The Contingent-Claims Approach to Investment Decisions*

This paper presents a contingent-claims approach to project valuation when capital expenditures are made sequentially over time. It focuses on an important facet of sequential investment projects that the firm can undertake—or pass up projects—as more information becomes available. The contingent-claims approach takes account of this important feature of firms' investment decision process, whereas the traditional capital budgeting procedure does not. Since the traditional method does not reflect the options nature of investment opportunities, it underestimates the value of sequential investment projects. As a result, a naive implementation of the traditional capital budgeting procedure could result in rejecting profitable projects. The extent of undervaluation associated with the traditional capital budgeting procedure is greater when the correlation between the random component of the future asset value and that of the required capital expenditure is smaller and/or when the growth rate of the required capital expenditure is higher.     

The sophistication of capital budgeting in Malaysian companies

The sophistication of capital budgeting in 70 Malaysian companies is assessed in terms of a three-stage model of the capital budgeting process with reference to the following: the percentage of capital investments for which the techniques are used, explicit assessment of risk, the method of determining the cost of capital, the method of measuring cash flows, the formal profit contribution analysis, the extent of use of management science/operations research in capital budgeting, information systems support and the planning and control of capital expenditures. The assessment reveals a general tendency in the direction of increasing sophistication in the various phases of capital budgeting in Malaysian companies.     

AUTOCORRELATED CASH FLOWS AND THE SELECTION OF A PORTFOLIO OF CAPITAL ASSETS *

Capital budgeting models for analyzing real assets typically are based on a set of restrictive assumptions that influence financial managers' decisions and may prevent optimization of the firm's objectives. This research examines the common restrictive assumption that cash flows are intertemporally independent by first developing an economic state and simulation model based on a Markov process for including autocorrelated cash flows in the capital budgeting decision process and then demonstrating why managers should include autocorrelated cash flows in capital budgeting models by empirically testing the impact of assuming intertemporally independent cash flows on capital budgeting decisions. The results indicate that ignoring autocorrelated cash flows seriously limits the ability of capital budgeting models to provide optimal investment decisions. The model also is very attractive for practical application because it can be implemented with a minimum number of estimates and provides the set of input data required by a number of capital budgeting models. A discussion of the implementation of the model is included.     

Designing a capital budgeting system that works

Conventional capital budgeting systems do not fully reflect or adequately respond to the way in which capital expenditure decisions are actually made. Evidence also exists that the nature of this decision process is dependent on the type of the organization. This paper describes an empirically developed understanding of how capital expenditure decisions are being made, identifies ways to support and improve these decisions, and proposes an approach to linking the design of capital budgeting systems with the type of organization in which they are to operate.     

Classifying capital projects for top management decision-making

This paper is an attempt to redress a perceived imbalance in the research and literature of capital project analysis. There is a plethora of work on the quantitative aspects of project analysis, yet empirical surveys show limited use of such techniques. There is limited work on the organizational processes of project selection, but there appears to be little or no work taking place on formal organizational systems for project selection.The more quantitative literature generally takes a deductive approach using a model developed from microeconomics based on the assumption that the objective of the firm is the maximization of owners' wealth. In this paper it is argued that there is a need to take an inductive approach and place the capital investment decision in its organizational setting. This paper looks at the formal capital budgeting system within the corporate setting.It is suggested that the specific capital investment decision takes place against the background of a set of policies and constraints, which are more or less explicit.The selection of corporate projects is a complex issue, but to provide some structure so that the problems can be processed by the organization, a capital budgeting system is designed. Part of this system is the classification of projects according to some criteria. It would therefore appear that the purpose of this classification system is to aid capital project selection within an organizational context.A consideration of classification systems for capital projects is undertaken, this is followed by a survey of the classification systems which have been proposed in the capital investment literature. Finally a classification system based upon specific criteria is proposed.     

Codes of ethics and firm size: A stakeholder approach to strategic planning

A firm's capital budgeting and strategic planning decisions have the potential to affect many groups of people called stakeholders. A stakeholder is any group or individual who can affect or is affected by the achievement of the firm's objectives. This study examines whether the presence of a code of ethics that specifically addresses capital budgeting/strategic planning decisions will significantly raise the awareness of social responsibility during the long-run planning process. This study also examines whether firm size is associated with the awareness of social responsibility during the long-run planning process. Support was found that a code of ethics that addresses long-range planning is associated with higher awareness during the planning process. Firm size was not found to be statistically different.     

