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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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
%age of Usage by the
firms
Section II describes the sample
selected for this paper and outlines
the research methodology, Section
100
III provides the findings and their
impact for these firms in detail.
80
Section IV presents conclusions
60
and some recommendation. The
40
survey responses clearly show that
firm size significantly affects the
20
practice of corporate finance. Most
0
companies follow academic theory
and use discounted cash flow
(DCF) techniques to evaluate investment projects.
II.
Techniques used by Respondents
91
88
85
52
52
49
0
NPV
IRR
ARR
PP
MIRR
PI
Others
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
Respondents Role in Decision
purpose of analysis and drawing
conclusions.
Making
III.
ANALYSIS
39%
This paper investigates what capital
budgeting decision making practices are
used by firms listed on KSE based on the
46%
15%
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Only Recommending to BoD Fully Authorised
Electronic copy available at: http://ssrn.com/abstract=1308662
Partly Authorised
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.
%age of Firms
We have found through
Sophisticated DCF Techniques' linkage with Investment Outlay
this study that most of
50
the firms employ Net
Present Value, NPV,
43
40
(91%), Internal Rate of
30
Return, IRR, (88%) and
27
Payback Period, PP,
20
(85%) in making capital
15
15
budgeting
decisions.
10
However, firms also use
0
MIRR (52%), PI (52%)
0
All Amounts
>10 m
>25 m
>50 m
NA
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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Electronic copy available at: http://ssrn.com/abstract=1308662
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
NPV
PP
Not Imp
Mod. Imp
Important
Very Imp
9
18
18
55
9
6
6
79
9
IRR
12
6
73
MIRR
58
21
21
PI
46
54
ARR
100
Other
91
9
Upon asking the firms, what cost of
Basis for Cost of Capital for DCF Analysis (%age of Respondents)
capital rate /discount rate they use in
case they employ a technique
46
involving discounted cash flows, we
15
49
received the feed back that 49% of
the firms use ‘Risk Free Rate plus a
67
52
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
CoE
CoD
WACC
RFR
Others
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.
Basis for Risk Assessment of Projects by Respondents
%age of the Opted Firm
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
80
79
60
55
46
40
20
49
6
0
0
Basis for Assessing Impact of Change in Riskiness (%age of Respondents)
Firm Ignore it
Cov. of Proj CFs
40
35
30
25
20
15
10
5
0
Subjective Judgement
Probability of Loss
37
Prob. Dist of CFs
Others
33
21
9
Shortening the Reqd. Raising the Reqd PP Raising the Disc. Rate
PP
in PV
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None of these
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.
%age of Firm
The firm’s cost of the capital may
Frequency of Review of Cost of Capital Estimates
be reviewed at various times. Very
90
high percentage of the firms (85%)
85
80
review the cost of capital at ‘Project
70
67
60
Evaluation time’ and 67% of the
50
firms evaluate it when there is
40
‘Significant Business Environment
39
30
Change’. 39% of the firms review
24
20
their cost of capital on ‘Semi-annual
10
12
Basis’, only 24% of the firms
0
Quarterly
Semi-Annually
Annually
On Proj.
On Sigf Bus.Env
review it on ‘Quarterly Basis’ and
Evaluation
Change
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
Basis of Periodic Reveiw of Cost of Capital
between growth rate of the firms and
capital budgeting techniques, we
9
have found that the companies
46
whose P/E ratio is high (more than
45
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%
Opportunity Cost of Equity Cost of Debt Only Weighted Average CoE & Debt
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
Growth
High
P/E (>30)
Moderate
P/E (<30 &
IRR
ARR Others
PP
MIRR
%age value of the responding firms
PI
14
0
0
0
16
50
0
45
43
0
50
52
50
0
Page 5 of 11
>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
25
0
0
17
50
0
(More than 70:30)
Moderate
13
17
0
17
50
0
(31:69 to 70:30)
Low
62
83
0
66
0
0
(0:100 to 30:70)
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:
Page 6 of 11
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.
Page 7 of 11
V.
REFERENCES
J.A. Fremgren. “Capital Budgeting Practices: A Survey,” Management Accounting, (May 1973), PP 1925.
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 623645
Page 8 of 11
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
3.
1 to 3 years
4 to 7 years
8 to 10 years
More than 10 years
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
5.
51 – 150
151 – 300
300 – 500
Over 500
Company’s current Paid-Up Capital (in Rs. million) is:
Less than 20
100 – 200
20 – 50
200 – 500
50 – 100
More than 500
Page 9 of 11
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 50
8.
More than 10
Not Applicable
More than 25
Indicate the significance of each capital budgeting technique used by you?
Not
Applicable
Technique
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
11.
Do you make use of different Capital Budgeting Technique for different classes of Risk?
Yes
12.
After-Tax Cash Flow
No
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
Page 10 of 11
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 _____________
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