capital budgeting - decision making practices in pakistan

Electronic copy available at: http://ssrn.com/abstract=1308662

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Capital Budgeting - Decision Making Practices in Pakistan

H. Jamal Zubairi, Associate Professor (Accounting, Finance & Economics)

Farrukh Amin, Assistant Professor (Computer Science & MIS)

Institute of Business Management, Karachi, Pakistan

ABSTRACT

A number of capital budgeting techniques find place in basic as well as advanced text books on

Financial Management and Corporate Finance. Each technique has its pros and cons as a

decision making tool.

The research paper investigates the decision making practices of Pakistani companies with

respect to Capital Budgeting including the techniques employed and basis for estimation of cost

of Capital / Project risk. The paper also examines the linkage between the techniques employed

and various factors such as; size of investment outlay, nature of industry, company size, growth

rate and capital structure. Also probed is the extent of delegation of decision making authority in

respect of capital budgeting decisions. Further, the respondents’ views on relative

popularity/significance of the techniques and reasons for the same have also been studied.

Furthermore, the differences in techniques and decision making practices of local and foreign

companies operating in Pakistan have also been looked into.

The information/data for the above stated purpose was collected through a questionnaire from

sample companies listed on the Karachi Stock Exchange (KSE).The main findings extracted

from the responses to the questionnaire are, that key decision makers in Pakistani firms are quite

aware of and practically using sophisticated capital budgeting techniques. The study shows that

bigger size companies give greater preference to IRR, while smaller firms rely more on NPV.

Also smaller firms are keener in estimating the pay back period (PP) as compared to larger

companies. Consciously or unconsciously the firms relying more on debt financing or with high

growth rates give more preference to the NPV technique, while low leverage and low growth

firms rely more on IRR. I. INTRODUCTION

The importance of capital budgeting for a firm cannot be overemphasized. Capital budgeting

decisions have a long term impact on the viability of a firm and its ability to operate as a going

concern. Compared to current asset management decisions, there is almost no room for

flexibility or correcting a mistake if a wrong capital budgeting decision has been made and

implemented. For instance, if you once have a bad experience with a particular supplier for raw

material inventory, you may change to a better and more reliable supplier the next time you order

inventory. However, if you realize some time after procuring and installing a manufacturing

plant that you chose the wrong process or wrong plant capacity, the cost of change in plant

would usually be prohibitive.

Given the importance of capital budgeting decisions, this research paper highlights commonly

used capital budgeting techniques, computation of discount rate and methods for estimating

project risk; as employed by business firms listed on Karachi Stock Exchange (KSE). In this

regard, a survey questionnaire (see Appendix A) was designed to collect data from sample

companies listed on KSE. The design of the survey permitted us to thoroughly understand the


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91 88

0

85

52 52 49

0

20

40

60

80

100

%age

of

Usa

ge b

y t

he

firm

s

Techniques used by Respondents

NPV IRR ARR PP MIRR PI Others

capital budgeting decisions making practices and their relationship with various characteristics of

the firms. Specifically we mainly looked into the following:

i) Relationship between the size of the firm and the capital budgeting techniques used

ii) Extent of delegation of authority in the firms in respect of capital budgeting decisions

iii) Relative importance and significance of different capital budgeting techniques

iv) Linkages of capital budgeting techniques used with the investment outlay.

v) Relationship of capital budgeting techniques used with financial leverage of firms

vi) Linkage of capital budgeting techniques employed with growth rate of firms

vii) Basis for risk assessment of a project and for change in riskiness

viii) Frequency of review of firm’s cost of capital

Section II describes the sample

selected for this paper and outlines

the research methodology, Section

III provides the findings and their

impact for these firms in detail.

Section IV presents conclusions

and some recommendation. The

survey responses clearly show that

firm size significantly affects the

practice of corporate finance. Most

companies follow academic theory

and use discounted cash flow

(DCF) techniques to evaluate investment projects.

