Capital Budgeting 105

techniques and return on capital, sometimes in combination and sometimes solely, in

their investment evaluation; the use of payback is wide-spread. A recent study by Pike
shows that the use of the DCF methods has significantly increased in UKin 1992, and
NPV is more popular than IRR. However, this increase has not reduced the importance
of the traditional methods such as payback and return on investment. Payback continues
to be employed by almost all companies.

One significant difference between practices in India and USA is that payback is used
in India as a primary' method and IRRJNPV as a 'secondary' method, while it is just
the reverse in USA. Indian managers feel that payback is a convenient method of
communicating an investment's desirability, and it best protects the recovery of capital-
a scarce commodity in the developing countries.

Cut-off Rate

In the implementation of a sophisticated evaluation system, the use ofa minimum

required rate of returm is necessary. The required rate of return or the opportunity cost
of capital should be based on the riskiness of cash flows of the investment proposal;
it is compensation to investors for bearing the risk in supplying capit81 to finance
investment proposals.

Not all companies in India specify the minimum acceptable rate of return. Some of
them compute the weighted average cost of capital (WACC) as the discount rate.
WACCis defined either as: (i) after-tax cost of debt x weight+ after-tax cost of equity
X weight (cost of equity is taken as 25 per cent (a judgmental number) and weights
are in proportion to the sources of capital used by a specific project);: (ii) (after tax cost
of borrowing x borrowings + dividend rate x equity) dividend by total capital.

Business executives in India are becoming increasingly aware of the Importance of the
cost of capital, but they perhaps lack clarity among them about its computation. Arbitrary
judgment of management also seems to plays role in the assessment of the cost of
capital. The fallacious tendency of equating borrowing rate with minimum rate of
return also persists in the case of some companies. In USA, a little mom than 50 per
cent companies have been found using WACC as cut-off rate. In UK, only 14 per cent
firms were found to attempt any calculation of the cost of capital. As in USA and UK,
companies in India have a tendency to equate the minimum rate with interest rate or
cost of specific source of finance. The phenomenon of depending on management
judgement for the assessment of the cost of capital is prevalent as much in USA and
UK as in India.

Recognition of Risk
The assessment of risk is an important aspect of an investment evaluation. In theory.
a number of techniques are suggested to handle risk. Some of them, such as the
computer simulation technique are not only quite involved but are also expensive to use.
How do companies handle risk in practice?