Capital Budgeting Decisions

Capital budgeting decisions, being strategic in nature, are likely to have a marked bearing on profitability of corporate business enterprises. The analysis in respect of the sample companies has been carried out on the basis of the two broad parameters: (a) the investment and financing activities of the sample companies and (b) the capital budgeting practices followed by such enterprises. Capital budgeting practices in India, at least amongst the sample companies, appear to have improved over the past two decades with an increasing number of companies using more sophisticated DCF techniques. A striking finding of the survey is that internal rate of return (IRR) is preferred over the net present value (NPV) method by most of the sample companies, in spite of the superiority of the NPV method. The theory–practice gap is a recurrent theme in the capital budgeting literature, in particular with regard to NPV. Despite the recommendations of the financial literature on using NPV as the primary technique, this research too found that respondent firms indicated a preference for IRR compared to NPV. As far as the capital expenditure activity is concerned, the sample companies have made substantial investments in acquisition of new fixed assets. It is pertinent as well as satisfactory to note that paucity of funds is not an inhibiting factor in undertaking capital projects by the sample companies. While it is true that the postliberalisation period has witnessed a salubrious effect on their investment activity, the rate of investment in new fixed assets (measured on a year-to-year basis) has been impressive in that it has been at a rate of 18.06 % during the 11-year period (2001–2011) of the study. This is in contrast to the modest figure of less than 5 % recorded for the public sector enterprises (PSEs) over a 13-year period (1991–2003) in a separate study conducted by the authors (Jain and Yadav 2005). Above all, the global recession has not impacted, to a marked extent, the sample companies (representing vital segment of Indian economy). As far as the financing pattern of long-term investment projects is concerned, it is satisfying to note that the sample companies are following sound policies in this regard – their fixed assets have been financed from long-term sources. Equally commendable is the aspect that their permanent working capital needs have also been financed through long-term sources of finance. This is in conformity with the sound principles of financial management. Cost of capital constitutes an integral part of capital budgeting proposals. It is encouraging to note that the vast majority of the sample companies follow theoretically sound and conceptually correct basis of computing cost of capital, that is, weighted average cost of capital (WACC). More than two-thirds (67.85 %) of the firms have been following the appropriate WACC basis compared to other methods, suggesting a reduction in the theory–practice gap compared to the past studies. Also, consistent with finance theory, the survey reveals that the sample companies are risk-averse. Sensitivity analysis is the most popular approach used by these companies to incorporate risk in their capital budgeting decisions, followed by shorter payback period method and higher cut-off rate for more risky projects. Another notable finding is the emergence of new techniques of real options and abandonment options as a part of practice by the sample companies, while evaluating capital budgeting proposals. This perhaps signals the adoption of emerging techniques by the sample companies, an encouraging indication of growing professionalism in their decision-making. Half of the respondent firms (50 %) used real options while evaluating their investment projects. The results are in sharp contrast with other international studies reporting low usages of the same. Very high fixed-cost components of capital projects and the irregularities in prediction of future cash flows due to decrease in sales and increased competition seem to be the major factors leading to failures of capital budgeting decisions for the sample companies. This is perhaps a reflection of the growing challenges of a volatile global marketplace.