Capital budgeting practices in South Africa: A review

C Correia

doi:10.4102/sajbm.v43i2.180

Abstract

This paper reviews the capital budgeting survey literature in South Africa over the period 1972 to 2008. The survey evidence indicates a significant growth in Discounted Cash Flow (DCF) methods and a fall in the use of other methods. In particular, there has been growth in the use of Net Present Value (NPV). Yet, the Internal Rate of Return (IRR) technique remains the primary method used in practice despite some serious drawbacks. Larger companies are more likely to use DCF methods. There has been a significant growth in the use of sensitivity analysis and scenario analysis. However, there is little use of sophisticated risk analysis tools such as Monte Carlo simulation, and decision trees. Although financial theory predicates the use of risk adjusted discount rates, surveys indicate that the majority of companies use a single firm discount rate. Companies have increasingly used inflation-adjusted cash flows but the process of ranking mutually exclusive projects is not aligned with finance theory. There is limited use of the Modified Internal Rate of Return (MIRR) method and DCF dominant companies do not outperform non-DCF dominant companies. The most important phase of project evaluation is the project definition and cash flow estimation phase and yet research studies have focused mainly on the financial analysis and project selection phase.

Highlights

In capital budgeting there has been a growing convergence between theory and practice in the USA and other countries such as the UK and Australia
The results are generally consistent with the findings for South Africa to the extent that there has been a significant growth in the use of the Net Present Value (NPV) method in the UK, from 32% in 1975 to 99% in 2003 whilst the use of internal rate of return (IRR) has grown from 44% to 89% over the same period
Despite the limitations of comparing surveys in South Africa over time, it is clear that there has been significant growth in the use of Discounted Cash Flow (DCF) capital budgeting techniques, a trend which is consistent with financial theory

Summary

Introduction

In capital budgeting there has been a growing convergence between theory and practice in the USA and other countries such as the UK and Australia. Over the last three decades, there have been numerous surveys of capital budgeting practices in South Africa. The objective of this paper is to provide a review of the capital budgeting survey literature over the period 1972 to 2008, to analyse trends in capital budgeting practices, analyse the state of the art and identify areas for further research. This paper analyses the use of capital budgeting techniques in South Africa as measured by numerous published surveys and unpublished surveys, and compares the use and trends in capital budgeting practices in relation to financial theory. This study compares results to overseas surveys. The paper focuses on such aspects as capital budgeting methods, risk analysis, discount rates and specific issues such as the performance of postaudits, the evaluation of the relative performance of DCF dominant firms, the treatment of mutually exclusive investments and the acceptance of more recent finance developments such as real options

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