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1.1 Background of the Study
Capital budgeting is the process by which firms determine how to invest their capital. Included in this process are the decisions to invest in new project, reassess the amount of capital already invested in existing projects, allocate and ration capital across divisions and acquire other firms. In essence, the capital budgeting process defines the set and size of a firm’s real assets, which in turn generate the cash flows that ultimately determine its profitability, value and viability. In principle, a firm’s decision to invest in a new project should be made according to whether the project increases the wealth of its shareholders.
Efficient allocation of capital usually referred to as capital budgeting is one of the most important functions of financial management in modern times. This function involves the firm’s decision to commit its funds in long- term assets and other profitable activities. The firm’s decision to invest funds in long-term assets is of considerable significance since they tend to influence its wealth, determine its size, set the pace and direction of its growth and affect its business risk, Pandey (1981).
Capital budgeting addresses the question of how a company decides to make investments in additional capacity or in new products and to replace worn-out fixed assets. Awomewe and Ogundele, (2008), in their thesis “The importance of the payback method in capital budgeting decision”, submitted to the school of management, Blekinge Institute of Technology, wrote: “the capital budgeting decision has been a very topical issue in the sustenance of a company. Several companies have lost their identity or liquidated due to wrong capital budgeting decision they made at one particular time or the other. Based on these prevalent problems in industries and the effect of globalisation on industries, it is important to use effective method to analyze investment before decision is made. Capital budgeting is extremely important because the decision made involves the direction and opportunity for future growth of the organisation.”
Under conditions of global economy, the steady increase in the variety and scale of uncertainties, competitive interactions and risks prevail, and the difficulty to make reasonable investment decisions is growing. The effective allocation of scarce resources can best be achieved with a sophisticated capital investment process. The process increases the probability of making relevant investments by ensuring that corporate strategy will be followed, that all investment opportunities will be considered appropriately and consistently, and that the counterproductive political aspect of informal decision-making will be minimized.
Because capital investment decisions rank among the most critical types of managerial decisions made in a firm and can have major long-term implications, both positive and negative, for the success of a firm, managers must understand how capital investment decisions are made if they are to participate in improving corporate performance.
Researches on capital budgeting and investment decisions in Nigeria have concentrated on the techniques used such as the payback period, net present value, internal rate of return, accounting rate of return, profitability index, etc. They established that Nigerian companies actually adopted one or more of these techniques but the outcomes have not been adequate.
Capital budgeting is becoming increasingly more important as a kind of managerial tool in recent years. One important responsibility of a financial manager is to choose investments with satisfactory cash flows and rates of return. It therefore follows that a financial manager must be able to decide whether an investment is worth undertaking and be able to choose intelligently among two or more alternatives. To do this, a procedure called capital budgeting is used to compare, evaluate and select the desired project or investment, Graham and Harvey (2001).
Making correct capital budgeting and investment decision (e.g. whether to accept or reject a proposed project), often requires recognising and correctly estimating the potentialities associated with projects. Inadequate evaluations and decision tools risk the possibility of applying scarce resources to areas which provide a return less than the cost of capital, resulting in a destruction of value, Brigham (1992).
Most of the time, firms are attracted to any market opportunity or projects which will increase the owners’ equity. However, due to limitations of the new projects and availability of funds, management needs to use capital budgeting techniques to determine which projects will achieve the best return over an applicable period of time,Nasser (2010). He further summarised the procedures for capital budgeting as involving the accurate estimation of the project cost, correctly forecasting its cash flows, evaluating the associated risks, calculating the firm’s cost of capital and using these to determine the present and net present values of the project.
A given Nigerian manufacturing firm operates in an environment where accurate and reliable data are inadequate. The infrastructures needed to support its investments are weak and limited while its capacity to hire and retain sufficiently qualified personnel is hampered by lack of funds. This economic scenario poses a lot of challenges to the ability of the firm to correctly budget for its long-term expenditure that determines its survival and growth. It is for this reason that this study sets out to evaluate the process of capital budgeting and investment decisions in the selected Nigerian firms with a view to unveiling the factors that drive the processes and making recommendations that will engender better results.
1.2 Statement of the Problem
Capital investment decisions rank among the most critical types of managerial decisions made in a company and can have major long-term implications, both positive and negative. For the success of a company, managers must understand how capital investment decisions are made if they are to participate in improving corporate performance.
The challenge faced by empiricists when testing for the presence and impact of managerial biases on capital budgeting and investment decisions is to develop a plausible measure of their biases. Although managerial overconfidence is likely to lead firms to overinvest, simply uncovering incidences of overinvestment to prove or disprove any bahavioural theory of capital budgeting and investment decisions-making is generally insufficient. The reason is simple; many alternative theories revolving around asymmetric information or agency arguments can lead to the same predictions, Stein (2003).
As such, in order to make a convincing case about behavioural influences on capital budgeting, researchers must associate some measure of overconfidence with firms’ eventual investment decisions and the outcome of these decisions. For a long time, such overconfidence were hard to find in finance, especially for agents making important decisions within corporations.
