Capital Budgeting Projects Research Articles

Underdiversification puzzle, volatility puzzle and equity premium puzzle: a common solution

PurposeThe purpose of this paper is to use some of the contributions of the option pricing theory to solve three outstanding puzzles in finance: the underdiversification puzzle, the volatility puzzle and the equity premium puzzle.Design/methodology/approachTo approach the issue, this paper considers the applications of the option pricing theory to both sides of the corporate balance sheet. Applications to the left-hand side of the balance sheet has led to the real options theory that has expressed the value of a capital budgeting project as the sum of the values of its “discounted cash flow (DCF) method” and “real options.” This paper argues that, because the balance sheet must balance, the value of equity, which appears on the right-hand side of the balance sheet, should also be expressed as the sum of the values of its “DCF method” and “equity options.”FindingsThis proposed model of equity valuation solves the three outstanding puzzles in finance: the underdiversification puzzle, the volatility puzzle and the equity premium puzzle.Research limitations/implicationsThis study may not be able to explain the full extent of the three puzzles.Practical implicationsThe dividend discount model of equity valuation needs to be augmented by an option component.Social implicationsThe community of finance scholars will become more confident of their scholarly work because three puzzles will be solved to a great extent.Originality/valueTo the best of author’s knowledge, the extant literature does not either solve any single one of the three puzzles through the contributions of option pricing theory or solve all three puzzles at the same time with a single solution. The originality of this paper is that it makes both of these contributions to the extant literature.

Overconfidence and Resistance to Abandoning Unprofitable Capital Budgeting Projects: The Effects of Autonomy, Internal Audit, and Accountability

ABSTRACTThe purpose of this study is to investigate the effects of managers' autonomy in choosing a capital budgeting project has on their confidence in managing the project. Furthermore, this study examines the role that internal audit reports and accountability play in mitigating the impact of autonomy on managers' resistance to abandoning unprofitable capital budgeting projects. Building on motivated reasoning theory, we hypothesize and find that managers who are given autonomy to choose their own projects are more confident that their projects will be successful than managers who are assigned the projects by their superiors. This study also shows that internal audit reports and accountability are effective mechanisms for reducing the influence of prior decisions on managers' resistance to abandoning unprofitable projects.

The Effect of Attribute Framing and Justification on Capital Budgeting Decisions

This study aims to analyze the effect of the attribute framing and justification on decision making through the capital budgeting process. This study also aims to examine the effect of justification as moderation on the effect of attribute framing on capital budgeting decisions. The capital budgeting decision in this study is a decision toward the proposed capital budgeting project in the form of approving or rejecting the proposed project. This study uses a quasi-experimental research design with the data taken is primary data. The quasi-experimental research was designed 2 x 2 between subjects which was conducted to 83 financial students in the Magister of Management, Diponegoro University. Data analysis techniques used in this study were one-way ANOVA and two-way ANOVA.The results of the study shows that attribute framing and justification can influence decision making through the capital budgeting process. In particular, the information that is positively presented has an impact in the higher approval of a proposed capital budgeting project. This research also concluded that justification could not reduce the effect of the attribute framing on capital budgeting decisions. This shows that belief revision theory- foundation approach cannot explain the phenomenon of this study.

Integral decision analysis in mutually exclusive capital investment projects. Case study: Hard Rock Cafe at Riviera Maya

ABSTRACTBrands that have worldwide recognition are perceived as profitable businesses. One of the reasons for this perception might lie in the belief that these companies usually employ some degree of financial evaluation to make the right choice in terms of investment; Hard Rock Cafe is no exception. The brand opened one restaurant in the Riviera Maya in 2011 which closed within nine months. Could a better investment decision have been made if the Hard Rock Cafe Mexico management had followed the Integral Decision Analysis (IDA) method? This method gives decision-makers a chance to analyze mutually exclusive capital budgeting projects. The case study illustrates the type of elements that the model can yield, it provides a brief explanation on how this process could have been used by the Hard Rock Cafe management and it offers an explanation on how this knowledge might have helped in supporting a final investment decision. In conclusion, the IDA method used to analyze this project might reduce the risks in capital investments.

