University of Leicester Centre for Management Studies MBA (Finance) — October 2008 “Capital Budgeting Practices and Economic Development: A Comparative Study of Companies in Europe and West Africa” By George Ekegey Ekeha Email: ekegey24ge@yahoo.co.uk March 2007 THIS DISSERTATION IS PRESENTED TO THE CENTRE FOR MANAGEMENT STUDIES, UNIVERSITY OF LEICESTER, UNITED ND IT IS IN PART FULFILMENTS OF THE COMPLETION OF s WARDS THE AWARDS OF MASTERS OF BUSINESS ADMINISTRATION DEGREE (FINANCE OPTION). NO PART OF THI s 'D FOR ANY PURPOSES, OTHER THAN ACADEMIC, |AL CONSU N WITH THE AUTHOR AND/OR THE UNIV! AUTHORITIE! GEORGE E EKEHA 1 MBA -OCT. 2007TABLE OF CONTENT LIST OF FIGURES AND TABLES. ABSTRACT. PREFACE. 1.0 INTRODUCTION.. 1.1 MOTIVATION OF THE STUDY ..... 1.2 THE DERT SERVICING CYCLE OF Less DEVELOPED COUNTRI 10 1.3 THE PROBLEMS AND RESEARCH HYPOTHESIS u 1.4 ORGANISATION OF THE STUDY 12 2.0 LITERATURE REVIEW ... 2.1 ECONOMIC DEVELOPMENT IN AFRICA, 2.2 THE CAPITAL BUDGETING DECISION .. 2.3 STUDIES ON CAPITAL BUDGETING PRACTICES IN DEVELOPING COUNTRIES 3.0 CAPITAL BUDGETING PROCESS AND PROJECT CLASSIFICATION! 3.1 CLASSIFICATION OF INVESTMENT PROJECTS... 3.1. Undependent Projects. 18 3.1.2 Mutually Exclusive Projects 0. oennenennnennnnnnnnnnnnnnes 18 3.1.3 Contingent Projects 18 3.2 THE CAPITAL BUDGETING PROCESS 19 3.2.1 Strategic planning. 20 3.2.2 Identification of investment opportunities 21 3.2.3 Preliminary screening of projects. 21 3.2.4 Financial appraisal of project... “ . see 22 3.2.5 Qualitative factors in project evaluation... oe 22 3.2.6 The acceptlreject decision... sos soo 23 3.2.7 Project implementation and monitoring... seonnnnnnnnnnnnnnnns 23 3.2.8 Post-implementation audlt...urunsnnninnnnnnnnnnnnnnnnnnnns sens 24 GEORGE E EKEHA 2 MBA -OCT. 20074.0 DETERMINANTS OF CAPITAL BUDGETING PRACTICE! 5.0 SURVEY DESIGN AND METHODOLOGY... 6.0 RESEARCH RESULTS AND ANALYSIS 6.1 COMPANY AND CFO CHARACTERISTICS 28 6.2 CAPITAL BUDGETING TECINIQUES 30 6.2.1 European CFOs 32 6.2.2 West African CFOs 33 6.2.3 European versus West African CFOs 6.3 COST OF CAPITAL ESTIMATION METHODS... 6.3.1 European CFOs 6.3.2 West African CFOS o.oo . . . . ose 37 6.3.3 European versus West African CFOS oc. 37 6.4 Cost oF EQUITY ESTIMATION METHODS. 38, 6.4.1 European CFOs 40 6.4.2 West African CFOs 40 6.4.3 European versus West African CFOs 41 6.5 CAPITAL BUDGETING TECHNIQUES, COST OF CAPITAL AND CosT OF EQUITY ESTIMATIONS: MULTIVARIATE ANALYSIS 6.5.1 The Multivariate Analysis 6.5.2 Capital Budgeting Techniques. se seven 4 6.5.3 Cost of Capital Estimation... essen sosnennne, 46 7.0 SUMMARY AND DISCUSSION .. LIST OF REFERENCES. RESEARCH QUESTIONNAIRE! GEORGE E EKEHA 3 MBA -OCT. 2007FIGURE 1: THE CAPITAL BUDGETING PROCESS... TABLE 1: COMPANY CHARACTERISTIC: TABLE 2: CAPITAL BUDGETING METHODS USED BY CFO! TABLI OF CAPITAL (% OF TOTAL). 3: MOST FREQUENTLY USED METHODS TO MEASURE THE COST ve 36 TABLE 4: MOST FREQUENTLY USED METHODS TO ESTIMATE THE COST OF EQUITY (% OF TOTAL).. 39 TABLE 5: DETERMINANTS OF CAPITAL BUDGETING METHODS: MULTIVARIATE LOGIT ANALYSIS. 45 TABLE 6: DETERMINANTS OF THE MOST FREQUENTLY USED METHODS TO MEASURE THE COST OF CAPITAL: MULTIVARIATE LOGIT ANALYSIS, sve AT TABLE 7: DETERMINANTS OF COST OF EQUITY ESTIMATION METHODS: MULTIVARIATE LOGIT ANALYSIS 48 GEORGE E EKEHA 4 MBA -OCT. 2007ABSTRACT Over the years, efforts have been made to increase the developmental strides of African countries, Many projects move from donor countries like the United Kingdom and the United State into Africa to help improve the lives of the people. However, these efforts have not been able to redeem Africa from abject poverty and indebtedness to the West. Various projects that are targeted towards the reduction of poverty are normally completed with no changes in the lives of the people. These projects, in my opinion, have not been scrutinised to assess their capabilities of meeting some stated target. Capital budgeting practices are some of the vital inputs in the decision-making process of embarking on investment projects. A very good analysis, scrutiny, implementation and monitoring of such projects could yield the expected results for the stakeholders (people of the country). According to Dayananda et al (2002), the capital budgeting practices are used to make investment decisions so as to increase shareholders value. Capital budgeting is primarily concerned with sizable investments in long-term assets, Brealey & Myers (2003). These assets may be tangible items such as property, plant or equipment or intangible ones such as new technology, patents or trademarks, Investments in processes such as research, design, development and testing — through which new technology and new products are created — may also be viewed as investments in intangible assets (ibid). Dayananda et al (2002), argued that irrespective of whether the investments are in tangible or intangible assets, a capital investment project can be distinguished from recurrent expenditures by two features. One is that such projects are significantly large. ‘The other is that they are generally long-lived projects with their benefits or cash flows spreading over many years. Sizable, long-term investments in tangible or intangible assets have long-term consequences (ibid). This implies that today’s investment will determine the overall corporate strategic position over many years. These capital investments also have a considerable impact on the future cash flows of the organization and the risk associated with those cash flows. Capital budgeting decisions thus have a long-range impact on the strategic performance of the organization and are also critical to its success or failure. GEORGE E EKEHA 5 MBA -OCT. 2007This paper compares the use of capital budgeting techniques by companies in Europe and West Africa, using data obtained from a survey between 225 European and 120 West African companies. The main aim is to analyse the use of capital budgeting techniques by companies in both economic blocs from a comparative perspective to see whether economic development matters in the choice of which technique to use. ‘The empirical analysis provides evidence that European CFOs on average use more sophisticated capital budgeting techniques than their counterparts in West African, At the same time, however, the results suggest that the differences between European and West African companies is smaller than might have been expected based upon the differences in the level of economic development between both economic blocs. At least, this is, evident with respect to the use of methods of estimating the cost of capital and the use of CAPM as the method of estimating the cost of eq GEORGE E EKEHA 6 MBA -OCT. 2007PREFACE ‘The work presented in this thesis was carried