II. METHODOLOGY

We designed a comprehensive survey questionnaire to collect the responses of the business firms

in Pakistan. We targeted only those firms which are listed on the Karachi Stock Exchange

(KSE). Most of these firms have there head offices located in Karachi (Sindh)

There were 685 firms listed on KSE as on December 31, 2007. Presently, about 230 firms’ scrips

are more actively traded on the exchange. We sent our questionnaire to 150 firms but despite

active follow up, only 35 firms responded in terms of providing completed questionnaire. This

translates into a response of 23%, which looks healthy as most studies show a response of 8 to

10% in similar surveys.

The questionnaire was designed to probe into the eight main areas detailed in Section I. The

responses were then tabulated for the

purpose of analysis and drawing

conclusions.

III. ANALYSIS

This paper investigates what capital

budgeting decision making practices are

used by firms listed on KSE based on the

Respondents Role in Decision

Making

39% 46%

15%

Only Recommending to BoD Fully Authorised Partly Authorised


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27

0

43

15 15

0

10

20

30

40

50%

age o

f F

irm

s

Sophisticated DCF Techniques' linkage with Investment Outlay

All Amounts >10 m >25 m >50 m NA

sample survey. The findings of the paper show that majority of the respondents (46%) are only

partly authorized to take capital budgeting decisions on their own. 39% of the respondents only

have recommending authority, while only 15% were fully authorized to take decision on their

own. This significance of decision making authority is true even in case of multi-national

companies (MNCs). About 49% of respondents out of the total MNCs take capital budgeting

decisions with a combination of both i.e. independently as well with the approval of head

quarters.

We have found through

this study that most of

the firms employ Net

Present Value, NPV,

(91%), Internal Rate of

Return, IRR, (88%) and

Payback Period, PP,

(85%) in making capital

budgeting decisions.

However, firms also use

MIRR (52%), PI (52%)

and some firms use

other techniques (49%). According to the sample data collected, none of the firm uses ARR as

their decision making tool for Capital Budgeting. 27% of the firms use these tools for every

investment outlay, 43% of the firms apply these when investment amount is more than Rs. 25

million and only 15% of the firms use these techniques only when the size of investment is more

than 50 million.

Significance of these techniques

a) Net Present Value (NPV)

The study shows that majority of the firms (55%) rate NPV as ‘a very important’ tool, 18% rate

it as ‘important’ and the rest of the firms consider it as ‘moderately important’. Only 9% of the

firms do not consider it as a significant technique.

b) Payback Period (PP)

This technique is also given high importance by the firms (79%), whereas 6% of the firms

consider it as ‘important’ in decision making. Only 6% of the firms rate it as ‘moderately

important’.

c) Internal Rate of Return (IRR)

In the view of 73% of the firms this tool is ‘very important’ for decision making, 6% of the firms

rate it as ‘important’ and only 9% firms consider it as ‘moderately important’.

d) MIRR

This technique is rated as ‘important’ by 21% of the sample firms while an equal 21% regard it

as ‘very important’. Large number of firms (58%), either do not use this tool or do not consider it

at all as decision making tool for capital budgeting.

e) Accounting Rate of Return (ARR)

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Basis for Cost of Capital for DCF Analysis (%age of Respondents)

52 67

461549

CoE CoD WACC RFR Others

Our responses show that none of the firm uses this tool for capital budgeting decisions.

Significance of Capital Budgeting Tools are used by the Firms

Tools Applied Not App Not Imp Mod. Imp Important Very Imp

NPV 9 18 18 55

PP 9 6 6 79

IRR 12 9 6 73

MIRR 58 21 21

PI 46 54

ARR 100

Other 91 9

Upon asking the firms, what cost of

capital rate /discount rate they use in

case they employ a technique

involving discounted cash flows, we

received the feed back that 49% of

the firms use ‘Risk Free Rate plus a

Risk Premium’ based on judgment

regarding their risk class. 52% of the

responding firms said that they used

‘Weighted Average Cost of Capital’,

46% responded that they use ‘Cost

of Equity Capital’ and very large

number of firms (67%) use ‘Cost of

Debt’. The responses in respect of discount rate total to more than 100% since the respondents

were free to give more than one response. The cash flow used in their analysis for capital

budgeting decision making were mostly ‘After-Tax Flows’ (79%). The firms also confirmed that

most of them (82%) use different capital budgeting techniques for different risk classes.