Cash flow statements and firm value: Evidence from Taiwan

By studying cash flows from operating, investing, and financing activities, we explore the effect of these various cash flows on firm value by employing censored panel data models due to concerning panel data employed and characteristics of dependent variables. Results imply that firms raising funds for capital budgeting projects can enhance their firm value, resulting in cash inflows from financing activities and cash outflows to investing activities consistent with our cognitions. However, results reveal that cash inflows from operating activities may not be regarded as a positive signal different from the relevant studies. We infer that the market is increasingly competitive for Taiwanese enterprises due to more and more competitors from South Korea and China; in addition, we argue that firm value might not be enhanced if cash inflows from operating resulting from sales increased due to lower profit margin or purchases shrunk owing to market share declined.

Estimation of certain parameters of Black-Scholes model in analysing effectiveness of development investments

The option pricing theory has wide applicability in corporate finance, but it is also increasingly used to analyze the effectiveness of non-financial (material) investments. In traditional investment analysis, a project or a new investment should be accepted only if the returns on the project exceed the hurdle rate; in the context of cash flows and discount rates, this translates into projects with positive net present values (NPV). There is no doubt that it does not take full account of the numerous options that usually relate to developer investment. However, in many cases, the valuation of real options is more difficult than the valuation of options for financial assets. In this paper, we will analyze one of the options, which isembedded in capital budgeting projects - the option to delay a project, especially when a the company has exclusive rights to the project. The value of the option is largely derived from the variance in cash flows – the higher the variance, the higher the value of the project delay option. The variance in the present value of cash flows from the project can be estimated in different ways, however, in the case of non-financial investment projects, these methods are very limited. We are analyzing the possibility of estimating this volatility, taking into account the fact that the forecasted cash flows may show varying volatility in individual years. The paper shows, that by using a probability-based valuation model (using the Crystal Ball techniques) it is possible to incorporate uncertainty into the analysis. The method of presented volatility estimation can be applied by taking into account the randomness of many input data to the project.

Stochastic internal rate of return on investments in sustainable assets generating carbon credits

Internal rate of return (IRR) is a widely used tool in ranking capital budgeting projects and eventual accept or reject decisions. In this paper, we consider an investment decision involving a sustainable, energy efficient, greenhouse gases (GHG) reducing asset and incorporate the value of carbon emission allowances for the investing company. These allowances create cash flows that may be characterized by significant volatility and uncertainty. The methodology developed in this paper allows decision makers to integrate their knowledge of carbon trading markets and the cash flows that result from sale of emissions credits. The novel methodology utilizes a Bayesian model for IRR that uses Gibbs sampler. Analysis of the results shows that IRR is influenced by volatility and uncertainty of carbon credit cash flows. Ignoring those uncertainty characteristics and simply using the expected values of cash flows can result in significantly inaccurate investment rate of returns. When compared to deterministic IRR calculations, the results show that the occurrence of very high and very low cash flows affects IRR positively, whereas higher variability of cash flow distribution affects IRR of GHG-reducing asset negatively. In other words, frequent large or small cash flows are preferred over fluctuating cash flows. The results may also provide a rationale for the existence of an anomalous consumer behavior known as the energy efficiency gap.

Baker Packaging, Inc

Students consider which capital budgeting approach to take when evaluating a packaging manufacturer's joint venture proposal. Suitable for MBA and undergraduate students, the case presents a scenario in which a lack of short-term profits and the resulting lack of tax payments could make adjusted present value a better choice than weighted average cost of capital. Students also consider how to value the industrial bond financing that would fund construction of a new plant. A supplemental student spreadsheet is available (UVA-F-1624X). Excerpt UVA-F-1624 Rev. Jan. 18, 2011 Baker Packaging, Inc. Tom Hanes of Baker Packaging, Inc., had just finished reviewing the materials for the new joint venture with Thurston, Inc., a large European printing firm. The proposal was for the development of a new packaging and printing plant to be built in Rocky Mount, North Carolina. Even though the company had always used a weighted average cost of capital (WACC) approach to evaluate capital budgeting projects, Hanes was concerned the analysis might not capture all of the proposal's nuances. His concerns centered on the fact that the project would sustain losses in the early years, which would mean no tax payments. In addition, he had some questions concerning how much value to attribute to the industrial revenue bond (IRB) financing that was being used to fund the project. Baker Packaging management needed to make a decision by December 15, 2010. It was already December 1, so Hanes knew he had little time to completehis review. The Company Baker Packaging was founded by John and Karen Baker in 1985 in Medford, Massachusetts. Previously, Karen had been a corporate lawyer for a large multinational company. Her husband, John, trained as an engineer, had worked 15 years at Federal Paper Board Company, Inc., and he believed Federal was not taking full advantage of developing technologies. The couple started their own company with the aim of fully integrating new technology into what had been up to that point a relatively labor-intensive process. Sales had grown from about $ 100,000 in the initial year to over $ 50 million. Baker Packaging operated five plants that produced packaging and paper products for a number of large consumer products companies. (See Exhibit 1 and Exhibit 2 for Baker's recent financial information.) . . .