out over a period between late 2006 and early 2007 for the award of MBA (Finance) degree with University of Leicester, During this time and all my studies period I had help from several different people that I would like to thank, First, I would like to thank my lecturer Jeremy French, administrators Hamza and Nikos at Citi Banking College and Peter Alfano at Centre for Management Studies, University of Leicester for their support and helpful advice during my period of studies. Secondly, I would like to thank all the responding CFOs for taking the time to participate in this study. I would also like to thank my family, my wife Mrs Beauty Ekeha, my mum Agnes Obri, who was looking after my kids during the period of my studies and all my kids Norris Walter, Bright Mawusi, Urielle Jorgbenue and Suzzy Selase for their support during my studies. Finally, I would like to thank my Administrative Director, Mr. Samuel Boakye and all members of the Finance Department at Ghana Statistical Services, Ministry of Finance. Throughout the period of my studies in the United Kingdom and work with this thesis, I have gained a lot of knowledge, experience, and insight of good business management in the area of capital budgeting techniques, and this would also help me contribute to the future research within this area and other managerial processes both in public and private sectors, March 2007 GEORGE EKEGEY EKEHA GEORGE E EKEHA 7 MBA -OCT. 20071.0 INTRODUCTION This paper reports the results of a survey with respect to the current practices of capital budgeting techniques in two different economic blocs at two different levels of economic development: Europe and West Africa, The main aim of this paper is to analyse the use of capital budgeting techniques by companies in a comparative perspective to sce whether economic development matters in the choice of techniques. Whereas several papers in the past have investigated the use of such techniques, this is one of the very few studies that use such a comparative perspective, comparing a more developed with a developing economy. This analysis was carried out using standard differences of mean tests and multivariate regression analysis to see whether there is a so-called “country effect” on the choice of capital budgeting technique. This means that the research tried to establish whether capital budgeting practices differ significantly between companies in the two economic blocs and whether these differences can be explained by differences in levels of economic development. Again, only very few papers have addressed the determinants of capital budgeting practices using these types of analyses, let alone in a comparative economic perspective. Notable exceptions, among others, are Brounen, et al. (2004) and Payne, et al. (1999). Yet, both studies analyse the determinants of capital budgeting practices for a number of developed countries (The Netherlands, Germany, France, Canada, the U.S. and the U.K.) West Africa and Europe have been chosen for this comparison for the following reasons. The researcher was a Finance Manager in a government department of one West African country and considers West African countries as strongly emerging, yet still less- ich has received a lot of attention in the developed economy in many respects, w1 economic and financial development literature during recent years. Moreover, the researcher also considers Europe as a typical example of a developed economic bloc and also most companies in this bloc have various investment interests in Africa. Finally, the researcher believes that most CFOs in African countries do not utilise the sophisticated capital budgeting techniques to scrutinise projects very well before selection. This resulted in various mismanagement and failure to achieve economic heights, GEORGE E EKEHA 8 MBA -OCT. 20071.1 Motivation of the Study Capital budgeting involves making investment decisions concerning the financing of capital projects by organisations, Making a good investment decision is important since funds are scarce and the investment is expected to add to the value of the organisation especially in Less Developed Countries (LDCs) and Third World poor nations. Capital investment decision is thus one of the requirements, if properly applied, that can help accelerate economic development. All countries of the sub-Saharan Africa expend an upward of 13.5 billion dollars per annum on foreign debt payment to rich foreign creditors, World Bank report (2005). Many countries in the third world borrowed huge sums of money in expectation that interest rates would remain stable. Many African countries accepted these loans for political and economic stabilization in the post, independence era, however prominent problems such as corruption make these loans ineffective to save the recipients countries from their economic woes. For example in Ghana, a governance and corruption survey was commissioned by the World Bank, which was conducted by the Centre for Democratic Development (CDD - GHANA). Evidence from the surve} showed that public concer about corruption in the country is very high and that there is a widespread public perception that corruption has had a negative toll on productivity and efficiency of both the public and private sectors and consequent effects on popular welfare, CDD Ghana (2000). The Ghana Integrity Initiative (GI) a local chapter of ‘Transparency Intemational, has also on various occasions undertakes some educational programs on corruption and good governance through seminars and workshops for various interest groups in the country. One recent study on administrative costs faced by private investors in 32 developing countries most from Africa reported that it takes up to two or three years to establish a new business in many developing countries (Morisset and Lumenga Neso: 2002). Their study found that the most delays occurred in securing land access and obtaining building permits. The associated administrative costs were found to be positively correlated with estimates of the level of corruption and negatively correlated with the quality of corporate governance, degree of openness, and public wages, among others (Morisset and Lumenga Neso: 2002). The authors finally argued that the level of corruption or the lack of good governance is expected to influence administrative costs as bureaucrats and politicians are more likely to capture the extra rents (ibid), In fact, the corrupt practices of most executives in both public and the private sectors of these developing West African countries have led to increases in debts to their borrower countries with GEORGE E EKEHA 9 MBA -OCT. 2007the intended targets of the loans not met. On the side of the creditors as well, many of these loans were