In order to assess the riskiness of a

project, most firms take into account

more than one measure. For

example, 55% of the firms use their

‘Subjective Judgment’, large number

of firms (79%) considers

‘Probability Distribution of the

Project’s Projected Cash Flows’,

46% of the responding firms use

‘Covariance of Project’s Cash Flow

with Cash flows of other Projects’

and 49% of the firms give weightage

to ‘Probability of Loss’ in the

projects. The firms assess the impact

of change in the riskiness of a

project by employing various

methodologies. 37% of the firms do

0

55

79

46 49

6

0

20

40

60

80

%ag

e of the

Opted

Firm

Basis for Risk Assessment of Projects by Respondents

Firm Ignore it Subjective Judgement Prob. Dist of CFs

Cov. of Proj CFs Probability of Loss Others

9

3733

21

0

5

10

15

20

25

30

35

40

Shortening the Reqd.

PP

Raising the Reqd PP Raising the Disc. Rate

in PV

None of these

Basis for Assessing Impact of Change in Riskiness (%age of Respondents)

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so by raising the required payback period, 33% of the firms resort to raising the discount rate in

computing the present value of the investment and only 9% of the firms shorten the required

payback period. Also quite a few of the firms (21%) use none of the methodologies mentioned in

our questionnaire.

The firm’s cost of the capital may

be reviewed at various times. Very

high percentage of the firms (85%)

review the cost of capital at ‘Project

Evaluation time’ and 67% of the

firms evaluate it when there is

‘Significant Business Environment

Change’. 39% of the firms review

their cost of capital on ‘Semi-annual

Basis’, only 24% of the firms

review it on ‘Quarterly Basis’ and

only a few (12%) of the firms assess

it on ‘annual basis’. While reviewing the periodic cost of capital, it may involve estimating the

Opportunity cost of capital, Cost of debt only and Weighted Average Cost of Equity and Debt.

There are 46% of the firms who give preferences to ‘Weighted Average Cost of Equity and

Debt’, 45% only to ‘Cost of Debt’ and just 9% to ‘Opportunity Cost of Equity’.

For evaluating the relationship

between growth rate of the firms and

capital budgeting techniques, we

have found that the companies

whose P/E ratio is high (more than

30), give most importance to use of

MIRR (50%) followed by PP (16%)

and NPV (14%). Similarly when the

P/E ratio is moderate say less than 30

but more than 10, the firms give

nearly equal importance to MIRR,

NPV and PP i.e. 50%, 45% and 52%

respectively. Whereas companies

whose P/E ratio is low (below 10),

rate IRR, NPV and PP as high in importance i.e. 57%, 41% and 32% respectively.

NPV IRR ARR Others PP MIRR PI

Growth %age value of the responding firms

High

P/E (>30) 14 0 0 0 16 50 0

Moderate

P/E (<30 & 45 43 0 50 52 50 0

24

39

12

85

67

0

10

20

30

40

50

60

70

80

90

%a

ge

of

Fir

m

Quarterly Semi-Annually Annually On Proj.

Evaluation

On Sigf Bus.Env

Change

Frequency of Review of Cost of Capital Estimates

Basis of Periodic Reveiw of Cost of Capital

4645

9

Opportunity Cost of Equity Cost of Debt Only Weighted Average CoE & Debt

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>10)

Low

P/E (<10) 41 57 0 50 32 0 0

Similarly regarding the relationship between financial leverage of firms and capital budgeting

techniques used, we found that highly leveraged firms use MIRR (50%), NPV (25%) and PP

(17%), moderate leveraged firms use MIRR (50%), NPV (13%), IRR (17%) and PP (17%).

However, low leveraged firms extensively use IRR (83%) followed by PP (66%) and NPV

(62%). The study clearly shows that none of the leveraged firms use either ARR or PI.