Capital Budgeting Practices in Nepal: A Survey

This study aimed at ascertaining the adequacy of financial resources for capital investment, financial objectives, qualitative factors, capital budgeting techniques, minimum return standard, and method of measuring the risk in the context of Nepalese enterprises. The study was based on questionnaire survey of 65 financial executives conducted in 2006. The study revealed that the majority of respondents did not have adequate resources for investment in fixed investment. The majority of the enterprises had plan to increase their investment in fixed assets. The major type of capital budgeting project was related to expanding plant capacity, followed by adding new product line, undertaking reorganization/modernization program, and undertaking replacement activities. It was observed that DCF methods, which were regarded as theoretically sound methods, did not reveal to be the most preferred methods of capital budgeting evaluation.As regards qualitative factors, the most important factor was legal factors while the least important factors were employee safety and morale. With respect to minimum required rate of return for the accept/reject criterion in capital budgeting evaluation, ‘management determined target rate of return’ was observed to be the most popular one. The weighted average cost of capital did not appear to be the most preferred standard.Concerning the cash flow forecasting methods in capital budgeting, the most preferred method was observed to be management’s subjective estimates. The quantitative methods were used less by Nepalese enterprises while estimating cash flows.The most preferred definition of risk in capital budgeting was observed to be the probability of not achieving target return. The majority of Nepalese respondents did not use any formal risk analysis technique. For those who were using risk analysis technique, the important methods were, shortening the payback period and raising required rate of return.

The use of capital budgeting techniques: an outlook from Italy

Capital budgeting is one of the most important areas of financial management. Different techniques are used to evaluate capital budgeting projects: the Payback Period (PP), the Net Present Value (NPV) and the Internal Rate of Return (IRR). Graham and Harvey (2002) highlight that financial managers favour methods such as the IRR or non–discounted Payback Period (PP). The results of this research revealed that PP, followed by NPV, is the most used method. The more complex methods are most favoured by the large enterprises. The principal weakness of the evaluation process is the definition of cost of capital: approximately 70% of the enterprises considered use non–quantitative techniques to consider risk. This study provides those evaluating investment projects or conceiving capital budgeting manuals or policies with knowledge about common pitfalls that, if acted upon, could improve decision making. This study is exploratory research and the results represent a basis for further research.

Capital Budgeting: A 'General Equilibrium' Analysis

As presented in leading corporate finance textbooks the predominant method for making capital budgeting decision is discounted cash flow analysis. The primary benefit of this approach is that it allows for different discount rates to be used for different projects. In this paper, I argue that this alleged benefit is, in fact, a detriment for two reasons. First, the betas that determine the differing discount rates are not only measured with significant error, but tend to drift substantially over the life of typical capital budgeting projects. Second, introducing differential discount rates is likely to conflict with other “general equilibrium” management objectives related to developing a successful corporate culture that promotes collaboration and innovation. This explains why many companies, particularly companies that have a large number of growth options, choose alternatives to discounted cash flow such as the internal rate of return.

Reinvestment Assumptions Inherent in DCF Methodologies: The Concept of Reinvestment IRR

The Reinvestment Assumptions in DCF Methodology does not matter when capital budgeting projects are evaluated individually under normal circumstances. This is because the free cash flows are expected to earn opportunity cost of capital. The reinvestment assumptions become important when ranking mutually exclusive projects that differ in timing of cash flows. Though the NPV measure ranks the projects correctly even in the case of mutually exclusive projects, the implicit reinvestment assumption in DCF Methodology becomes important and is the actual reason for different ranking by IRR and NPV measures. Also, in such cases, the projects chosen depend on the firm and its applicable cost of capital. The financial literature generally provides two interpretations for reinvestment assumptions. These are mathematical interpretations that are valid within the duration of the life of the project. When extended beyond the duration of the project, they do not reflect the implicit reinvestment assumptions inherent in the DCF Methodology. This paper elaborates on the reinvestment assumptions inherent in the DCF Methodology using the concept of “Reinvestment IRR” by differentiating the Free Cash Flows (FCF) of capital budgeting projects with that of Firm Valuation Models. The paper also shows that the concepts like MIRR do not have valid theoretical basis. The paper shows that when two mutually exclusive projects are evaluated, the investor becomes indifferent between the two projects if the shorter project’s free cash flows can be reinvested at a Reinvestment IRR equal to Fisher Rate. This is also the inherent assumption behind the evaluation using incremental cash flows generally adopted for mutually exclusive projects. The paper shows that the Fisher Rate and Incremental Cash Flow analysis are not based on the conventional interpretations of reinvestment concept. The impact of reinvestment IRR for projects and firms with differing risk characteristics is analysed.

