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Table of Contents

Table of Contents..................................................................................................................i

CHAPTER ONE..................................................................................................................1

INTRODUCTION ..............................................................................................................1

Background..........................................................................................................................1
Historical Development in Capital Budgeting.....................................................................2
Capital Budgeting Techniques.............................................................................................4
Theories in capital budgeting..............................................................................................5
Critique of the Capital Budgeting Techniques...................................................................10
CHAPTER TWO...............................................................................................................11

2.1 EMPIRICAL EVIDENCE..........................................................................................11


RESEARCH METHODOLOGY......................................................................................15
Hypothesis..........................................................................................................................15
Research design.................................................................................................................15
Population........................................................................................................................15
Sample selection................................................................................................................15
Data collection...................................................................................................................15
Data analysis......................................................................................................................15
CONCLUSIONS AND UNRESOLVED ISSUES............................................................16

Suggested Study Areas......................................................................................................16


Conclusion.........................................................................................................................17
REFERENCES..................................................................................................................18

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CHAPTER ONE

INTRODUCTION

Background

Gitman (2002) defines capital budgeting as the “process of evaluating and selecting long
term investments that are consistent with the business’s goal of maximizing owner
wealth”. Firms make a variety of long-term investments but the most common are those
in fixed assets commonly referred to as earning assets. Every organization that embarks
on this process must take all necessary steps to ensure that their decision making criteria
supports the business’s strategy and enhances its competitive advantage over its rivals.

The capital budgeting decision is an important decision for the firm since the firms’
survival and profitability hinges on capital expenditures, especially the major ones
Pandey (1995). Capital budgeting decisions are crucial to a firm's success for several
reasons. First, capital expenditures typically require large outlays of funds. Second, firms
must ascertain the best way to raise and repay these funds. Third, most capital budgeting
decisions require a long-term commitment finally, the timing of capital budgeting
decisions is important. When large amounts of funds are raised, firms must pay close
attention to the financial markets because the cost of capital is directly related to the
current interest rate.
A good capital budgeting process does more than just make accept-reject decisions on
individual projects. It must tie into the firm’s long range planning process that decides
what lines of business the firm should concentrate in and sets out plans for financing,
production and marketing etc. It must also tie into a procedure for measurement of
performance (Brealey & Myers, 2007).

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Historical Development in Capital Budgeting

1.1.1 The Period up to 1950

Earlier approaches to capital budgeting models were concerned mostly with the
economic evaluation of individual projects. For many years, most firms used Payback
period to evaluate investment project. In 1899, Irving Fisher first articulated the concept
of NPV as the market value of securities minus cost of resources. Fisher (1930) advanced
the Theory of Interest in which he suggested that NPV is the key part in theory of optimal
resource allocation. Fisher labeled his theory of interest the “impatience and opportunity”
theory. He put forward that Interest rates, were as a result of the interaction of two forces:
the “time preference” people have for capital now and the investment opportunity
principle (that income invested now will yield greater income in the future). The interest
rate, or what is called cost of Capital, forms the basis of the Internal Rate of Return (IRR)
defined as the discount rate that will equate the present value of future cash flows to the
resources employed now.

Fisher defined capital as any asset that produces a flow of income over time. A flow of
income is distinct from the stock of capital that generated it, although the two are linked
by the interest rate. Specifically, wrote Fisher, the value of capital is the present value of
the flow of (net) income that the asset generates.

In the period between 1930s and 1950s non owner managed firms put in place capital
budgeting control systems that identified planned capital investments going forward. The
size of non financial investments and the number of non owner managed firms increased
during the industrial revolution. These simultaneous changes created fertile ground for
use of more sophisticated evaluation techniques and for the capital budgeting processes in
use today (Chapman & Hopwood, 2007)

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1.1.2 1951 to date

During the 1950s, practicing financial controllers began to network with each other, with
consultants and with academicians to develop models for capital budgeting (Chapman &
Hopwood, 2007). Dean (1951), in his book Capital Budgeting, advanced the
implementation of Discounted Cash flows (DCF) methodology in its current form.

Managers are required to maximize return on investment at a given level of risk.