given in order to gain and or retain the loyalty of those corrupt regimes, which is the characteristic of African governments, 1.2 The Debt Servicing These debt-trapped nations were underdeveloped and their debt crisis further plunge Je of Less Developed Countries them into deeper economic crisis and abject poverty due to excessive borrowing. Most executives of these developing countries have the selfish tendency of mismanaging the various project assigned to them. Some managers of the projects are eager to satisfy their personal needs before thinking of the implementation of whatever projects has been assigned to them. This leads to poor budgeting, poor monitoring and hence poor implementation of the project. Governments of the nations have to then borrow more funds in order to complete and maintain the existing projects. Due to the fact that these loans were thoughtlessly accepted, and collected by most African governments, they had neither little implications for development nor benefit for the masses. Finally the unreliable market prices in the world’s market for agricultural products and low-technologically manufactured goods, which make it particularly difficult for African countries to diversify and increase exports to hard currency markets, Thus making it difficult for them to earn their way out of the debt trap. In my opinion, the developed countries, like the USA and UK who have been prophesising their lengthy plans to alleviate Africa from its economic woes must endeavour to ensure some monitoring system such that the aids will go a long way to improve the investment capacity of the continent, Intemational markets should also be opened to the African manufacturers in the said developed countries. Finally, loans must be channelled towards the transformation of the primary products into produets worthy for the international market, Notwithstanding, however, the researcher believes that these debt-ridden nations in the ‘Sub-Saharan Africa are expected to make attempts at improving their economic status themselves through huge research and development leading into economic productivity. The concerns of the developed nations may be to no avail if these less developed nations GEORGE E EKEHA 10 MBA -OCT. 2007do not take steps that will help relief their situation. The capital investment decision is thus one of the most critical and crucial decisions that any country or organisation can take to achieve economic development-thus by adding economic value. Since economic development depends on the multiplicity of viable corporate organisations and enterprises in the country, the approach adopted here is to demonstrate how capital budgeting, as an investment decision can help Aftican countries promote corporate organisational growth by using acceptable techniques to identify viable projects. In other words, capital budgeting is an integral part of the corporate plan of an organisation, which reflects the basic objectives of an organization. The capital investment decision involves large sums of money and may introduce a drastic change in companies as well as the whole economy, when it is well scrutinised. For instance, acceptance of a project may significantly change a company’s operation, profitability and create more jobs within the country. These changes might also affect investors’ evaluation of a company (Osaze, 1996:40-44), 1.3 The Problems and Research Hypothesis Most third world countries depend excessively on importation. They do not develop an enduring technological base that can support the growth of their economies. Their capital investment decisions are not usually well articulated. This may be due to the fact that their governments do embark on white elephant projects that gulp huge sums of money and are useless in terms of utility to the people. The projects often are abandoned halfway and in some cases, are only executed on papers. The current efforts of some African governments like those of Ghana and Nigeria, towards privatisation of hitherto government-owned firms and corporations is an indirect concession to the fact that the former investment decision patter of the national government is not wise enough to alleviate their countries from poverty. In fact, most of the diversified companies have improved productivity and quality with enormous benefits to their countries. Considering the matter from the corporate perspective therefore, the researcher believes that capital budgeting decision is one of the decision-making areas of a financial manager that involves the commitment of large funds in long-term projects or activities. And these projects have a huge impact on the county’s economic development. GEORGE E EKEHA MW MBA -OCT. 2007This study therefore secks to examine the importance of capital investment dec bs capital investment projects so that the overall country’s economy can grow from the ions; the steps in making capital investment decisions and the techniques used in evaluating corporate sector investments. It is also expected to show that the use of sophisticated techniques by both corporate and governmental CFOs will help in the development efforts of Africans and other poor nations. The researcher believes that most developed countries in Europe have achieved highs in today’s competitive international market because they put money where it adds value. Investments are well scrutinised using various sophisticated techniques, both qualitative and quantitative, before final decision is arrived and such projects are well monitored until fully completed. It is my believe also that most African Countries remain in the low economic growth and poverty zone because CFOs don’t make use of technical tools to analyse various investment projects, which have significant impact on the economic development. These differences might be due to the level of education, technology and economic development between the two economic bloes. Therefore, the researcher hypothesizes that CFOs of European companies will use net present value (NPV) and internal rate of returns (IRR) methods more often than their counterparts in West Africa, whereas the opposite will be true for the pay back (PB) and accounting rate of returns (ARR) methods. An additional contribution of this paper to the existing empirical literature on capital budgeting practices is in terms of the countries for which the researcher had gathered data, Most previous studies focus on the United States and the United Kingdom and there are some few studies available for the Netherlands (Herst, Poirters and Spekreijse, 1997; apital ountries” (Elumilade, et al Brounen, De Jong and Koedijk, 2004). The researcher is also aware of study on “ Budgeting and Economie Development in the Third World 2006) but there were no comparisons with any developed economy. 