A STUDY conducted by the author to assess commonly used capital budgeting techniques, computation of discount rate and methods for estimating project risk by firms listed on the Karachi Stock Exchange revealed that there is a significant negative correlation between the size of the firm and the use of net present value and payback period metrics.

This is perhaps because large firms have huge investments, and therefore prefer internal rate of return (IRR) as even a marginally higher return than the cost of capital would translate into a huge rupee-benefit for them.

The purpose of the study was to examine whether, and to what extent, sophisticated capital budgeting techniques were being actually employed by decision-makers of local companies while taking capital budgeting decisions. This could also provide a useful feedback to academics over the practicality and real life relevance of the techniques being taught by them at business schools.

In this regard, a survey questionnaire was designed to collect data from a sample of 150 companies listed on the KSE, to which 35 responded. The capital budgeting techniques surveyed included net present value (NPV), IRR, modified internal rate of return (MIRR), accounting rate of return (ARR), payback period (PP) and profitability index (PI).

It is heartening to note that sophisticated capital budgeting techniques are being used by Pakistani firms, and that these are not just confined to textbook study

The trend towards the use of more sophisticated capital budgeting techniques was evidenced by the most popular use of NPV, followed closely by IRR, MIRR and PP.

There was 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.

The results also emphasise that the authority for making capital budgeting decisions lies mainly with higher management/board of directors, and not with individuals. The more advanced techniques are used mainly when investment amounts exceeded Rs25m. 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 companies rely more on debt financing. They are more concerned that their net cash flows, after accounting for debt servicing, should be positive, and hence prefer NPV and MIRR.

It is heartening to note that sophisticated capital budgeting techniques are being used by Pakistani firms, and that these are not just confined to textbook 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 in decision-making quality at the industry level.

In this respect, various industry associations can play a leading role, so as to minimise 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 benchmarks and guidelines for capital budgeting/financing on the following criteria:

1. Which capital budgeting techniques to employ for major investments, such as on new projects, expansion, or BMR prospects, and for small investments, like replacement or renovation of machinery and 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 completed, industry associations can arrange for regular training programmes on capital budgeting for new professionals entering the industry. This would augment the theoretical knowledge which the professionals 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 find its way into provisional and federal government departments and autonomous bodies as well. Ultimately, this will go a long way towards helping optimise the use of resources, and minimise the chances of projects going sick due to incorrect or faulty capital budgeting decisions.

The writer is the head of Accounting and Finance Dept. at the Institute of Business Management, Karachi

Published in Dawn, Economic & Business, July 21st, 2014