However capital budgeting models only consider the return on investment. As a result,
managers don’t usually have all the information to make the right decisions as far as risk
is concerned. To address this flaw, Hertz (1964) provided a discussion on how computer
simulation can be used to provide managers with a measure of risk on a capital
Investment Project.

Agency theory that developed in the late 1970s and early 1980s gave rise to analytical
models of capital investment process. These models suggest that current capital
budgeting procedures are a means of reducing agency costs that emanate from the
conflict of interest between owners of firms and management. The internal rate of return
(IRR) and the net present value (NPV) have long been the accepted capital budgeting
measures preferred by corporate management and financial theorists, respectively. While
corporate management prefers the relevancy of a yield-based capital budgeting method,
such as the IRR, financial theorists, based on Orthodox economic theory, endorse the
NPV method. The debate between NPV and IRR methods dates from the inception of
modern interest theory. The introduction of the NPV as amore superior model created the
impetus for conflict between the two methods. However, both methods suffer from
inconsistencies when ranking potential investment projects based on the assumption of
wealth maximization. Therefore, a consistent capital budgeting method must be robust
when correctly ranking and selecting superior investments in varying investment
environments, remain theoretically sound by maintaining the assumption of wealth

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maximization, and be expressed as a yield based measure as preferred by corporate
management (Chapman & Hopwood, 2007).

Capital Budgeting Techniques


Bringham and Besley (2000) identify several basic methods used by businesses to
evaluate projects and to decide whether they should be accepted for inclusion in the
capital budget. These methods are; Payback period, net present value and internal rate of
return. The payback period method is a non discounting technique since it does not
consider the time value of money. NPV and IRR are referred to as discounting techniques
since they take into account time value of money.

1.1.3 Pay Back Period

Bringham and Besley (2000) define payback period as the number of years required to
recover the original investment. It’s the simplest and the oldest formal method used to
evaluate capital budgeting method. Using the pay back to make capital budgeting
decisions is based on the concept that it’s better to recover the cost of a project sooner
rather than later. As a general rule a project is considered acceptable if its payback
period is less than the maximum cost recovery time established by the firm. The major
limitations of this method are the failure to recognize the time value of money and cash
flows beyond the payback period.
Pay back period =initial cash outlay
Annual cash inflows

1.1.4 Net present Value (NPV)

(Bringham & Besley, 2000), defines NPV as a method of evaluating capital investment
proposals by finding the present value of future net cash flows discounted at a rate of
return required by the firm. To implement this approach, we find the present value of all
future cash flows a project is expected to generate and then subtract its initial investment
to find the net benefit the firm will realize from investing in the project. If the net benefit

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computed on a present value basis is positive, then the project is considered acceptable
investment. The advantage of this method is that it recognizes the the time value of
money.

1.1.5 Internal Rate of Return (IRR)

IRR is the discount rate that equates the PV of the cash inflows with initial investment
associated with the project (Gitman 2002). As long as the project’s IRR, is greater than
the rate of return required by the firm for such an investment, the project is accepted. The
technique has two major limitations. First, when a project has unconventional cash flow
patterns, there is a likelihood of getting multiple IRRs. This is because there exists an
IRR solution for each time the direction of the cash flows associated with a project
changes. Secondly, in the case of mutually exclusive projects, the technique can result in
the acceptance of the lesser viable project. This is because the IRR method assumes that
the interim cash flows are reinvested at the projects’ discount rate. (Bringham & Besley,
2000)

n CFt
IRR : ∑ = $0 = NPV
t = 0 (1 + IRR ) t

1.1.6 Modified Internal Rate of Return (MIRR)

Bringham & Besley (2000) define MIRR as the discount rate at which the present value
of a project’s cost is equal to the present value of its terminal value, in which the terminal
value is found as the sum of the future values of the cash flows, compounded at the firm’s
required rate of return. The use of the technique helps overcome the IRRs limitation
resulting from the reinvestment rate assumption.

Theories in capital budgeting

1.1.7 MMs capital budgeting theory

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MM pursues value maximization to increase the combined market values of debt and
equity. In mms theory the two sources of financing used are permanent and equity is a
form of permanent financing. Since permanent financing is employed, the payment of
principal is unnecessary so unlike in normal capital budgeting depreciation is set aside
each year to replace the obsolete capital and investors do not recover the initial
investment at all. According to MM the cost of capital is the weighted average cost of
capital. To sum up MM theory, the value of a levered firm is the after –tax cash flows for
the stockholders discounted at the cost of equity plus the after tax flows from bond
holders discounted at the cost of debt or identically its value is the NOI discounted at the
Wacc. Therefore MM maximized the combined value of equity and debt or equivalently
the combined wealth of the stockholders and bond holders.