1.4 Organisation of the study The paper is organised in seven different sections, with section one dealing with introduction, hypothesis and motivations of the study. Section two discusses literature GEORGE E EKEHA 12 MBA -OCT. 2007review on capital budgeting practices and further discussed the capital budgeting process, classification of investment projects and alternative determinants of capital budgeting discu practices in sections three and four. This was followed by ion of the design of the survey in section five. Section six then provides the results of the survey and a discussion of the empirical analysis of determinants of capital budgeting practices. The paper ends with a summary and discussion of the results in the final section. 2.0 LITERATURE REVIEW In this section the researcher tries to outline previous studies relevant to this study. The section discussed various studies on economic development, capital budgeting among CFOs from various countries and if there is any comparative study between developed and developing countries, 2.1 Economic Development in Africa Economic development in Africa has not been steady. In fact, when compared to the situation in the Western countries like Europe, the conclusion is that countries of the third world are either qualified as undeveloped or mildly put underdeveloped, African scholars have tended to heap the blame on the Europeans; saying that colonialism or neo colonialism is the bane of Africa’s economic woes. This notion is referred to by Onigbinde (2003:21-25), as the “Original Sin Fallacy”. The present economic woe of underdeveloped countries (UDCs) according to this fallacy is that UDCs” condition is original “in relation to a so-called non-achievement, the present condition of the underdeveloped world is a historical product of capitalist expansion (ibid). The crisis of underdevelopment in Africa is also captured in the “Africa at the Doorstep of Twenty-First Century” by Adebayo Adedeji as sited by Onigbinde, 2003. According to him, African within the world is, ...poverty increased in both the rural and urban areas: real carning fell drastically; unemployment and underemployment rose sharply; hunger and famine became endemic; dependence on food aid and food imports intensified; disease, including the added scourge of AIDS, decimated population and became a real threat to the very process of growth development; and the attendant social evils-rime delinquency, there is a mess vengeance (Onigbinde, 2003: 78-79) GEORGE E EKEHA 1B MBA -OCT. 2007The United States Assistance for International Development (USAID), 1988-1992 (cited from Onigbinde, 2003:79-80), stated among other things that, ... approximately 180 million of sub-Saharan Africa's 500 million people could be classified as poor, of whom si 66.7 percent, or 120 million, are desperately poor. By every international measure, be it per capital income ($330), life expectancy (51 years), or the United Nation’s Index of Human Development (0,255 compared to 0.317 for South Asia, the next poorest region), Africa is the poorest region in the world, Onigbinde 2003, The solution to all these problems lies in the fact that firms are to embark on projects that would give rise to company’s value which will by extension enhancing the desired economic development for the country. In the course of achieving these development efforts, the company’s activities become more complex and corporate management assumes a sound financial position in the handling of problems and decisions therein In his study of “The obstacles to investment in Africa...”, Professor Peter Montiel of the World Bank concluded among other things that “One set of explanations is based on the view that investment projects with high economic rates of return are not as plentiful in Africa as the simple neoclassical growth paradigm would scem to imply. One argument is that for a variety of reasons, aggregate production functions may be characterized by lower levels of productivity in Africa than in creditor countries. An alternative or complementary story is based on generalizing the aggregate production function to include roles for human capital, public capital, and institutional capital” Montiel (2006). He continued to say “These effects raise questions about the abundance of investment opportunities yielding high economic rates of returns in Africa at the present time”, (ibid). This conclusion suggests that, though not abundant, investment opportunities with high returns exist in African countries and when applied properly, it could bring economic growth to Africa. One of the best ways to serutinise these opportunities is by using various techniques like the capital budgeting techniques, to access the profit, potentials, GEORGE E EKEHA 14 MBA -OCT. 20072.2 The Capital Budgeting Decision Capital budgeting decisions are among the most important decisions the financial manager of a company has to deal with. Capital budgeting refers to the process of determining which investment proj result in maximisation of shareholder value, Dayananda et al, 2002. Generally speaking, there are four main capital budgeting, techniques the manager may use when evaluating an investment project. In fact, there are other techniques that could have been considered, such as sensitivity analysis, real options, book rate of return, simulation analysis, etc, (Graham and Harvey, 2001, pp.196- 197). However, the researcher has chosen to focus on the most well known techniques to keep the study simple, The net present value (NPV) and internal rate of return (IRR) methods are considered to be discounted cash flow (DCF) methods. The payback period (PB) and average accounting rate of return (ARR) methods are so-called non-DCF methods, Brealey and Myers, 2003. From a pure theoretical point of view the NPV is considered to be the most accurate technique to evaluate projec sophisticated of the four, followed by the IRR method. Both non-DCF methods are Yet, it is also the most considered to be less accurate, of which the PB method is the least sophisticated (ibid). In the past, several studies of capital budgeting practices have been carried out. Most studies focus on companies in the U.S. Comparing survey results of capital budgeting practices in the U.S. over time generally seems to show that the analytical techniques used by executives have increased in terms of sophistication. For example, in one of the carliest studies reporting the results of questionnaires on capital budgeting practices, Klammer (1972) shows that in 1959, based on a sample of 184 large U.S ‘ompanies, 19 per cent indicated that they used DCF methods as their primary method to evaluate projects. The majority of companies used either