Small companies account for 40% of Australian jobs and yet most of the studies on capital budgeting techniques have been focused on large firms. A mistake in their capital budgeting process could lead to disastrous consequences as they do not have the financial clout to recover from them. The purpose of the paper is to investigate where small manufacturing companies in Australia stand in regard to the use of capital budgeting techniques and risk analysis. The research concludes that while there is an indication of usage of the Payback Period with Discounted Cash Flow (DCF) techniques, there is a need for more frequent usage of risk analysis as well as management sciences which is found lacking in the capital budgeting process of small companies.
One of the most important aspects of managing a company, besides leading it towards the vision of its owners, is the management of capital. The use of capital budgeting techniques is hence an integral tool in capital management. Capital budgeting can be defined as the “total process of generating, evaluating, selecting and following up on capital expenditures”. Hence, capital budgeting techniques would be the set of tools with which financial managers use to establish criteria for investing capital into available opportunities. A mistake in its capital budgeting process thus would cause a detrimental effect to the financial position of the company in the future. The pressure on a financial manager is understandably enormous. Therefore, depending on the needs and direction of the company, the financial manager is to apply capital budgeting techniques that would maximize the value of the company.
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• Its future cash flow;
• The degree of uncertainty associated with these future cash flows;
• The value of these future cash flows considering their uncertainty.
Even though small manufacturing companies account for 41% of all employment in Australia, limited studies have been done on small manufacturing companies. Hence, the aim of this research is to ascertain where small manufacturing companies in Australia stand in regard to the use of capital budgeting techniques and risk analysis.
Surveys are few and far between when it comes to capital budgeting techniques and small manufacturing companies. Chadwell-Hatfield et al. [
A questionnaire was used to obtain information regarding the capital budgeting practices of the targeted manufacturing companies. The survey, complete with reply paid postage, consisted of 12 close ended questions and 6 open ended questions. Based on the Australian Research Council’s Standard Industrialization codes, a random selection of 360 manufacturing companies were selected from the Kompass Business Directory of Australia. According to the then House of Representatives Standing Committee on Industry, Science and Technology, manufacturing companies were deemed to be small if they employed less than 100 employees. The survey sought to include small manufacturing companies as well as a small proportion of medium sized companies. So the targeted companies were to have less than 150 workers under their employment It is against this criteria from where the companies were chosen from the Kompass Directory.
360 surveys were sent out to various companies selected from the Kompass Business Directory. A total of 62 surveys were returned yielding a response rate of 17 percent.
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This data shows that even though these companies are defined to be small by the ABS due to the fact that they have less than 100 employees, the principal decision making functions do not rest entirely on the shoulders of the owners or managers. Financial controllers and accountants have been employed to provide the owners with a better understanding of the consequences of their decisions in pursuing any particular project.
Respondents were asked to rank objectives of their company in terms of importance. The results are shown in
From the above table it is obvious that the most important objective of the companies is to make as much profit as possible. Furthermore, 66.1% of the companies felt that increasing profitability is the most important with a mean score of 4.55. Companies also felt that increasing sales growth, providing a high quality of service and the provision of their particular business were high on their agenda. One company stated that in order to be a successful company, they needed to excel in all of the above objectives listed out. However, majority of the respondents felt that increasing employment did not have such a high priority on their list of objectives. This would probably be due to the fact that increasing employment would not necessarily aid in their aim on increasing profitability as it is widely known that labour costs are the highest contributing factor to the cost of production. As computers represent a lower cost in the long run, they are increasingly being used by manufacturers who only hire skilled labour to maintain these computers systems. Hence, the manufacturers do not view increasing employment as an important objective.
Respondents were asked about their use of capital budgeting techniques and the way with which they go about using it.
*(Likert scale; 1—least important, 5—most important).
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Respondents were asked which techniques whey used when deciding which projects to pursue. The results are shown in
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Only 12.9% of those surveyed used Profitability Index (PI) frequently, 33.9% never used this technique in the capital budgeting process. With a mean score of 2.39, it is not entirely favourable with financial managers but is still used once in a while. This technique could be used by them as a secondary tool to gauge a project. As PI is not entirely accurate when comparing between mutually exclusive projects, as the project may show the same increment in values but different net present values, this may explain the lack of usage. The mean score of 3.35 for the technique internal rate of return suggests that it is moderately used. It is also the next most popular technique after the Payback Period. This shows that the financial managers are using this technique along with NPV to compliment that of Payback Period. Even though it is not as commonly used as the Payback Period, it shows that small companies are beginning to adopt the usage of sophisticated capital budgeting techniques in their evaluation of investments. From
Respondents were asked of the techniques that they used, which were the ones that they used for outright acceptance or rejection of a project. They were also asked to provide criteria with which they would accept or reject a project based on that technique.
