A New Approach to Capital Budgeting in Closely-Held Firms and Small Firms

Abstract

The traditional application of the net present value method in capital budgeting involves the use of market derived discount rates such as the cost of capital. Justification of these discount rates stems from the separation principle that states that investment decisions can be made independent of shareholders' tastes and preferences. The purpose of this paper is to show that the separation principle does not hold for closely-held firms and small firms, and, accordingly, market-derived discount rates are inappropriate. Two capital budgeting techniques which are appropriate for these firms are presented. Accept/reject decisions for capital budgeting projects are often made using a technique known as “net present value” (NPV).1 Using the NPV method, acceptable projects are those for which the project's cost is less than the present value of the project's cash flows discounted at the firm's cost of capital; in other words, acceptable projects have a positive NPV. The firm's cost of capital is usually taken to be the weighted average of the firm's cost of equity and debt as measured by investor returns in the capital markets. Justification for use of a discount rate, determined by reference to market-wide investor returns, is based on “the separation principle” which asserts that corporations can make capital budgeting decisions independently of their shareholders' views.2 But because a critical assumption of the separation principle is that shares are readily marketable, it is likely that the separation principle and, hence, market-determined discount rates are inappropriate for closely-held firms and small firms.3 In this paper, we discuss two capital budgeting approaches which are applicable to firms whose shares are not readily marketable. This paper is divided into five sections. First, we discuss the traditional net present value approach to capital budgeting and, then, we indicate in detail, why it may not be suitable for use by closely-held firms and small firms. In the third and fourth sections, we explain two capital budgeting techniques which may be appropriate for use by these firms. Finally, we summarize our conclusions.