PB (34 per cent of the total sample) ot ARR methods (34 per cent) as their primary method of evaluation. In 1970, the picture had changed drastically: DCF methods were used by $7 per cent of the companies; 26 per cent used ARR and only 12 per cent used PB as their primary method of project, evaluation (ibid). In a later study, Hendricks (1983) reports that in 1981 76 per cent of the companies in his sample studied used DCF methods as their primary tool. Only 11 per cent stated they used the PB method as their primary tool. Trahan and Gitman (1995) GEORGE E EKEHA 15 MBA -OCT. 2007show that, based on a 1992 survey of 58 of the Fortune 500 large companies and 26 of the Forbes 200 best small companies, most companies used DCF methods as their primary evaluation tool, although these methods were more important for the ge companies (88 per cent for NPV and 91 per cent for IRR) than for the small companies (65 and 54 per cent for NPV and IRR respectively). A recent study by Graham and Harvey (2001), a comprehensive survey published on capital budgeting practices (using answers from a 1999 survey among 392 Chief Financial Officers (CFOs) of companies in the U.S. and Canada) showed that the NPV and IRR techniques are the most frequently used capital budgeting techniques. Their survey reported that 75 per cent of the CFOs always use NPV and 76 per cent always or almost always use the IRR method. Their survey results also show, however, that even though over time the use of the PB method has declined as a primary tool for project evaluation, it remains to be an important secondary instrument CFOs normally use. According to Hendricks (1983), in his 1981 survey 65 per cent of the companies in his sample used PB as a secondary measure, Trahan and Gitman (1995) show that in 1992, 72 per cent of the large and 54 per cent of the small companies used PB as one of the evaluation tools. In the 1999 survey of Graham and Harvey (2001) 57 per cent indicated they use the PB method as one of their evaluation tools, The general picture that emerges from the previous short discussion also emerges from survey studies based on other U.S. as well as U.K., European and Australian companies (Gitman and Forrester (1977); Schall, et al. (1978); Kim and Farragher (1981); Shao and Shao (1996); Pike (1996) and Brounen, et al. (2004) ; Freeman and Hobbes (1991) and Truong, et al. (2005); Herst, et al. (1997) and Brounen, et al. (2004). A comparison of the results of these survey studies also showed an increasing sophistication with respect to the use of evaluation techniques over time, At the same time, however, it seems that companies in European countries report lower rates of the use of DCF techniques as compared to U.S. companies. GEORGE E EKEHA 16 MBA -OCT. 2007Brounen et al (2004) replicate the Graham and Harvey (2001) survey in four European countries (U.K., France, Germany and the Netherlands; total sample was 313 companies) in 2002-2003 and find that for the U.K. companies in their sample 47 per cent states that NPV is (almost) always used as a tool of evaluating projects, whereas 69 per cent (almost) always use the PB. For the Netherlands these figures are comparable (70 and 65 per cent, respectively); for France and Germany the figures are even lower (42-50 per cent and 44-51 per cent, respectively). 2.3 Studies on Capital Budgeting Practices in Developing Countries A few studies have reported survey evidence on capital budgeting practices in the Asia- Pacific region. These studies show a somewhat different picture. Wong, et al (1987) used information from a survey among a large number of companies in Malaysia, Hong Kong, and Singapore in 1985 and found that in these countries the PB method was the most popular primary measure for evaluating and ranking projects. For Malaysia this picture was confirmed in Han (1986). In a recent paper by Kester, et al. (1999), based on information from surveys of 226 companies in Australia, Hong Kong, Indonesia, Malaysia, The Philippines and Singapore in 1996- 1997, it was reported that the PB ‘method was still an important method. Yet, DCF methods seem to have inereased in importance as well. Excluding Australia from the sample of the countties studied, 95 per cent of the companies in the five Asian countries indicated that they use the PB method and 88 per cent of them said they use the NPV method when evaluating projects. In terms of importance (on a scale from 1 to 5, where 1 = unimportant and 5 = very important) both methods are rated almost equally important (3.5 versus 3.4) (ibid). When comparing, these results to the results of studies for companies in Western economies, these figures seem to be very high. Comparing the results of the study by Wong, et al. (1987) with those of Kester, et al, (1999) does seem to suggest that the level of sophistication of capital budgeting techniques has increased quite rapidly during a period of just one decade within the developing countries in Asia, GEORGE E EKEHA v MBA -OCT. 20073.0 CAPITAL BUDGETING PROCESS AND PROJECT CLASSIFICATIONS, 3.1 Classification of Investment Projects Investment projects can be classified into three categories on the basis of how they influence the investment decision process: independent projects, mutually exclusive projects and contingent projects, Dayananda et al (2002). 3.1. Undependent Projects An independent project is the one which the acceptance or rejection of does not directly eliminate other projects from consideration or affect the likelihood of their selection. For example, management may want to introduce a new product line and at the same time may want to replace a machine, which is currently producing a different product. These two projects can be considered independently of each other if there are sufficient resources to adopt both, provided they meet the firm’s investment criteria (ibid). This, implies that the projects can be evaluated independently and a decision made to accept or reject them depending upon whether they add value to the firm. 3.1.2 Mutually Exclusive Projects According to Dayananda et al (2002), two or more projects that cannot be pursued simultaneously are called mutually exclusive projects — the acceptance of one prevents the acceptance of the alternative proposal. Therefore, mutually exclusive projects involve ‘either-or’ decisions ~ alternative proposals cannot be pursued simultaneously. The early identification of mutually exclusive alternatives is crucial for a logical screening of investments. Otherwise, a lot of hard work and resources can be wasted if two divisions independently investigate, develop and initiate projects, which are later recognized to be mutually exclusive (ibid). 