most of the important information is normally provided through variance reports availed by the accountants in charge. Capital budgeting decisions are influenced by certain factors dealing with economic, social, political, as well as cultural diversity².

There has been tremendous increase in the level of foreign direct investment (FDI) in the last two decades. This has been brought about by the spread of business investment activities across countries of the world. Multinational organisations have faced various challenges due to lack of reliable and accurate methods which could be used in making appropriate decisions within the market place. The paper comprises of various parts the first presenting both theoretical as well as practical overview of the given organisation.

The second part of the reports gives the methodology, including data collection techniques as well as design of questionnaire. Then there are the findings from the research and finally conclusions and recommendations. However, capital budgeting techniques provide measures through which capital budgeting requests are analysed. Net Present Value utilizes the aspect of time value of money concepts, Payback period has been discovered to be deficient of time value techniques³.

Introduction about the company

Capital budgeting is applied in the company’s planning process to determine the status of the firm in line with long term investments⁴. The chamber is one of Saudi Arabia’s oldest and well-established organisations. The promotion of the private sector contribution to the economy is the cause The Chamber is most devoted to.

To that end, it has formulated a lot of services that have significantly helped in development and, especially, promotion with the attempt of giving all the possible support to the beginners of the private sector in such spheres of economy as industry, trade craft and services.

The main aim of the company is to have an active and successful development of Eastern Province private sector activities and to be only one service provider and assistant for the business development in the Eastern Province. The main aim is to provide separate and qualitative services that meet all the requirements the expectation of the private sector, and successful association in the social and economic spheres of life.

The Chamber aims to provide unique and high-quality services that meet the aspirations of the private sector, thus ensuring continuous development through the optimal investment in available resources, renewable technologies and effective participation in the economic and social development of the region; thus realising the wishes of our members in light of the values and principles of our society.

The advancement of the economic growth by means of the full mobilisation of the resources of the private sector to assist the economic development is its final goal.

It aims at promoting the private sector’s origin by means of different steps that include detecting all existing possibilities for the business production, searching for all the possible solutions to different problems that may crop up in the process according to the rules of the system and government programs and working out the plan of the international trade in the attempts of getting the main goals.

The branch expansion has also served as a tool of promoting membership.

The Chamber’s products and services centres around provision of distinct products and services of added value to members, provision of unique preparation and training programs, excellence in the segments of research, studies and information for the purposes of supporting business sector within Eastern Province. Also, they indulge in supporting small and medium enterprises and encouraging innovation and creativity and the culture of self-employment.

Within the last fifty years, the Chamber has been devoted to the private sector in such areas as contact between the business association and the government, promotional agency and of fellowship amongst businesspeople. Provision of a medium for the private sector, allowing them to perform social obligations as well as provision of information on investment opportunities and changes in economic and commercial policies.

Purpose of Research

The study seeks to examine the various capital budgeting techniques used in Saudi Arabia’s chamber and the various factors influencing financial investment practices within the country. The focus is to find out how capital budgeting is used by Saudi Arabia’s chamber.

Various techniques used in optimising the financial cash flows and at the same time, computation of effective financial rates are covered within the study. There is also the determination on the manner in which capital budgeting should be applied by the use of Net Present Value (NPV), Internal Rate of Return (IRR), and Profitability Index (PI).

Research questions and methodology of collected data

The use of an appropriate type of research design ensured appropriate resolution of the research problem and at the same time help in improving effective level of marketing research. The designs applicable in financial researches always focus on three types of research design which include exploratory research, descriptive research and casual research⁵.

Exploratory research is applicable where general nature of the problem needs to be established. The alternative decisions need to be verified in consideration of relevant variables.

The research methods are characterised by high flexibility and unstructured means granting application of clues concerning the problem situation. Descriptive research involves the use of speculative hypothesis making the relationships not to appear casual and then finally casual research, which seeks to reveal the relationship existing between variables used within the study⁶.

The study involved the use of both descriptive and explanatory, whereby descriptive helped in identifying the value of capital budgeting within Saudi Arabia chamber. And on the other hand, an explanatory approach used to explain the contributions of capital budgeting towards development of corporations within the country.

The research problem can be solved using various methods such as induction and deduction. Inductive approach focuses on obtaining general conclusions from the observations obtained from empirical investigation. The deductive method, on the other hand, utilised the use of hypothesis and theories subject to testing within the empirical world. However, the more preferable way through this research was the use of abduction method. This method incorporates both empirical and theoretical measures.

The study discussed much on theories and frameworks based on capital budgeting framework used in the analysis of the various corporations within the chamber. The study also required to establish and identify capital budgeting intangibles which need the application of observations from empirical studies for the purposes of deducing some assumptions. Hence most of the study focused on abduction method⁷.

The following procedures were incorporated in the solution of the research problems involved. Secondary literature was obtained from books, journals, internet as well as electronic databases. This provided the required literature used in establishing a theoretical framework necessary for the study.

The empirical study involved the use of mail survey, where the survey was conducted amongst various corporations within the private and public sector through the use of detailed questionnaire. This was done in order to establish the various methods of restructuring and work design the chamber uses for international markets ⁸.

It is widely accepted that the best way to evaluate capital budgeting proposals are the discounted cash flow methods. More recent studies suggest that firms are increasingly adopting discounted cash flow analysis, although this was not always the case in the past. Much of the empirical research on capital budgeting practices adopted by corporate managers are always drawn from US data research based on different countries is also done by other authors.