Technology Investment and Management Accounting Practice

Management accounting techniques and information are often accused of having many limitations that are likely to constrain investment in new technology. However, relatively little is known about the actual influence of management accounting practices on investment decisions. The empirical evidence of this research shows that new technology investment decisions are both highly complex and political. These decision attributes give rise to a protracted, circuitous, decision process that is very different from the rational model which dominates the capital budgeting literature. The research also shows that the management accounting system captures only a fraction of the information generated by this process and consequently has a relatively low influence on these investment decisions.     

INVESTMENT STRATEGY FOR A SMALL GROWTH COMPANY*

The purpose of this article is to illustrate the impact of the simultaneous investment-financing decisions required by a small growth company when accepting relatively large investment projects. By such illustration, the capital budgeting rationale for using “rules of thumb” will be clarified, and correspondingly, the implicit assumptions for approximating a company's “cost of capital” will be exposed. To provide quantitative estimates of the various impacts of different capital budgeting strategies, a relatively simple simulation model was constructed. Once the implicit assumptions are exposed, the importance of a strategy combining the rules of thumb and cost of capital criteria is evident. It is believed that this combined strategy provides a practical bridge between the “art” and science of finance.     

Functional and Behavioral Application

Simulation techniques have been recommended in the recent literature as vehicles for improving the analysis of the corporate capital budgeting decision. Such techniques are alleged to provide more helpful measures of both return and risk than do single-point discounted cash flow estimates of project worth. This contention is challenged here. The conclusion is reached that the information provided by simulation is, at best, no better than is generated by the traditional single-point present value approach and, in one very important respect, is markedly inferior.     

How planning and capital budgeting improve SME performance

This paper focuses on the use of strategic planning among small and medium sized enterprises (SMEs) in the UK manufacturing sector. It analyses the relationship between the intensity of strategic planning, business objectives, perceived performance, changes in the business environment and the use of capital budgeting techniques. Capital budgeting is of particular interest as an area of investigation, and is one which has seldom featured in previous studies of strategic planning behaviour. These issues were investigated via a survey of UK manufacturing SMEs carried out in the winter of 1996/97.

The key results suggest that SMEs incorporate a range of objectives into their strategic planning process, with profit improvement perceived to be the most important objective, followed by sales growth. SMEs engaged in detailed strategic planning are more likely to use formal capital budgeting techniques, including the net present value method, which is consistent with maximising the companys' value. Perceived profitability and success in achieving organisational objectives were positively associated with planning detail, suggesting that strategic planning is a key component improving performance. Planning detail was also associated with a significantly higher level of perceived change in the business environment.     

Concepts,Theory, and Techniques INFLATION,MAINTENANCE OF CAPITAL,AND THE IRR MODEL OF CAPITAL BUDGETING*

Businesses operating under inflationary conditions need capital-budgeting models that help them judge the adequacy of returns on their investments and also allow them to keep capital intact by considering the erosive effects of inflation. The model proposed in this paper computes a modified internal rate of return (IRR); if cash inflows from a project are divided between earnings and recovery of capital, total recovery equals that amount which the capital-budgeting concept adopted by the business specifies (such as the original investment in constant dollars or its replacement cost). Under this model, a project should be accepted only if this computed rate equals or exceeds a hurdle rate that consists of the inflation-free rate of return plus the effect of inflation on such a return. Other modifications to the IRR model suggested in the literature do not completely satisfy the objective of capital budgeting under inflationary conditions.     

Capital budgeting and lagrangian relaxation: A case study

This paper presents a new approach to the classical multiyear capital budgeting problem. Three basic operational principles, arising out of an actual implementation of such a model, are specifically addressed in this approach. These principles are: (1) all budgets except that of the first year possess a degree of flexibility; (2) the user favours a series of near optimal solutions to a single optimal solution; and (3) an effective low cost procedure for dealing with large problems is required. Using the particular example of capital budgeting in the area of highway maintenance, an algorithm is developed and computational results for a variety of problem sizes are presented.     