3.1.3 Contingent Projects Finally, a contingent project is the one which the acceptance or rejection is dependent on the decision to accept or reject one or more other projects. Contingent projects may be complementary or substitutes (ibid). For example, the decision to start an agricultural GEORGE E EKEHA 18 MBA -OCT. 2007project in a West African village may be contingent upon a decision to build roads leading to the project sites. In this case the projects are complementary to each other. The cash flows of the farming project will be enhanced by the existence of good roads to transport inputs and outputs to and from the farm and conversely the cash flows necessary for the road maintenance will be enhanced by the existence of high road taxes, paid by the trucks using the road, In contrast, substitute projects are ones where the degree of success (or even the success or failure) of one project is increased by the decision to reject the other project. For example, market research indicates demand. sufficient to justify two restaurants in a shopping complex and the firm is considering one Chinese and one Thai restaurant. Customers visiting this shopping complex seem to treat Chinese and Thai food as close substitutes and have a slight preference for Thai food over Chinese (ibid). Consequently, if the firm establishes both restaurants, the Chinese restaurant's cash flows are likely to be adversely affected. This may result in negative net present value for the Chinese restaurant, In this situation, the success of the Chinese restaurant project will depend on the decision to reject the Thai restaurant proposal. Since they are close substitutes, the rejection of one will definitely boost the cash flows of the other, Contingent projects should be analysed by taking into account the cash flow interactions of all the projects (ibid). 3.2 The capital budgeting process This section was adopted from Dayananda et al (2002), they stated that there are several sequential stages in the process. For typical investment proposals of a large corporation, the distinctive stages in the capital budgeting process are depicted, in the figure 1 below: GEORGE E EKEHA 19 MBA -OCT. 2007Figure 1: The Capital Budgeting Process Rees renin) Pees Accept/reject decision on the projects Facilitation, monitoring, control & review ala] ‘Post-implementation audit Souree: Capital Budgeting: Financial Appraisal of lavestment Proje (Dayanunds eval 2002) 3.2.1 Strategic planning A strategic plan is the grand design of the firm and clearly identifies the business the firm is in and where it intends to position itself in the future, Strategic planning translates the firm’s corporate goal into specific policies and directions, sets priorities, specifies the structural, strategic and tactical areas of business development, and guides the planning process in the pursuit of solid objectives, Daft (2003). A firm’s vision and mission is encapsulated in its strategic planning framework. There are feedback loops at different stages, and the feedback to ‘strategic planning’ at the project evaluation and decision GEORGE E EKEHA 20 MBA -OCT. 2007stages — indicated by upward arrows in Figure | — is critically important. This feedback may suggest changes to the future direction of the firm, which may in effect, cause changes to the firm’s strategic plan Dayananda et al (2002). 3.2.2 Identification of investment opportunities According to Dayananda et al (2002), the identification of investment opportunities and generation of investment project proposals is an important step in the capital budgeting process, They proposed that the projects have to fit in with a firm’s corporate goals, its vision, mission and long-term strategic plan. Of course, if an excellent investment opportunity presents itself the corporate vision and strategy may be changed to accommodate it. Thus, there is a two-way traffic between strategic planning and investment opportunities. Deyananda et al (2002) went on to argue that this is very tactical level of the capital budgeting process because, some investments are mandatory — for instance, those investments required to satisfy particular regulatory, health and safety requirements — and they are essential for the firm to remain in business. Other investments are diseretionary and generated by growth opportunities, competition, cost reduction opportunities and so on (ibid). Some firms have research and development (R&D) divisions constantly searching for and researching into new products, services and processes and identifying attractive investment opportunities. Sometimes, excellent investment suggestions come through informal processes such as employee chats in a staff room or corridor (ibid). 3.2.3 Preliminary screening of projects ies is to do initial ‘The next stage after identifying various investment opportuni sereening. It is obvious that all the identified opportunities cannot go through the rigorous project analysis process. Therefore, the identified investment opportunities have to be subjected to a preliminary screening process by management to isolate the marginal and unsound proposals, because it is not worth spending resources to thoroughly evaluate such proposals. Dayananda et al (2002) suggested that the preliminary screening may involve some preliminary quantitative analysis and judgements based on intuitive feelings and experience. GEORGE E EKEHA 21 MBA -OCT. 20073.2.4 Financial appraisal of projects ‘The next stage after the initial screening of identified projects is to go through rigorous financial appraisal to ascertain if they would add value to the firm. According to Dayananda et al (2002), this stage is also called quantitative analysis, economic and financial appraisal, project evaluation, or simply project analysis. This project analysis may predict the expected future cash flows of the project, analyse the risk associated with those cash flows, develop alternative cash flow forecasts, examine the sensitivity of the results to possible changes in the predicted cash flows, subject the cash flows to simulation and prepare alternative estimates of the project’s net present value. Thus, the project analysis can involve the application of forecasting techniques, project evaluation techniques, risk analysis and mathematical programming techniques such as linear programming. The financial appraisal stage will provide the estimated contribution that the project would make towards the increase of the firm’s value in terms of the projects’ net present values. “If the projects identified within the current strategic framework of the firm repeatedly produce negative NPVs in the analysis stage, these results send a message to the management to review its strategic plan” (ibid). It is noteworthy therefore that the feedback from project analysis to strategic planning plays an important role in the overall capital budgeting process. The results of the quantitative project analyses will therefore influence the project selection or investment decisions. 