Capital Budgeting Journal
Content
International Research Journal of Finance and Economics
ISSN 1450-2887 Issue 2 (2006)
© EuroJournals Publishing, Inc. 2006
http://www.eurojournals.com/finance.htm
Capital Budgeting and Economic Development in the Third
World: The Case of Nigeria
D. O. Elumilade, T. O. Asaolu and A. O. Ologunde
Department of Management and Accounting
Faculty of Administration
Obafemi Awolowo University
Ile-Ife, Osun State
Nigeria
Abstract
Poor and Unrealistic capital budgeting has long been the bane of socio-economic
development in Africa and of course, Nigeria. The issue of capital, investment and how it
was undertaken in the capital budgeting process thus constitutes a major concern of this
paper. Even in the midst of vast economic and resources cum endowment, African
countries are not only technologically backward but wallow in neckdeep poverty and
indebtedness.In the bid to resolve this nagging problem, this paper looked at the form and
approach of the Nigeria government to capital budgeting. It tried to unravel the causes of
project abandonment, capital disappearance and inhibition placed on capital budgeting as
the country related to other countries outside her borders (particularly in the Western
world). The paper adopted a basic research approach whereby it collected primary data
from questionnaires administered on 94 firms primarily and they were complemented with
vast secondary data extracted from Nigerian stock exchange fact books from 1980-1999.
The analysed data were presented in tables, percentages and were critically discussed.
Basically, the study found out that most firms used one form of the criteria or another for
selecting optimum investment. However, the study revealed that the most common method
is the payback period. The study also revealed that dividends and taxation payouts as well
as shareholders’ funds and share capital strongly influenced public companies growth
performance when juxtaposed with retained earnings and credit investment. Moreover, net
cash flow on investment is found to be a strong determinant of performance since higher
income dictates better investment returns and vice-versa.The paper concluded that capital
budgeting decision is an unnegotiable investment decision making strategy that must be
taken very seriously. Given the fact that only private sectors made use of various methods
of project valuation, which accounts for the reason why the little development visible in
Nigeria are from the private sectors, the study therefore pushes that the government should
embrace capital budgeting if it is to witness appreciable economic development.
Key words: Capital Budgeting, Economic growth
JEL classification: E24, C22
I. Introduction
Capital budgeting in a developing economy is very vital and must be approached with all sense of
diligence. The rate of economic development in the third world has been relatively slow and it needs to
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be accelerated. Gone were the days when a community would say that she will keep to herself. The
modern world is not only a competitive world but a globally captured village. As such, it is either a
society or community braces up with modern requirements for development or suffers self-inflicted
setbacks. Capital budgeting involves making investment decisions concerning the financing of capital
projects by firms. Making a good investment decision is important since funds are scarce and it will
add to the value of the firm especially in Less Developed Countries LDCs and Third World poor
nations of the world. Capital investment decision is thus one of the requirements, if properly applied,
that can accelerate economic development
The forty-eight countries of the sub-Saharan Africa expend an upward of 13.5 billion dollars per
annum on foreign debt payment to rich foreign creditors. The origins of this debt trap for poor states lie
in the formation of the Organization of Petroleum-Expecting Countries (OPEC) in 1973 and the
dramatic rise in oil prices that year. The OPEC states deposited their new oil wealth in Western banks.
Since idle money loses against inflation, which was rising rapidly at the time, the banks needed to find
countries to take loans. Many states in Eastern Europe and 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.
On the side of the creditors as well, in context of the cold war, little thought was given to the
purpose of the developing countries for collecting loans. More so, many of these loans were given in
order to gain and or retain the loyalty of corrupt regimes, which was characteristic of Africa at that
time. The expectation of the third world states, that Interest rates will remain stable, was shattered by
two major trends in global economy over the two decades;
First, the fixed exchange rate system that had been established after the second world war collapsed,
and state began to use interest rates to stabilize their exchange rate. Secondly, interest rates rose in the
1980s in response to trade and budget deficits in the United States. This caused a downturn in the
economies of industrialized states, thereby reducing export markets for poor states. The global prices
for primary commodities, which formed a large bulk of third world’s export earnings, collapsed as
well. These left many of these states in abject financial bankruptcy. Debts incurred were so large that
they needed new loans to finance them. This brings the other side of the debt story to high
Debt Servicing
This debt trap or debt ‘cancer’ as some writers have put it, represents a continuing humanitarian
disaster for some over seven hundred million of the world’s poorest people. These debtor states were
under-developed and their debt crisis further plunge them into deeper economic crisis and abject
underdevelopment.