Leverage (Long Term Debt to Total

Capitalization Ratio) NPV IRR ARR PP MIRR PI

High

(More than 70:30) 25 0 0 17 50 0

Moderate

(31:69 to 70:30) 13 17 0 17 50 0

Low

(0:100 to 30:70) 62 83 0 66 0 0

IV. CONCLUSION

The trend towards the use of more sophisticated capital budgeting techniques is evidenced by the

most popular use of NPV followed closely by IRR, MIRR and PP. The study shows that there is

a significant negative correlation between the size of the firm and the use of NPV and PP. This is

perhaps because big firms have large investments and therefore prefer IRR because even a

marginally higher return than the cost of capital would translates into a huge rupee benefit for the

firm. There is virtually no correlation between the size of the company and the use of IRR. In

other words irrespective of size , all firms are interested in knowing the IRR of an investment

project, while the smaller ones might be more inclined to use NPV for decision making. It also

emphasizes that authority for capital budgeting decision lies mainly with higher management/

Board of Directors and not with the individuals. The more advanced techniques are used mainly

when investment amount exceeds Rs.25 millions. It is also noted that highly leveraged firms tend

to prefer NPV, PP and MIRR, while low leverage firms give more preference to IRR but also

employ NPV and PP. Similarly high growth firms use NPV, PP and MIRR as tools for decision

making whereas moderate and low growth firms use NPV, PP and IRR. This is because higher

leverage and higher growth firms rely more on debt financing. Thus these firms are more

concerned that their net cash flows after accounting for debt servicing should be positive. Hence,

the greater preference towards NPV and MIRR.

It is heartening to note that sophisticated capital budgeting techniques are practically being used

by Pakistani firms and are not confined to text book study at Business Schools. However,

keeping in the view the importance and virtual irreversibility of a major capital budgeting

decision, there is a need for improvement of decision making quality at the Industry level. In this

respect Industry Associations of various industries can play a lead role, so as to minimize the

wastage of resources on account of bad or faulty capital budging decisions. More specifically,

industry associations should form expert working groups comprising relevant professionals, who

can develop industry bench marks and guidelines for capital budgeting decisions, focusing on the

following:

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1. Which capital budgeting techniques to be employed for major investments such as new

projects, expansion or BMR projects and small investments like replacement or

renovation of machinery / other fixed assets.

2. Basis to be used for estimating:

a. Company’s cost of capital

b. Project Riskiness

c. Appropriate Capital structure for new as well as existing projects in the Industry.

Once the above proposed exercise has been done, the industry associations can arrange for

regular training programs on Capital Budgeting for new professionals entering the industry. This

would augment the theoretical knowledge which the fresh graduates bring with them from

Business Schools.

It can be expected that if the above referred proposal is implemented seriously, a more

professional approach to Capital Budgeting will also find its way into Provisional / Federal

Government Departments and Autonomous Bodies. Ultimately this will go a long way towards

helping in optimizing the use of our resources and minimizing the chances of projects going sick

due to incorrect or faulty capital budgeting decisions.

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V. REFERENCES

J.A. Fremgren. “Capital Budgeting Practices: A Survey,” Management Accounting, (May 1973), PP 19-

25.

D.F. Istvan. “The Economic Evaluation of Capital Expenditures,” Journal of Business, (January 1961), PP

45-51

Lawrence D. Schall, Gary L. Sundem and Willaim R. Geijsbeek, Jr, “Survey and Analysis of Captial

Budgeting Methods,” Journal of Finance, (March 1978), PP 281-288

T.Klammer, “Empirical Evidence of the Adoption of Sohisticated Capital Budgeting Techniques,”

Journal of Business, (October 1977) PP 387-397

John Graham and Campbell Harvey, “How do CFOs make capital budgeting and capital structure

decisions?” Journal of Applied Corporate Finance, (2001), Vol 60

J. Moore and A. Reichert, “An Analysis of the Financial Management Technqiues currently eimployed by

Large U.S. Corporations,” Journal of Business Finance and Accounting, Vol 10 (1983), pp 623-

645

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APPENDIX

Survey Questionnaire

Preliminary Information

Company’s Name

Responding Person’s Name

Respondent’s Position (Title)

Last Qualification

(with Major)

How long has respondent been working in

the current job?