1.1.8 Contemporary capital budgeting theory


Contemporary capital budgeting theory is deeply rooted in MM's theory which was
discussed in the previous section. Slight differences abide, though, because, contrary to
MM's permanent cash flows, investment projects have limited useful lives in the real
world. In making capital budgeting decisions, five important elements are to be
considered: the initial investment, the operating cash flow, the useful life of the project,
the salvage value, and the cost of capital.

Since the limited project life creates discrepancies between MM's and contemporary
theory, it is discussed before the other four components. In most major textbooks, a fixed
serviceable life is assumed, so the project will be in place for a few years, and, after that
period, it will be closed. See Block and Hirt (1994), Brigham and Gapenski (1993), Kolb
and Rodriguez (1992), Van Home (1992), and Weston and Brigham (1993). The
implication is that, upon the close of the project, the venture is to be dissolved, so the
company must pay back the par value of bonds to bondholders and the par value of
common shares to stockholders. Therefore, unlike in MM, depreciation is not
accumulated from year to year to replace the capital asset. Instead it is added back to the
NOI to increase the operating cash flow for the investors.

The initial investment is the amount of capital required upfront to start a project which
includes, but is not limited to, the purchase price of the capital asset, sales taxes,

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transportation cost, installation cost, and the working capital needs. In MM, the investors
never recapture the initial investment because the project will go on forever; in current
theory this amount is recovered through the operating cash flows from the project.
The operating cash flow in current theory is the cash inflow to the investors from the
project. MM's cash flow is the NOI given by equation (1), but the operating cash flow in
today's capital budgeting (OCF, hereafter) is MM's NOI less the tax shield benefit of
interest payment plus depreciation.

1.1.9 Real options theory

Black, Scholes, and Merton (1973) their work offers us a standard pricing model for
financial options. Together with Stewart Myers, they recognized that option-pricing
theory could be applied to real assets and non-financial investments. To differentiate the
options on real assets from the financial options traded in the market, Myers coined the
term “real options”, which has been widely accepted in academic and industry world.
Unlike the standard corporate resource allocation approaches, the real options approach
acknowledges the importance of managerial flexibility and strategic adaptability. Its
superiority over other capital budgeting methods like discounted cash flow analysis has
been widely recognized in analyzing the strategic investment decision under uncertainties
(Luehrman, 1998)

Traditional approaches to capital budgeting, such as discounted cash-flows (DCF), cannot


capture entirely the project value, for different reasons: it is assumed that investment
decision is irreversible, interactions between decisions today and future decisions are not
considered, and investment in assets seems to be a passive one i.e. management doesn’t
interfere during the life of the project. Managerial flexibility generates supplementary
value for an investment opportunity because of managerial capacity to respond when new
information arises, while the project is operated. Investment in real assets includes a set
of real options that management can exercise in order to increase assets value (under
favorable circumstances) or limit loses (under unfavorable situations). Managerial
flexibility in decision-making process introduces an asymmetry for probability
distribution of net present value (NPV) for a project. An investment opportunity value is

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dependent on future uncertain events, so it will be greater than forecasted value in the
situation of passive management. From this perspective, a project has a standard value,
determined through traditional techniques (DCF, which does not capture adaptability and
strategic value), but also a supplementary value, coming from operational and strategic
real options held by an active management (Vintila, 2007).

Real options are options to modify projects. If financial managers treat projects as black
boxes, they may be tempted to think only of the first accept–reject decision and to ignore
the subsequent investment decisions that may be tied to it. But if subsequent investment
decisions depend on those made today, then today’s decision may depend on what you
plan to do tomorrow. When you use discounted cash flow (DCF) to value a project, you
implicitly assume that the firm will hold the assets passively. After managers have
invested in a new project, they do not simply sit back and watch the future unfold. If
things go well, the project may be expanded; if they go badly, the project may be cut
back or abandoned altogether. Projects that can easily be modified in these ways are more
valuable than those that don’t provide such flexibility. The more uncertain the outlook,
the more valuable this flexibility becomes. The various real options in capital budgeting
decisions include;
Option to Wait (Option to Defer)

Management has an option to choose the timing of investment. This type of real option
usually occurs in natural-resource-extraction, real estate development, farming and
fishery industries.