An appraisal in the application of the capital budgeting in the retail sector was undertaken in the Kingdom of Saudi Arabia as a basis for strategic capital budgeting for the purposes of developing this study. The focus of the study was to address the extent of use of capital budgeting in retail sector in the kingdom of Saudi Arabia in terms of using financial and accounting tools, sales forecast, external factors, benchmarking and feedback mechanism.

It also sought to establish the extent to which capital budgeting is applied in retail sector in the Kingdom of Saudi Arabia. This further established employee empowerment, negative effect of branch sales, comparison and application of standard budget for new companies within the SA chamber.

Sample

Random sampling was used to obtain data, where both private and public companies within Saudi Arabia were chosen at random for the mail survey. Then the statistical analysis was used to analyse and interpret data from questionnaires.

Empirical results

Capital budgeting of SA chamber presents one of the most important means of making decisions. Capital budgeting is necessary for the purposes of maximising shareholder wealth. The empirical results are presented, and the analysis is given based on the data obtained.

The study provided participants from the chamber with relevant techniques allowing them to tick various importances of capital budgeting techniques from the questionnaire given. The companies from both private and public sector that were sampled added up to 124; however, responses were received from only 60 representing 48% response rate. Good percentage of the questionnaires was answered by intended respondents from the chamber.

Table1: showing the response rate

Respondents were found to be learned since they had considerable academic qualifications. This indicated that they had valuable information concerning the area of study. The size of the capital budget was also identified from each respondent and tabulated as below. The companies within private and public sector differ in terms of size hence vary in annual capital budget.

There were also responses on the frequency of the use of the various budgeting methods. These include; net present value (NPV), profitability index (PI), Internal rate of return (IRR), modified internal rate of return (MIRR) as well as payback. The results were as follows⁹.

Table: Capital Budgeting Techniques

The results indicate that the techniques mostly used in evaluation of projects within Saudi Arabia Chamber are net present value and internal rate of return. This is clearly shown by 94% preferring the use of NPV, 90% of the companies use IRR in most occasions while 70% of the participants use payback period method. This reveals that NPV, payback period, IRR are the most preferred techniques with NPV and IRR forming the most popular methods.

Table showing number of techniques used by companies within chamber

The findings from the table revealed that most companies use multiple budgeting techniques in the process of evaluating their projects. The survey revealed that around 46% of the participants use less than three techniques while the rest utilize more than three techniques.

Table showing significance differences of importance between Capital Budgeting Techniques

The table above represents ranking of techniques based on their importance value attached by the companies. The ranking places NPV, IRR and Payback at the top of the table showing their level of importance. The results reveal some significant differences between participants based on the importance of the capital budget techniques. Most of the companies rank NPV as the most important technique used in evaluating projects.

Conclusion

The objectives of the study were eventually met despite the shortcomings encountered. The results revealed the various capital budgeting techniques and how they are utilized by various companies. This gives vital information to companies concerning the best financial strategies applicable within the current market environment.

Limitations and recommendations

There were various limitations to this study which included the sample group used in the survey which was only 60 companies within the Saudi Arabia Chamber. This means that more data is required so as to establish the exact trend from both lowly ranked and highly ranked companies in private and public sectors.

This would enable adequate understanding on the nature of capital budgeting technique used and the associated impacts on Saudi Arabia chamber. There was high possibility that local meanings of the techniques were lost during the translation process. There were instances where some companies could not allow their capital budgeting practice to be published for the fear of being miss-interpreted.

Based on the study’s findings, the following recommendations are proposed: the owners and management of retail family establishments should use these three elements in the preparation of capital budget; Financial statement or profit and loss statement, Cash flow and Balance sheet. They should also empower employees to help them prepare estimates of their cash flow in terms of sales forecast using data gathered from other reliable sources.

They should employ management tools such as the break-even analysis, payback analysis, net present value and internal rate of return. The organisation at the same time should consider external factors such as government regulations, price increases, stiff competition and customer’s needs. Multiple sales assumptions should be used along with a standard budget. Comparison of different projects within the organisation should also be done.

References

Adrian B, International Capital Budgeting, 3th edition, Simon, NY, 1996

Dayananda D, R Irons, J Herbohn & P Rowland, Financial appraisal of investment projects. Capital Budgeting. Pitt, New York, 2002

Gray SJ, SB Salter & LH Radebaugh, Global Accounting and Control: A Managerial Emphasis, John Wiley and Sons, London, 2001

Leedy, PD & JE Ormrod, Practical Research Planning and Design. 8th ed. Pearson Prentice-Hall, New Jersey, 2005

Modigliani, F &M Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment”. American Economic American Economic Review, Vol 48 no3, 2003, pp 261–297

Footnotes

¹ B Adrian, International Capital Budgeting, 3th edition, Simon, NY, 1996

² SJ Gray et al, Global Accounting and Control: A Managerial Emphasis, John Wiley and Sons, London, 2001

³ D Dayananda et al, Financial appraisal of investment projects. Capital Budgeting. Pitt, New York, 2002

⁴ Ibid

⁵ PD Leedy & JE Ormrod, Practical Research Planning and Design. 8th ed. Pearson Prentice-Hall, New Jersey, 2005

⁶ Ibid

⁷ Ibid

⁸ PD Leedy & JE Ormrod, Practical Research Planning and Design

⁹ F Modigliani, &M Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment”, American Economic American Economic Review, Vol 48 no.3, 2003, pp 261–297