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In regard to NPV, it was found that only 11 companies used NPV as a technique that decided out rightly on whether the company should accept a project. All of the companies that indicated that NPV was used stated a >0 criterion when choosing to accept the project.
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Respondents were asked what determined their rate of return. The results are shown in
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companies use the cost of debt in determining their rate of return. The cost of debt refers to the cost that is incurred when incurring a debt from, say the bank. Hence, the interest that banks charge would be the cost of debt. This suggests that the manufacturers would base their rate of return on the debt incurred for investments like replacement of old machinery, extension of product lines etc. It can also be seen that only 8.1% of companies based their rate of return on the cost of equity capital which is the return that is required by suppliers of capital to compensate them for providing capital. No respondents chose Weighted Average Cost of Capital as their rate of return. It could be because it is highly complex and only large companies utilize such a return. From
Respondents were asked what size in A$ must a project be to be subjected to formal quantitative analysis using capital budgeting techniques.
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Respondents were asked to rank stages in the capital budgeting process according to their importance. The results are given in
most critical stage. This shows that after correctly estimating the project and cash flows, capital budgeting techniques were to be applied to decide which projects maximised the wealth of the owners.
Project implementation is the 3rd most critical stage of the capital budgeting process; this stage is crucial as a project needs to be executed flawlessly to achieve the desired results. Hence, this stage deserves more recognition by the managers. With a mean score of 3.74, the project review stage is the least critical of the 4 stages. 74.2% of the respondents rated it the least important. This does not justify the importance of the stage.
Respondents were asked how much each factor proposed affected the way they chose the appropriate amount of debt for their companies. The details are shown in
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43.5% of those surveyed believed that they should not compare their debt levels to others in the same industry. With a mean score of 1.89 it signifies that most managers do not manage their debt against such a barometer. This data shows that the debt levels of other companies should be used to indicate their well-being and not as a yardstick for your own debt level. From a mean score of 2.55 for credit rating, it indicates that this factor is moderately unimportant in the determination of the level of debt. This shows that the managers are not bothered that their credit rating may drop which affects their ability to get loans in the future at an acceptable rate and period. With a mean score of 3.45 for Transaction cost and fees for incurring debt, it shows that managers are somewhat concerned with the consequences of incurring debt. Financial flexibility, with a mean score of 3.93, is the most important factor when determining the amount of debt.
This indicates that managers are not willing to sacrifice their financial flexibility in case some lucrative project comes along and they are unable to act on it because of inflexible financial ability.
Respondents were asked if they used any method for incorporating risk in the evaluation of capital expenditure proposal. The results are shown in
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Respondents were asked how frequently they used certain methods for risk adjustment. The results are given in
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Respondents were asked when evaluating a project, did they adjust the discount rate or cash flows or both for certain risk factors. The results are given in
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The results indicate that even though the Payback period is still ever present in the evaluation of capital investments for small companies, it is encouraging to find that
more sophisticated techniques like the NPV and IRR are being utilized to aid them in the capital budgeting process. It is recommended that small companies continue to focus on utilizing such sophisticated techniques that maximises the wealth of owners instead of succumbing to the financial pressure put on them by financial institutions.
Project estimation and cash flow estimation was found to be the most important aspect of thew capital budgeting process. It is followed by financial analysis and project selection then project implementation and finally project review. Project evaluation is actually an integral part of the complete manufacturing strategy. Every investment or project should be followed up to determine that effectiveness of the decisions made in earlier stages of the capital budgeting process. It is further confirmed that project evaluation is not critical to those surveyed when a large number of them indicated that they did not perform postaudits on capital investment. So it is recommended that more attention should be paid onto project evaluation as not every capital investment is properly analysed and small companies are more susceptible to these possible mistakes made as they do not have the financial muscle to recover.
It was found that financial flexibility was a major factor in determining what level of debt the companies maintained. Other major factors included the volatility of earnings and cash flows, transaction cost for incurring debt and the potential cost of bankruptcy. It is hence not advisable to have such a high level of debt based on the above factors plus with the present economic climate, those factors would have a higher chance of occurring.
Uses of risk analysis techniques were found to be a minimum. Scenario forecast was the most widely used method, followed by measuring expected variance in returns. Complex techniques like Monte Carlo Simulation, Sensitivity Analysis and Calculation of bailout Factor are rarely used. It is hence recommended to integrate these risk analysis techniques into their capital budgeting process in light of the global economic and social instability.
This is an extended version of a paper that was published in the proceedings of 7th Asia Pacific Industrial Engineering and Management System Conference.