Option to Abandon

If market conditions change unfavorably management has an option to abandon current


operation permanently and regain some of the initial investment cost by selling it. The
abandonment option is mainly important in new product introductions in uncertain
markets, capital-intensive industries, such as airlines, shipping lines and railroads.

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Option to Switch

Use (e.g., Inputs or Outputs): When output prices or the output demand changes
management can change the output mix (product flexibility) or produce the same output
using different types of inputs (process flexibility).

Growth Options

This type of option occurs when initial investment is chained to other subsequent
investment projects. Growth options are mostly expected in all infrastructure based or
strategic industries, hi-tech, R&D (computer, pharmaceuticals) and industries with
multinational operations and strategic acquisitions.

Time-to-Build Option (Staged Investment)

When investment costs occur in stages there is always an option to abandon the next
stage of the investment if expectations change unfavorably. Each stage is an option on the
value of the subsequent stages. This option is important in long-development capital-
intensive projects, all R&D-intensive industries, energy generating plants and
pharmaceutical industries.

Option to Alter Operating Scale (e.g. to Expand; to Contract; to Shut Down):

If market conditions are more favorable than expected, the firm can expand the scale of
production or accelerate resource utilization. Conversely, if conditions are less favorable
than expected, it can reduce the scale of the operations. Examples of this real option can
be found in natural-resource industries (mining), consumer goods and commercial real
estate.
Among the above options, option to wait and option to abandon are recognized as the
most important real options which are embedded in most investment opportunities

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Critique of the Capital Budgeting Techniques

In Brealey & Myers (2007), NPV is professed as the more superior method to all others.
However, the NPV method also has deficiencies and is inconsistent in some investment
environments. Specifically, the NPV has been shown to be inconsistent in selecting
superior investments and ambiguous in maintaining the goal of wealth maximization in
environments when investments have different economic lives.

Alternative methods, such as the Payback method and the use of earnings multiples, are
also common. The payback is seen as possibly the most seriously flawed method,
because it ignores the time value of money and cash flows beyond an arbitrary cut-off
date. Weston and Bringham (1981) suggest that it may be rational for cash constrained
firms to use this method. Other suggested explanations for the use of the Payback method
are that it may be used by managers to approximate the riskiness of a project. That it can
approximate the option value of waiting to invest and that it can be explained by the lack
of sophistication of management (Graham & Harvey, 2002).

The traditional DCF methods are popular; however, financial economists have long
acknowledged that its universal application is not strictly appropriate. The problem arises
because the simple DCF approach ignores management’s ability to alter decisions and
outcomes once a project is undertaken. This managerial flexibility is referred to as “real
options” in the academic literature.

The idea that real options should be included in a capital budgeting analysis has recently
gained wider acceptance and is commonly promoted as the most appropriate method for
valuing strategic investment decisions.

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CHAPTER TWO

2.1 EMPIRICAL EVIDENCE

(Kadondi, 2002) A survey of Capital Budgeting Techniques used by companies


listed at the Nairobi Stock Exchange (NSE)

In her study, Kadondi (2002) carried out a survey on capital budgeting techniques used
by companies listed at Nairobi Stock Exchange (NSE). The objectives were to document
the capital budgeting techniques used in investment appraisal by corporations in Kenya,
to determine whether the techniques used conform to theory and practices of
organizations in developed countries and to determine how firms and CEO characteristics
influence the use of a particular technique.

She intended to conduct the study on 54 Companies listed at the NSE but the analysis
included only 43 Companies whose annual reports and accounts were available. Of these,
only 28 Companies responded of which 50% were small companies and 50% large
companies. Data was collected through questionnaires.

Data was analyzed using SPSS and was put into frequency distribution tables. Chi-square
test was used to test relationships between techniques and firm characteristics. The
findings of the study were that 31% of the companies used Payback Period method, 27%
use NPV while 23% uses IRR. According 71% of respondents, their companies
considered capital budgeting process a strategy for achieving competitive edge
advantage. Another finding of the study was that small companies use IRR and Payback
Methods while large Companies with high net profit margins use NPV, IRR and Payback
Period methods.