Coffee Anyone? - Part 2: Additional Business Opportunity Statements For Unstructured Capital Budgeting Projects

This paper builds on an earlier paper that presented an unstructured, semester-long team-based capital budgeting project for senior level undergraduate accounting students. Successfully completing this project required accounting students to step outside of their narrow accounting transactions framework and to apply extensive organizational, analytical, information gathering, and critical thinking skills. This extension paper provides two additional Business Opportunity Statements that can be assigned to student groups for semester projects. Utilizing these additional Statements will allow faculty to challenge consecutive semesters of students.

The Effects of Autonomy, Internal Control, and Accountability on Overconfidence in Capital Budgeting Decisions

The purpose of this study is to investigate the effects of managers’ autonomy in choosing a capital budgeting project on their confidence in managing the project. Furthermore, this study examines the role of internal audit report and accountability in mitigating the impact of autonomy on managers’ resistance to abandon unprofitable capital budgeting projects. Building on the motivated reasoning theory, we hypothesize and find that managers who were given autonomy to choose their own projects are more confident that their project will be successful as compared to those who were assigned imposed the projects by their superiors. This study also shows that internal audit report and accountability are effective mechanisms to reduce the influence of prior decision on managers’ resistance to abandon the unprofitable projects.

Coffee Anyone? An Unstructured Capital Budgeting Project To Encourage Critical Thinking Skills In Accounting Students

Coffee Anyone? An Unstructured Capital Budgeting Project To Encourage Critical Thinking Skills In Accounting Students

To Iterate Or Not To Iterate? Using The WACC In Equity Valuation

The textbook discounted cash flow (DCF) valuation method involves estimating a target debt ratio for the firm, discounting firm cash flows at the WACC to estimate firm value, then subtracting the current value of debt to get equity value. This method gives the correct equity value in situations in which the firm will move toward the target debt ratio after the transaction is complete, such as takeovers and capital budgeting projects. The textbook method does not work well for estimating equity value in passive investments in which leverage is unlikely to change as a result of the potential transaction. Estimating equity value in passive investments when leverage is unlikely to change requires a simple iterative procedure to correct for circularity, which is demonstrated here. This situation sows confusion among students and practitioners. Finance scholars and textbook authors are aware of the situation but the author has never seen it clearly explained in prior textbooks or articles.

Capital Budgeting: A 1990 Study Of Fortune 500 Company Practices

Capital budgeting investment decisions are fertile ground for researchers because these decisions both involve the use of a large portion of a firms assets and require predictions of the future. Various techniques are used to analyze capital budgeting projects. Among these are (1) net present value (2) internal rate of return (3) payback and (40 several averaging methods. This paper seeks to determine what methods are currently used by major American firms to determine if the more theoretically correct methods are employed and how firms implement and monitor the techniques used. The authors surveyed the Fortune 500 Companies and received some surprising responses. Replies from firms indicated that most firms use the theoretically superior discounting methods when analyzing capital budgeting problems. However, almost 21% of the respondents stated that payback was their preferred method for analysis. The study further showed that payback, while popular, was used for relatively small projects. The study revealed one major area of concern which was that of review and feedback. Approximately 20% of the firms surveyed had no review mechanism and thus may be making poor decisions because of failure to adjust their models as business conditions change. In summary, the study has two surprising findings regarding capital budgeting. First, almost 21% of the responding firms used payback as the preferred method of analysis. While most of the projects where payback was applied were small, the wide acceptance of payback was surprising. Second, and perhaps of greater importance, was the failure by approximately 20% of the firms to employ a review procedure. Without such a procedure, those firms will be unable to adapt quickly to changes in the business environment.