Contact Number

E-mail

Date

1. What is your role in decision making?

Recommending decision to higher management

Fully authorized to take decisions

Partly (a) and Partly (b)

2. How long have you been in this firm? (Please Tick any one)

Up to 1 year 1 to 3 years 4 to 7 years 8 to 10 years More than 10 years

3. Company’s business falls in the following sector:

Closed-End Mutual Funds Modaraba Leasing

Investment Bank/COS/Securities Commercial Bank Insurance

Textile Spinning Textile Weaving Textile Composite

Synthetic & Rayon Jute Sugar & Allied

Cement Tobacco Refinery

Power Generation & Distribution Oil & Gas Mktg Oil & Gas Exploring

Engineering Automobile Parts Automobile Assembler

Cable & Electronic Goods Transport Technology & Comm.

Fertilizer Pharmaceuticals Chemicals

Paper & Board Vanaspati & Allied Leather & Tanneries

Food & Personal Care products Glass & Ceramics

Other (Please Specify) ____________________________________________

4. Number of people working in the company are:

1 – 50 51 – 150 151 – 300 300 – 500 Over 500

5. Company’s current Paid-Up Capital (in Rs. million) is:

Less than 20 20 – 50 50 – 100

100 – 200 200 – 500 More than 500

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6. Please mark the Capital Budgeting tools/techniques used by your company:

Net Present Value (NPV) Payback Period (PP)

Internal Rate of Return (IRR) Modified Internal Rate of Ret (MIRR)

Accounting RoR (ARR) Profitability Index (PI)

Others (Please Specify) ________________________________________________________

7. Capital budgeting techniques marked in 6 above are used for decisions pertaining to following investment

amounts (Rs. in million)

All Amounts More than 10 More than 25

More than 50 Not Applicable

8. Indicate the significance of each capital budgeting technique used by you?

Technique Not

Applicable

Not

Important

Moderately

Important Important

Very

Important

NPV

PP

IRR

MIRR

PI

ARR

Others

9. What cost of capital rate/discount rate do you use in case you use a technique involving discounted cash

flows?

Not Applicable Cost of Debt

Cost of Equity Capital A measure based upon past experience

Weighted Average Cost of Capital

Risk Free Rate + Risk Premium based on judgment regarding your risk class

Others (Please Specify)_____________________________________________________

10. The cash flow that you use in your analysis is:

Before-Tax Cash Flow After-Tax Cash Flow

11. Do you make use of different Capital Budgeting Technique for different classes of Risk?

Yes No

12. If you are an MNC, capital budgeting decisions are made:

Independently by the local management

With approval of the Regional Head quarters

A combination of both of the above

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13. On what basis do you assess the riskiness of the project?

Ignore risk and use single standard for all projects

Based on subjective judgment

Probability distribution of project’s projected cash flow

Covariance of Project’s cash flow with cash flows of other projects

Probability of loss

Others (Please Specify) ________________________________________________________

14. How do you assess the impact of change in riskiness of a project?

Shortening the required payback period

Raising the required payback period

Raising the discount rate in computing present value

None of the above

15. How often does your company review its cost of Capital Estimates?

Quarterly

Semi-Annually

Annually

Whenever there is new project to be evaluated

Whenever there is a significant change in business environment

16. The periodic cost of capital review involves, estimating:

Opportunity cost of Equity

Cost of Debt only

Weighted Average Cost of Equity & Debt

17. As per your company’s latest Balance Sheet, the long term debt to total capitalization ratio

(Long term debt / long term debt + equity) is nearly:

20 : 80 30 : 70 40 : 60 50 : 50

60 : 40 70 : 30 80 : 20

Other (Please Specify)_________________________________________________________

18. What is your company’s latest credit rating?

Short Term:___________ Long Term _________

Name of Rating Agency:__________________________________________________________

19. Based on current market price of your company’s share and latest earning figures, what is your company’s

current P/E (Price to Earning) Ratio?

� Market Price: Rs__________ as on ___________________(Date)

� Earning Per Share: Rs__________ for the year ended _____________

capital budgeting - decision making practices in pakistan

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