3.2.5 Qualitative factors in project evaluation Dayananda et al (2002), continued that when a project passes through the quantitative analysis test, it has to be further evaluated taking into consideration some qualitative factors. Qualitative factors are those which will have an impact on the project, but are virtually impossible to be evaluated accurately in monetary terms. They suggested the following factors for consideration: * the societal impact of an increase or decrease in employee numbers + the environmental impact of the proj * possible positive or negative governmental political attitudes towards the project + the strategic consequences of consumption of scarce raw materials GEORGE E EKEHA 22 MBA -OCT. 2007© positive or negative relationships with labour unions about the project «possible legal difficulties with respect to the use of patents, copyrights and trade or brand names «impact on the firm’s image if the project is socially questionable. ‘They argued that some of the items in the above list affect the value of the firm, and some not. The firm can address these issues during project analysis, by means of discussion and consultation with the various parties, but these processes will be lengthy, and their outcomes often unpredictable. This stage will require considerable management experience and judgemental skill together with high level of think-tack to incorporate the outcomes of these processes into the project analysis. In some cases, however, those qualitative factors which affect the project benefits may have such a negative bearing on the project that an otherwise viable project will have to be abandoned, 3.2.6 The accept/reject decision Having done the critical quantitative and qualitative analysis, the NPV results from the quantitative analysis combined with those qualitative factors will form the basis of the decision support information, The analyst relays this information to management with appropriate recommendations, Management considers this information and other relevant prior knowledge using their routine information sources, experience, expertise, ‘gut feeling’ and, of course, judgement to make a major decision — to accept or reject the proposed investment project (ibid), 3.2.7 Project implementation and monitoring Once investment projects have passed through the decision stage they must be implemented by management without any further delay. During this implementation phase various divisions of the firm like sales and marketing, production and technical are likely to be involved. An integral part of project implementation is the constant monitoring of project progress. This would cnable management to identifying potential bottlenecks thus allowing carly intervention. Deviations from the estimated cash flows GEORGE E EKEHA 23 MBA -OCT. 2007need to be monitored on a regular basis so that corrective actions will be taken when needed. 3.2.8 Post-implementation audit Dayananda et al suggest that, post-implementation audit does not relate to the current decision support process of the project; it deals with a post-mortem of the performance of already implemented projects. They said that, “An evaluation of the performance of past decisions, however, can contribute greatly to the improvement of current investment decision-making by analysing the past ‘rights’ and ‘wrongs’. The post-implementation audit can provide useful feedback to project appraisal or strategy formulation. For example, ex post assessment of the strengths (or accuracies) and weaknesses (or inaccuracies) of cash flow forecasting of past projects can indicate the level of confidence (or otherwise) that can be attached to cash flow forecasting of current investment, projects” (ibid). This might also be important because if projects are undertaken within the framework of the firm’s current strategic plan and they do not prove to be as lucrative as predicted, the audit information can prompt management to consider a thorough review of the firm’s current strategie plan. 4.0 DETERMINANTS OF CAPITAL BUDGETING PRACTICES As was shown in the previous section, over time, financial managers have applied various methods and procedures to determine which investments are beneficial to the firm. The choice of the evaluation method may therefore be determined by individual preferences of the manager and/or by the environment in which decisions have to be made. While in the literature several factors have been mentioned as determinants of the choice of capital budgeting practices, in this paper the researcher wants to focus on the role that is played by the level of economic development in this respect. The review of studies of capital budgeting practices in the previous section showed that over time, the use of more sophisticated DCF methods has become more popular. This may be explained by various factors. First, financial markets have developed over time, making the use of DCF methods more applicable, convenient and necessary. Due to the development of financial GEORGE E EKEHA 24 MBA -OCT. 2007markets (and especially stock markets) shareholder's value maximization has gained high importance, which has pressured CFOs of companies to use DCF methods over other simpler and less accurate alternatives. Second, training of CFOs has improved over time, which may have enabled them to better understand and thus use mote sophisticated techniques. Third, financial tools and programmes that help the CFO to determine which investments are beneficial to the firm have become increasingly sophisticated, which may also have stimulated the use of more sophisticated techniques. Finally, the increased use ‘of computer technology and the related reduction in the cost of this technology may have stimulated the use of more sophisticated techniques. This researcher believes that these factors are all related to increasing levels of development. More developed countries generally tend to have more sophisticated financial markets, Levine (1997) higher levels of human capital, Schultz (1988), Boozer et al (2003), and higher levels of technology, Evenson (1988). This would also mean that the level of economic development of a country and the sophistication of the capital budgeting techniques implemented by CFOs in that country are positively related. In general terms, therefore, it could be expected that CFOs of companies in more developed countries use DCF methods significantly more often than do their counterparts in less developed countries. The opposite may hold for the use of non-DCF methods. It is this hypothesis that will be