This study is consistent with the survey done by (Graham & Harvey, 2002) who found
that large firms favored the sophisticated techniques of capital budgeting while the
smaller firms favored the traditional methods of payback and ARR. The issue of capital

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budgeting techniques being used as a strategic tool for benchmarking and gaining
competitive edge was imminent in the study and we concur with the findings.

(Njiru, 2008): A survey of capital investment appraisal techniques used by


commercial parastatal in Nairobi.

The study’s objective was to identify the most commonly used capital investment
appraisal technique by commercial parastatals and determine the factors that influence
the choice of capital investment appraisal technique used by commercial parastatals. It
covered all commercial parastatals with headquarters in Nairobi and was for the period of
5 years between 2003 and 2008. The researcher used the survey method. He asked
questions about capital investment appraisal technique used in the organizations and
explored factors considered by the parastatals in making these decisions. He used
questionnaires consisting of both closed and open-ended questions.

Interpretation and analysis of data was done using the statistical package for social
science (SPSS). Out of the 30 parastatals targeted, only 20 responded which was a
response rate of 67%. Descriptive statistics, in particular, arithmetic mean and standard
deviation were used to interpret responses to the questionnaires.

The analysis revealed that on average, the annual size of capital budget is 1.4% of the
total asset base of the organizations studied. This implies a low intensive capital
investment during the study period (2003-2008). The study also found that all the
parastatals had a capital investment policy.

The results showed that incorporating risk, determination of the appropriate discount rate
and incorporating inflation in the capital investment analysis were the three main
challenges that parastatals faced in the capital investment appraisal process.

According to the study, the three main capital investment appraisal techniques used by
commercial parastatals are IRR (65%), NPV (25%) and pay-back period technique
(10%). The amount of funds required for the capital investment, size of the organization,

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government policy and industrial practices are the main factors that influence the choice
of the capital investment appraisal technique. Further the study found that 75% of the
respondents preferred discounted cashflow (DCF), 10% non-discounted cashflow (DCF)
technique whereas 15% did not respond.
(Grinstein & Tolkowsky, 2004)): The Role of the Board of Directors in the Capital
Budgeting Process - Evidence from S&P 500 Firms

Grinstein and Tolkowsky (2004) carried out a Survey to determine the role of the board
of directors in capital budgeting process. The study was carried out in the United States
of America. The sample consisted of “S&P 500” firms and covered the period from 1995
to 2000. Their final sample consisted of 2,262 firms after excluding financial institutions
due to their special governance regulations and requirements and a further 292 firms for
whose proxy statement information was not obtained.

They used several financial and governance variables to characterize what determines the
establishment of the capital budgeting committees which included firm size, board
structure and the ratio of number of independent directors to total number of directors.
They used both univariate and multivariate data analysis methods in their survey. The
findings were that 17% of the boards of directors of the sampled firms disclosed that they
establish committees that have a capital budgeting role. The study revealed that boards of
directors have four main roles in capital budgeting. These roles include reviewing of;
annual budgets, large capital expenditure requests, merger and acquisition proposals and
performance of approved projects. They found that committees that review budgets and
capital expenditure requests perform a monitoring role which is consistent with existing
theories.

They also found that boards are more likely to establish special committees to perform
these tasks where the auditing costs are low and when the overinvestment problem is
severe. Some committees have an advisory role in capital budgeting process. The main
finding of the study was that boards of directors have a dual role in capital budgeting
process, that is the disciplinary role and the advisory role.

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In our opinion, the findings of this study are very relevant, and the role of the board and
that of management should be clearly spelt out in the capital budgeting process of most
firms. It is evident that to reduce agency conflict, the board needs to play a more active
role in the approval of major capital projects.

(Pradeep & Quesada, 2008): The use of Capital Budgeting Techniques in Business:
a perspective from the Western Cape.

Pradeep and Quesada (2008), in a study on the use of capital budgeting techniques in
businesses in the Western Cape Province of South Africa, investigated a number of
variables and associations relating to capital budgeting practices. The sample consisted of
600 firms but only 211 interviews were conducted successfully giving a response rate of
35%.
A descriptive approach to the research finding was adopted. Chi-square test technique
was used to measure association between variables. Data analysis was carried out using
SPSS software.

