Cap Budgeting

Topics: Investment, Net present value, Corporate finance Pages: 19 (5837 words) Published: July 23, 2013
Briefing
Capital investment decision-making:
some results from studying entrepreneurial businesses
Francis Chittenden and Mohsen Derregia Manchester Business School, University of Manchester

Chartered Accountants’ Hall PO Box 433 Moorgate Place London EC2P 2BJ Tel 020 7920 8100 Fax 020 7638 6009 www.icaew.co.uk

Briefing
Capital investment decision-making:
some results from studying entrepreneurial businesses
Francis Chittenden and Mohsen Derregia Manchester Business School, University of Manchester

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Centre for Business Performance Thought leadership from the Institute…

The Centre for Business Performance promotes and funds, through the ICAEW’s charitable trusts, leading-edge research on performance-related issues of immediate and long-term importance to the business community. Its goal is to advance thinking and practice related to performance enhancement and value creation and to encourage discussion of new ideas by directors, entrepreneurs and others.

If you would like to know more about the Institute’s leading-edge activities, please contact: Centre for Business Performance, Chartered Accountants’ Hall, Moorgate Place, London EC2P 2BJ Fax: 020 7638 6009 Tel: 020 7920 8634 Website: www.icaew.co.uk/centre Email: centre@icaew.co.uk

The views expressed in this publication are those of the authors and are not necessarily those of the Centre for Business Performance of the Institute of Chartered Accountants in England & Wales. This briefing was produced with the help of a grant from the Institute of Chartered Accountants in England & Wales’ charitable trusts. These trusts support educational projects relating to accountancy and economics. The Centre for Business Performance manages all grant applications.

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Centre for Business Performance Thought leadership from the Institute… TECPLN 3582

Introduction

This Briefing presents the results from a two-year study of the relevance of ‘Real Options’1 to capital investment decision-making in small, medium, and large firms. In addition, we have sought to discover whether there are differences between the capital budgeting practices adopted by entrepreneurial firms and average performing businesses. The study confirms that many firms use the payback (PB) method of investment appraisal in addition to discounted cash flow (DCF) models. This is a well known observation that has been attributed to the apparent lack of sophistication of practising managers, amongst other things. However, by exploring the nature of business risk we conclude that the use of payback is consistent with ‘Real Options’ models of investment decision-making. The increasing levels of risk and uncertainty faced by businesses lead to a preference for rapid recovery of the funds invested, and demand for flexibility. However, this does not mean that discounted cash-flow models are no longer relevant. Many sophisticated companies use PB, internal rate of return (IRR) and net present values (NPV) as well as thinking about investment projects in ways that are consistent with real options concepts. They perceive the use of multiple techniques as different ways of looking at an investment. Recently some firms began to offer various types of fixed assets through operating leases and rental or hire contracts, thereby creating what we call the ‘capital asset uncertainty market’ (CAUM). As a consequence, companies of all sizes are now able to obtain some of the fixed assets they require with the provision to terminate a lease or hire contract subject to certain conditions. The practice of using CAUM to obtain fixed assets, conserve funds, and enhance flexibility is widespread, but it is limited by the degree of asset specialisation.

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Real options are the options companies have when making capital investment decisions. A company has the option to invest in such a project but can delay the decision. It can also put an existing operation on hold, it can expand an investment or reduce it,...
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