investigated in this study, using information from Europe and West African CFOs with respect to their capital budgeting practices. Although since the late 1980s some West African countries have seen some impressive economic growth, over the period, the researcher believes that at the beginning of the new millennium there was still a wide gap in levels of economic, human and technological development between West African countries and the developed countries such as Europe, Whiles the investment in high returns projects will facilitate the development efforts of these poor nations, the researcher also believes that the use of sophisticated capital budgeting techniques will help the West African CFOs to identify the most profitable projects and thereby helping their governments to achieve economic heights. The high level of economic and technological developments in the developed GEORGE E EKEHA 25 MBA -OCT. 2007countries have facilitated the ability to make use of very sophisticated techniques, which are more likely to produce more reliable results, Therefore, the researcher hypothesizes that CFOs of European companies will use NPV and IRR methods more often than do West African CFOs, whereas the opposite will be true for the PB and ARR methods. To test the hypothesis the researcher will also take into account other variables that according to the literature may also explain the use of capital budgeting practices, Brounen, et al, (2004) and Graham and Harvey (2001). These variables will be included in the multivariate analysi as control variables, In particular, the researcher included measures of the size of the firm, the industry to which the firm belongs, and the educational level and age of the CFO of the firm. Firm size is included because some papers have argued and indeed found evidence for the fact that larger companies are more inclined to use more sophisticated capital budgeting techniques (Payne, et al., 1999; Ryan and Ryan, 2002; Brounen, et al, 2004). One important reason for this may be that larger companies generally deal with larger projects, which makes the investment in the use of more sophisticated techniques less costly (Payne, et al., 1999), Based on this argument, the researcher expects to find a positive relationship between firm size and the use of DCF methods. The measure of the educational level of the CFO is included, since it may be expected that CFOs with higher levels of education will have less problems in understanding and using more sophisticated capital budgeting techniques. Again, therefore, the researcher expects a positive relationship between the level of the educational background of the CFOs of the companies and the use of DCF methods. With respect to measures of the industry and age of the CFO, there are no specific and priori expectations about the nature of the relationship. 5.0 SURVEY DESIGN AND METHODOLOGY ‘The data for the analysis have been obtained by using the results of structured questionnaires. The questionnaires were sent to 225 Europe and 120 West African listed and non-listed companies in the period between August 2006 and January 2007. The GEORGE E EKEHA 26 MBA -OCT. 2007questionnaires consisted of a number of multiple choice questions related to capital budgeting practices of companies, questions specifying firm characteristics, such as size, foreign sales and industry, as well as questions asking for the age and educational background of the respondent. With respect to the questions related to capital budgeting practices the researcher asked companies to indicate the frequency of the use of different project evaluation techniques (running from 0 to 4, where 0 = never and 4 = always), the cost of capital estimation method used most frequently, the use of methods to estimate the cost of equity. To increase the chances of getting responses from the companies, the researcher decided to keep the survey as short as possible. In total, I included only fifteen questions. The same set of questions was sent to European and West African companies. The questions were all structured in English and were sent by post. To increase the level of response, two reminders were sent to the companies: the first one was two weeks and the second three weeks after the original questionnaires were sent, all by email. The questionnaire was to be completed by the CFO of the company or any person in financial authority. The researcher received 36 responses, 28 from Europe and 8 from West African companies, resulting in a response rate of 12 per cent for the European and 6 per cent for the West African companies sampled. These response rates are somewhat on average to those found in other studies. For example, Graham and Harvey (2001) report a response rate of 9 per cent; Trahan and Gitman (1995) have a rate of 12 per cent and Brounen, et al (2004) reports a rate of 5 per cent. Kester, et al. (1999) shows an average response rate for the five Asian countries of 15.5 per cent. 6.0 RESEARCH RESULTS AND ANALYSIS This section first describes and compares the characteristics of European and West African companies in the sample that was considered to be relevant as determinants of their capital budgeting practices. Next, it discusses the outcomes related to the answers to the questions on capital budgeting practices, focusing on the use of different capital budgeting techniques and methods used to estimate cost of capital and equity. Finally, the researcher present a univariate and multivariate analysis of the relationship between firm, GEORGE E EKEHA 2 MBA -OCT. 2007characteristics and capital budgeting practices for the European and West African companies in the sample, 6.1 Company and CFO Characteristics Table 1 shows the information on the characteristics of both the European and West, African companies in the sample, With respect to total sales the table shows that the European companies on average report higher sales than the West African companies. While 36 per cent of the European companies have sales of more than | billion dollars, none of the West African companies reports sales in this category. About 55 per cent of the West African companies have sales of 100 million dollars or above, while the remainder have sales less than 100 millions dollars. If small companies are classified as hhaving sales of less than 100 million dollars, medium-sized companies having sales of between 100-499 million dollars, and large companies having sales of 500 million dollars or more, then the figures indicate that majority of the European companies responding to this study fall within the large companies category, whereas the West African companies responding to the study mainly consist of medium-sized and small-sized companies. GEORGE E EKEHA 28 MBA -OCT. 2007