I agree that many businesses around the world fail because of poor resources management, including the failure to base their capital investment decisions upon appropriate investment methods.
RESEARCHES AND USE OF THE VARIOUS INVESTMENT ASSESSMENT METHOD
Previous researches carried out by scholars and investment analysts in many parts of the world have indicated that though the importance of capital budgeting is recognized by companies, many companies still base their decisions upon incorrect methods of investment appraisal and capital expenditure as well. These researches have indicated that all over the years different businesses use different methods of investment appraisal and the majority rely on discounted cash flow method (either the internal rate of return or the net present value) as the primary method and the payback as the secondary method.
Research details published online by Allbusiness.com (2010), present various companies in Europe and America that used the various methods of investment appraisal. In 1972, as per Albusiness.com, In an in-depth study of the capital budgeting projects of 12 large manufacturing firms, Marc Ross found, that although techniques that incorporated discounted cash flow were used to some extent, some firms relied rather heavily on the simplistic payback model, especially for smaller projects. In addition, when discounted cash flow techniques were used, they were often simplified.(Ross, 1986). On the other hand, James Fremgen surveyed a random sample of 250 business firms in 1973 that were in the 1969 edition of Dun and Bradstreet's Reference Book of Corporate Management. Questionnaires were sent to companies engaged in manufacturing, retailing, mining, transportation, land development, entertainment, public utilities and conglomerates to study the capital budgeting models used, stages of the capital budgeting process, and the methods used to adjust for risk. He found that firms considered the internal rate of return model to be the most important model for decision-making. He also found that the majority of firms increased their profitability requirements to adjust for risk and considered defining a project and determining the cash flow projections as the most important and most difficult stage of the capital budgeting process (Fremgen, 1973). Laurence G. Gitman and John R. Forrester Jr. analyzed the responses from 110 firms who replied to their 1977 survey of the 600 companies that Forbes reported as having the greatest stock price growth over the 1971-1979 period. They found that the discounted cash flow techniques were the most popular methods for evaluating projects, especially the internal rate of return.
There are more researches published but bringing them all to this essay would cost us a lot of time. But, as we can appreciate from the researches above, the majority of the firms relied on a discounted cash flow method (either the internal rate of return or the net present value) as the primary method and the payback as the secondary method.
CURRENT RESEARCH
To support the researches above, this week I have had a conversation on capital budgeting and capital expenditure with the Financial Manager of Delta Corporations, Mrs. Patience Matsizere. She said that the Net Present Value (NPV) is the preferred one at Delta for investment appraisal. Mrs. Matsizere said that this method is preferred because it takes into consideration the relevant cash flows and also because �it has a direct bearing on the wealth of the business� Laureate Online Education (2007).
Delta Corporation is a broad-based company with interests in beverages (manufacturing and distribution) and the Agro Industrial sectors. It is listed on the Zimbabwe Stock Exchange and is one of the top quoted companies in terms of market capitalization. (Delta,2008). Deltas� investments on machineries and transportations are considerable. Last year, they invested on new technology machineries (capital expenditure) for the distillation site. The costs of the new machines were not revealed, but according to Mrs Matsizere, the machines have a life-span of 10 years and they are annually depreciating. The old machines were used for 25 yeas (15 years more than the projected and depreciation period) because of the cash problems that were caused by the financial and economic crisis and hyper-inflation Zimbabwe faces for the past 12 years. Obtaining foreign currency to invest on new technology machineries was a problem. There was a cash problem then. However, since the beginning of 2009, the Reserve Bank of Zimbabwe is using the USD and the SA Rand as the currency for Zimbabwe in order to deal with foreign currency issue. The country�s Zim$ has been put off until new changes. Now it�s comprehensible why most businesses use the NPV for investment assessment, because they take into consideration cash flow, since cash is �the life blood of a business� (Laureate Online Education, 2010).
The advantages of using the NPV as compared to other investment assessing methods such as Payback and Internal Rate of Return are (Laureate Online Education, 2007):
1 � It considers the timing of the cash flows.
2 � It considers the whole of the relevant cash flows
3 � It considers the objectives of the business.
(Laureate Online Education, 2007):
THE PAYBACK PERIOD METHOD
�Measures the length of time required to recover the cost of an investment. In this method, all other things being equal, the better investment is the one with the shorter payback period.� Investopedia (2010). The problem with this method is that: 1 - It ignores any benefits that occur after the payback period and, therefore, does not measure profitability; 2. It ignores the time value of money. Investopedia (2010).
INTERNAL RATE OF RETURN � IRR (also know as Economic Rate of Return)
�This model determines the interest rate at which the NPV equals zero. If this rate, called the internal rate of return, is greater than the minimum desired rate of return, a project is desirable. If not, it is undesirable� Horngren (2006)
HOW CAPITAL BUDGETING IS MADE WITHIN DELTA CORPORATION
At Delta, before projects are submitted to the Financial department for approval, the submitting department must make a pre-assessment about the cost-benefits of the projects. After all the project proposals are submitted to Finance, a further cost-benefit analysis is carried out with the Finance Team in order to assess the benefit of that project of capital expenditure using the Net Present Value. The approved projects are then included in the annual Capital Budget. Projects include buying new assets, replacement of old assets (machineries) or adding more value to existing assets. As a summary, the following are the steps involved (Jhingan and Stephen, 2006):
1 - Project generation
2 � Project Evaluation
3 - Project Selection
4 � Project Execution
(Jhingan and Stephen, 2006, p. 671)
RISK IN CAPITAL INVESTMENT
Investing in Capital involves taking risks. Businesses owners and managers are aware of this and that�s why appropriate caution is taken before the decision to invest in capital is taken. Laurate Online education (2007) suggest that �Investment decisions tend to be of crucial importance to the business because: 1 � Large amounts of resources are often involved; 2- It is often difficult and/or expensive to �bail out� of an investment once it has been undertaken� Laureate Online education (2007).
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CAPITAL INVESTMENT RISK MANAGEMENT AT AfDB
In an interview published by the African Development Bank (AfDB)�s website, Dr. Kodjeidja Diallo, who is the Bank�s Group Risk Management department Director, said that the bank�s inexperience in risk management has obliged collaborations with banks such as the International Finance Corporation (IFC) and the European Investment Bank (EIB). (AfDB, 2009). Dr. Diallo added that �the role of the risk management department is to ensure that the risks which the Bank takes are within appropriate parameters and limits and to ensure that the Bank has sufficient capital and risk bearing capacity to be able to take on those risks. The Bank currently has significant unused risk capital (50%) which will enable it to scale up its activities. The Bank�s risk capital would enable it to sustain lending under the medium term strategy (MTS) until around 2013. However, in order to further increase lending above the MTS levels, particularly in response to the financial crisis and to continue to sustain net income transfers to development initiatives, it is expected that additional risk capital would now be needed in 2011. The Board of Governors will consider a recommendation during the Annual Meetings of the Bank to begin consultations with its shareholders for a possible increase in capital. This is also in line with the recommendations of the G20 which recently called for the capitalization of each MDB to be evaluated and for further capital to be provided, if needed, to enable them to expand their lending to support their borrowing member countries during the financial crisis.� (AfDB, 2009).
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