Capital budgeting practices used by selected listed South African firms

This article investigates the application of capital budgeting techniques and the incorporation of risk into the capital budgeting process among a sample of South African industrial firms listed on the JSE Securities Exchange for at least ten years. Previous international and local research on this topic indicated a preference for the internal rate of return (IRR) as a capital budgeting method over the net present value (NPV), and that risk incorporation was relatively rarely incorporated into the capital budgeting process. The results of this study indicate that the NPV is just as popular as, and sometimes more so than, the IRR. Furthermore, compared to previous studies, risk is incorporated into evaluating capital budgeting projects more often. Sensitivity analysis is the most popular method, but adjustments to the cash flows and discount rate are becoming more popular. During the last decade the use of non-financial criteria to accept or reject a project has also increased in South Africa.

The Use Of Capital Budgeting Techniques In Businesses: A Perspective From The Western Cape

<p class="MsoNormal" style="text-align: justify; margin: 0in 0.5in 0pt; tab-stops: 1.0in;"><span style="font-family: Times New Roman;"><span style="font-size: 10pt; mso-fareast-font-family: Batang;" lang="EN-ZA">Capital budgeting is one of the most important areas of financial management. There are several techniques commonly used to evaluate capital budgeting projects</span><span style="font-size: 10pt;" lang="EN-ZA"> </span><span style="font-size: 10pt; mso-fareast-font-family: Batang;" lang="EN-ZA">namely the payback period, accounting rate of return, present value and internal rate of return and profitability index</span><span style="font-size: 10pt;" lang="EN-ZA">.</span><span style="font-size: 10pt; mso-fareast-font-family: Batang;" lang="EN-ZA"> Recent studies highlight that financial managers worldwide favor methods such as the internal rate of return (IRR) or non-discounted payback period (PP) models over the net present value (NPV), which is the model academics consider superior.</span><span style="font-size: 10pt;" lang="EN-ZA"> In particular this research focused on small, medium and large businesses and investigated a number of variables and associations relating to capital budgeting practices in businesses in the Western Cape province of South Africa. The results revealed that payback period, followed by net present value, appears to be the most used method across the different sizes and sectors of business. It was also found that 64% of businesses surveyed used only one technique, while 32% of the respondents used between two to three different types of techniques to evaluate capital budgeting decisions. The findings show that the more complicated methods such as IRR and NPV are most favored by the large businesses as compared to the small businesses. The majority of the respondents believed that project definition was the most important stage in the capital budgeting process. Implementation stage appeared to be the most difficult stage for the manufacturing sector whereas Project definition, Analysis and selection and Implementation were generally rated as being the difficult stages by the retail sector. Project definition and Analysis and selection </span><span style="font-size: 10pt; mso-ansi-language: EN-GB;" lang="EN-GB">were found to be the most difficult stages by the service sector.</span><span style="font-size: 10pt;" lang="EN-ZA"> Most businesses used the cost of bank loan as a basis in capital budgeting and</span><span style="font-size: 10pt; mso-ansi-language: EN-GB;" lang="EN-GB"> more than two thirds of respondents used non-quantitative techniques to consider risk when making a decision on investing in fixed assets. </span></span><span style="font-size: 10pt;" lang="EN-ZA"></span></p>

Why Entrepreneurs and VCs Disagree in Valuing Start-up Firms: Imputing the Target Rate of Return using DCF vs. Option-Based Approaches

Entrepreneurs and VCs often disagree on their valuation of start-ups. This article offers a new reason why. The Venture Capital (VC) method is a standard method for valuing startup firms. It requires an estimate of terminal firm value or Net Income, a comparable industry’s P/E ratio, and a target rate of return to be used as the discount rate. All of these quantities are subject to estimation risk, but the choice of the target discount rate is the most questionable. VCs typically use high target rates of return to compensate for the risk of the venture; a natural question is how to justify these high target rates of return. Discounted cash flow (DCF) methods, such as the VC method, assume that a start-up can be valued like any other standard capital budgeting project. However, start-ups have valuable embedded real asset options which are ignored by DCF methods. This article uses option pricing techniques to impute the appropriate target rate of return. It shows that the appropriate target rate depends on precisely what the VC is valuing. If the VC is valuing a stream of ordinary expected cash flows, as in the DCF approach, one target rate of return is implied. A different target rate is implied if the VC is valuing a start-up firm including its embedded real asset options. This article shows how to adjust target rates of return for insurance value and gives detailed illustrations of the magnitudes of the adjustment. <b>TOPICS:</b>Private equity, statistical methods, analysis of individual factors/risk premia, risk management