The results revealed that payback period followed by NPV appear to be the most used
method across the different sizes and sectors of businesses. 39% of respondents used
Payback period technique while 36% used NPV. 28% of respondents used internal rate of
return and profitability index. 22% of respondents used Accounting rate of return while
10% did not use any capital budgeting technique. The study also revealed that 64% of the
business surveyed used only one method of capital budgeting while 32% used between
two and three different techniques to evaluate capital budgeting decisions. The more
complicated methods such as NPV and IRR were favored by large businesses compared
to small businesses.

The findings of this study are contrary to earlier studies by (Graham and Harvey, 2001).
The finding that most firms prefer Payback period to NPV is a pointer to other behavioral
factors like use of intuition, fear of failure and resistant to change.

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CHAPTER THREE

RESEARCH METHODOLOGY

Hypothesis

We will formulate a hypothesis based on the relationship between use of capital


budgeting techniques in investment and profitability of the firm.

Research design
The study will use a cross sectional design. This is a study done at a particular point in
time.

Population
The study will focus on all the energy parastals in Kenya. The study will cover a period
of 5 years from 2004-2008.

Sample selection
Sample is the energy parastals in Kenya. The study will use probabilistic
techinique.Total no of company’s to be analyzed will be 4 firms.

Data collection.
The study will use primary sources of data namely interviews but incase of unavailability
of interviewees, questionnaires shall be used. It shall focus on 4 main energy parasatals in
Kenya. The information will be got from CFOS and staff from the finance department.

Data analysis
Questionnaires will be edited and relevant questions coded for ease of analysis. Statistical
package for social sciences (SPSS) will be used to analyse the data.

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CONCLUSIONS AND UNRESOLVED ISSUES

Suggested Study Areas


Although the area of capital budgeting has been studied widely and various
recommendations made on the most preferable methods, there is still a lot that needs to
be done. The area of real options in capital budgeting, though explored quite widely, has
not been studied locally and this will form very good grounds for a local study.

In their study, Li and Johnson (2002) concluded that although some recent studies
recognized the potential of real options theory in evaluating strategic IT investment
opportunities, they believed that the applicability of various real options models should
be scrutinized under different scenarios. Standard real options models assuming
symmetric uncertainty in future investment payoffs cannot be directly applied to the
shared opportunities because of the competitive erosion. With the presence of potential
competitive entry, real options analysis should balance the strategic benefit of preemptive
investment and the value of the option to wait. IT switching cost is another important
factor that must be considered when conducting real option analysis.

As high IT switching cost or technology locking is very common in the digital economy,
decision makers should pay more attention to the technology uncertainties. Since the
dynamics of the technology competition and standardization play an important role in IT
investment decision, more studies should be done to incorporate it into the real options
based decision-making process. Further real options analyses should be conducted to
explore the functions of open standard and technology interoperability in fostering IT
investment.

According to Grinstein & Tolkowsky (2004) most studies on the role of the board of
directors in capital budgeting have focused on the disciplinary or monitory role of the
board of directors. The advisory role of the board of directors is under explored. Studying
capital budgeting mechanisms that have both features is an important topic for future
research.

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The relation between firms’ investment risk characteristics and the choice of capital
budgeting method has also not been previously explored. There is also need to conduct
research on an evaluation of project success against capital investment appraisal
technique used. Studies to determine if a relationship exists between capital budgeting
practices adopted by firms and profitability also need to be conducted.

Conclusion

Despite a strong academic preference for NPV, surveys indicate that managers prefer
IRR over NPV. Volkman (1997) found that most companies apparently find it easier to
compare investments of different sizes in terms of percentage rates of return than by
amount of NPV. However NPV remains the more reliable reflection of long-term
investments value to the business. IRR, as a measure of efficiency may give better
insights in capital constrained situations though when comparing mutually exclusive
projects, NPV is appropriate. Other techniques such as Payback, Profitability Index and
Accounting Rate of Return(ARR) though not so robust as compared to both IRR and
NPV may find some meaning in context of simple evaluation of capital budgeting.

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