As Stein (2003) argues, ample evidence from psychology shows that individuals tend to be biased in their estimates of probabilities and that these biases affect their economic decisions. For the most part, however, the lack of direct overconfidence measures prevented empiricists from making a convincing case about the effects of this bias on capital budgeting decisions. The effects of overconfidence and optimism on capital budgeting points to the tendency of managers to overestimate project cash flows. This leads to overinvestment, especially if firms do not adopt any control mechanisms aimed at trimming estimated cash flows. A natural instrument to counterbalance the inflated cash flows resulting from the behavioural biases of decision-makers is the discount rate that they use to calculate net present values. More specifically, the prescription of an inflated discount rate to calculate a project’s net present value should serve to reduce the effect of the manager’s bias on his cash flow estimates.
In this circumstance, though the sampled firms budget for their capital expenditure using the recognised investment appraisal methods, their investment decisions have not been as accurate as expected because the very economic factors that were used could not be properly controlled in an uncertain business environment in which they operate. The outcomes of their investment decisions have led to huge losses, downsizing, declining capacity utilization and in some cases, closure of operations.
1.3. Research Objectives
The aim of this study is to improve management decision making with regards to embarking on a profitable capital budgeting that will enhance management performance, considering the high level of risk in capital budgeting decision making because once a decision is made on capital budgeting, it is irreversible. The main objective of this study is to examine capital budgeting as a decision techniques for effective management performance on the return on investment of listed manufacturing firms in Nigeria. This four (4) main objectives has been set out by the researcher to be achieved through this study are as follows:
• To examine the processes and procedures followed in the firm’s decision to commit current funds into the acquisition of long-term assets.
• To enquire into the organizational structure in place in respect of making capital investment decisions for the firm.
• To determine the investment appraisal method(s) that is most popular among Nigerian manufacturing firms.
• To examine the extent to which the economic environment affects the firm’s capital budgeting and investment decisions.
1.4. Research Questions
The researcher wishes to use this study to provide answers to the under listed four (4) questions.
• Does your firm follow any laid down rules in its decision to commit current funds into the acquisition of long-term assets?
• Does the organizational structure in place has no significant effect in making capital investment decisions for the firm.
• Which among the recognized investment appraisal techniques does your firm commonly use when budgeting for capital expenditure?
• How has the economic environment affected the outcomes of your firm’s capital budgeting and investment decisions?
1.5. Research Hypothesis
Based on the enormous challenges posed by capital budgeting and investment decisions on the profitability, survival and growth of a given firm, the hypothesis of this study is as follows:
H1: There is no significant effect in the processes and procedures followed in the firm’s decision to commit current funds into the acquisition of long-term assets.
H2: The organizational structure in place has no significant effect in making capital investment decisions for the firm.
H3: There is no significant effect in the investment appraisal method(s) that is most popular in investment decisions among the listed Nigerian manufacturing firms.
H4: The economic environment in which the firm operates does not significantly affect the outcome of its capital budgeting and investment decisions.
1.6 Scope of the Study
This study is based mainly on evaluation of capital budgeting as a tool used by management in decision making of manufacturing companies with regards to 7up Bottling companies of Nigeria covering a period from 2014-2015. It is the objective of the researcher to go into research work of others who has research on this similar topics to gather their opinions on capital budgeting and the various techniques used to analyse their work. The study shall dwell more on the capital budgeting as a tool for decision making for effective management performance in manufacturing companies. The study will consider whether manufacturing firms in Nigeria uses various investment appraisal techniques such as payback period, accounting rate of return, internal rate of return and net present value in capital budgeting decision making. Consequently, the study shall also consider how often does these various techniques used in analysing projects by both small, medium and large manufacturing firms in Nigeria for the purpose of capital budgeting decision making. Return on investment contribution on management performance of the firms shall be considered and the firm size which serves as a control mechanism in the listed Nigerian manufacturing firms for this study will also be looked into as well as management performance with regards to its contributions to the profitability of listed manufacturing firms in Nigeria. Therefore, the scope is restricted to capital budgeting decision as a tool to effective management performance in listed manufacturing firms in Nigeria. Also, literature on the topic as it relate to capital budgeting and management performance shall be reviewed.
1.7 Significance of the Study
This study will be of paramount to the management of listed manufacturing firms in Nigeria, since economic resources available to management of manufacturing firms are limited, the study will help outline ways in which management of manufacturing firms can make good capital budgeting decision which will bring more returns to the organisation. This study becomes valuable to management of manufacturing firms as it will enable them to carefully evaluate their projects before accepting or rejecting them, it will also help to a greater extent in assisting student who wants to specialize financial management guide them on the basic principles and theories guiding investment decisions of listed manufacturing firms in Nigeria. The members of the public and investors will also be of benefit to the study of this nature which explain the capital budgeting decision undertaken by the listed manufacturing firms in Nigeria. This will enable them have an over view of the effectiveness of capital budgeting as it relates to return on investment and management performance. In other words, to position them in making a better decision whether to invest with regards to investors or to known how manufacturing firms are runned as well as position them to have a unified knowledge on how things are done in manufacturing firms should in case they may want to establish one.
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