INVENTORY MANAGEMENT AND CAPITAL BUDGETING: A PEDAGOGICAL NOTE

This paper shows, through an alternative development of the lot size model, how the methods of capital budgeting can be logically applied to the determination of optimal inventory levels. There is no reason why inventory management needs be treated any differently than the management of fixed assets. The rule that the stock of fixed assets should be expanded until the marginal rate of return equals the marginal cost of capital results from maximizing the present value of profits as a function of the investment level. In a like manner, the “square root” formula from inventory theory results from maximizing the present value of profits as a function of the investment in inventory. In addition, formulating the inventory problem as a capital budgeting problem has advantages for incorporating deterioration, obsolescence, and other costs into the model in a more logical and less intuitive way.     

Performance Budgeting in Practice: the Case of Danish Hospital Management

Performance budgeting systems have been introduced in the OECD countries with the proclaimed aim to increase public sector efficiency. However, the aim has often been hampered by a lack of relevant information, symbolic politics and conflicting political preferences. In this study, we investigate Danish public hospitals to see how performance budgeting works in the regions where the fundamental problems of performance information are negligible and the regions statutorily obligated to increase public sector efficiency by performance budgeting. The analysis shows that the regions in general have designed the performance budgeting system to increase efficiency and mitigate the dilemma of performance budgeting between increasing activity and controlling cost at the same time. Still, there are signs of moderation of the instrumental efficiency use of performance budgeting due to political concerns for equity.     

The role of the controller in strategic capital investment projects: bridging the gap of multiple topoi

Journal of Management and Governance - The literature on capital budgeting and investment proposals is rich with techniques, such as portfolio management and stage-gate project management, which...     

RATIONING DISCRETIONARY ECONOMIC RESOURCES: A MULTIOBJECTIVE APPROACH

Prior research involving capital rationing has focused on capital budgeting issues: given a limited resource pool, which major long-lived fixed assets should be acquired? However, capital rationing can be extended to include not only new fixed-asset purchases but also expenditures for any other discretionary activity such as advertising, research and development, or maintenance. In this broader situation, measuring the contributions of certain discretionary activities to a single objective (e.g., maximize profits) or to multiple objectives often is hindered by a lack of reliable revenue estimates. This problem severely hampers the usefulness of traditional mathematical programming approaches to capital rationing. In this paper, we modify the usual multiobjective capital rationing procedures by treating each discretionary activity as an objective in itself. In this manner, we can mitigate the difficulties associated with revenue measurement problems and allow a decision maker systematically to explore the various trade-offs between competing discretionary investments.     

The cut-off rate for investment decisions in growth companies

In this article the author attempts to define cut-off rate for capital budgeting decisions of a “growth company” and to relate it to the firms long range planning. Dr Chandra argues that conventional measurement of cost of capital cannot be used in the growth company. In brief, he defines the cut-off rate in this type of company as— dividend yield plus the rate at which dividend is expected to grow.     

资本预算的层次与相宜经济指标的应用方法

资本预算应该划分为三个层次。不同层次适用的经济评价指标及其应用方法大不相同。对资本预算不同层次间差异的清醒认识对于避免投资决策失误意义重大。     

Rural supply cooperative: Capital budgeting decision case: feasibility study of auxiliary enterprises for a rural supply cooperative

This capital budgeting case evaluates the feasibility of adding an auxiliary enterprise to a feed milling operation that an agricultural supply cooperative is considering purchasing. Both quantitative and qualitative objectives are taken into consideration regarding the cooperative’s financial position, community employment, and farm level feasibility.     

Issues to consider in internalization of a service

In a staff-model HMO, the demand for services may be greater in one area than in another. Services with little demand and/or high cost are usually contracted to an external provider or institution. Equipment purchases or renovation of a facility to accommodate a new service sometimes go hand in hand with internalizing a service, and capital budgeting is an integral part of the process. The decision on when it is feasible to internalize services has to be considered on two levels: service and finance. This article will look at what issues affect the organization on these two levels and will consider the cost-benefit and legal issues that need to be considered when making such a decision. A work sheet that may be used as is or modified is included.