Capital budgeting theory and practices

Yasotharalingam, Lingesiya (2016) Capital budgeting theory and practices. (PhD thesis), Kingston University, .


Capital budgeting is crucial in order for companies to sustain themselves, survive and flourish in markets and to increase shareholders' wealth. Nonetheless, decisions on capital budgeting are critical owing to the influence of uncertainty factors and dramatic changes in the environment milieu. Capital budgeting practices vary from country to country, from company to company and from project to project. Although many studies have been conducted in developed countries, there is a dearth of studies in emerging economies. Therefore, aims of this study were to investigate the prevalent choice of capital budgeting practices and influences of firms' characteristics on their choice based on Sri Lankan emerging market, identifying uncertainty factors and its influence on use of capital budgeting practices and explore the interacting effect of uncertainty factors between capital budgeting practices and performance, and finally, develop a capital budgeting model that would meld with the core components of uncertainty, firms' characteristics and firms' performance based on Sri Lankan market. The data for this study were garnered from primary data and secondary data collections. The primary data were collected from 186 CFOs working in companies listed on the Colombo Stock Exchange using self-administered questionnaires. The questionnaire was piloted with a sample of five CFOs. The secondary data were mainly collected from CSE via the Bloomberg website/annual reports. After the data were collected, they were analysed using multivariate analysis such as factor analysis, confirmatory factor analysis and structural equation modelling. This study revealed that the most popular capital budgeting technique used in Sri Lanka was NPV, followed by IRR, PB, ARR and DPB. As for capital budgeting tools incorporating risk, the most preferred method among Sri Lankan firms was uncertainty absorption in cash flows, followed by sensitivity analysis, probability analysis, scenario analysis, and adjusting the required return. Moreover, this study found that the most popular method for calculating cost of equity was the CAPM model followed by average historical returns on common stock. Emerging real options are at an embryonic stage in Sri Lanka. The use of naive capital budgeting practices was mostly preferred by small firms and mainly managed by CFOs with non-MBA educational qualifications and a short tenure. Sophisticated and advanced capital budgeting practices were used mostly by large firms; these were mainly managed by MBA qualified CFOs with a long tenure. As for industry differences, ARR was primarily applied by non-MBA CFOs and was also preferred by non-manufacturing firms. None of the other methods made any significant differences in terms of type of industry. This study found four new levels uncertainty: operational uncertainties (input, labour and production), financial uncertainties (interest rate, inflation and exchange rate), social uncertainty (policy, political and social) and market uncertainty (competitive, output market and input market). Apropos of the model, sophisticated capital budgeting practices were determined by the size of the capital budget, market uncertainty and financial uncertainty. Advanced capital budgeting practices were determined by the size of the capital budget, the educational qualifications of the CFOs, operational uncertainty and "~'U"''''lal uncertainty. In a similar vein, naive capital budgeting practices were determined by the size of the capital budget, the educational qualifications of the CFOs, industry and financial uncertainty. Moreover, this study found that social uncertainty moderates the relationship: between advanced capital budgeting practices and effectiveness, between sophisticated capital budgeting practices and Tobin_q and between advanced capital budgeting practices and Tobin_q. Overall, this study has made theoretical contribution as melding with uncertainty factors with capital budgeting practices, geographical contribution as investigated the prevalent capital budgeting practices in Sri Lankan emerging market and parametric contributions as identified firm characteristics and uncertainty factors on the choice of capital budgeting practices and consequence influence on firm performances. The directions for future research are clearly discussed. In a nutshell, beyond its valuable contribution, this study serves as a springboard for future research.

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