Before solutions can be proffered to problems, apart from understanding the nature of the problem it
is important to analyse the cause or causes (if it is multifaceted) of the problem. The same thing goes
for the debt crisis in Africa. Apart from the historic cause that is the international economic regression
of the 1960s and 1970s, there are some other causes that can be regarded as important even though
they are indirect causes. They include:
Mismanaged lending and spending. In the 1960s United States’ expenditure was more than its
revenue. This made the country print out more dollars, thereby devaluing the dollar. Consequently, oilproducing state which had their economies pegged to the dollar were affected by these decrease in
dollar value. In 1973, the oil-producing countries hiked their prices in response, thereby earning a lot
of money, which they put in Western banks. Interest rates increased alongside and more lending
ensued by banks so as to prevent crisis.
Second, corrupt-leadership in borrower states. Due to the fact that these loans were thoughtlessly
accepted, and they were collected by western-backed dictators, they had little or no implications for
development nor benefit for the masses. Most of these leaders siphoned these loans for personal
aggrandisement.
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Thirdly, in 1982, Mexico defaulted on its debt payment, threatening the international credit system.
These moved IMF and World Banks to introduce Structural Adjustment Policies to help Mexico and
other Third World States facing these problems repay their debt. The harsh conditionality that came
with these policies have only further entrenched these debtor states in the indebtedness. Structural
adjustment advice in the past has led to the cut back on important spending such as health education in
order to be able repay loans. This has implied downward spiral turn and further crash down into
poverty in African states.
Finally the protection in the world’s market for agricultural products and low-technology
manufactures, which make it particularly difficult for African countries to diversify and increase
exports to hard currency markets, thus making it doubly difficulty for them to earn their way out of the
debt trap.
The danger of the debt crisis to North and South led both of them to seek ways out. The United
States, as the world’s leading economy and the largest single holder of Less Developed Countries’
(LDC) debt, has been at the vanguard of this effort. Some of which include Nicholas Brandy’s plan of
1989 when over 100 billion debt owed by LDCs was forgiven, interest rates lowered, and now loans
given. There has been increased flow of concessional aids from creditors. Sub-Saharan Africa has
emerged over the last two decades as the major aid-receiving region.
In October 1996, the first real attempt was made to deal with the problem when the World Bank and
the IMF won agreement from their Boards of Governors for the establishment of the Highly Indebted
Poor Country Initiative. At its launch, the policy offered the promise of poor countries achieving a
“robust exit” from the burden of unsustainable debts. This comprehensive approach to debt write-offs
with an enormous potential for poverty reduction is open to the poorest countries, which are eligible
for highly concessional assistance such as from World Bank’s International Development Association
and the IMF’s poverty Reduction and Growth Facilities; which after having applied full traditional debt
relief mechanism still face unsustainable debt situation and which have proven record in implementing
strategies focused on reducing poverty and building the foundation for sustainable economic growth.
The debt-ridden states however are expected to make attempts at helping themselves. The concern
of the northern states may be to no avail if these debtor states do not take steps that will help relief their
situation. Some of these measures may be long term. That is they may be foundational solutions, which
will require consistent build-up and development.
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. Since economic development
depends on the multiplicity of viable corporate firms and enterprises in the country, the approach
adopted here is to demonstrate how capital budgeting, as an investment decision can promote corporate
organisational growth. 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 is
more than investment in capital assets such as fixed assets, e.g., land and buildings, plant and
equipments etc.; it can include intangible fixed assets (e.g., research and development) and working
capital. Thus, the capital investment decision involves large sums of money and may introduce a
drastic change in a company. For instance, acceptance of a project may significantly change a
company’s operation, profitability and risk complexion (since the benefits will accrue in the future).
These changes might also affect investors’ evaluation of a company (Osaze, B.E. 1996:40-44).
Firms invest very heavily annually in fixed assets. These investment decisions can affect the firms’
turnover for years. A good decision will boost earnings sharply and dramatically increase the firms’
value. A bad decision can lead to bankruptcy. Hence, effective planning and control are essential if the
health and long-run viability of the firm is to be assured.
Capital Budgeting integrated the various elements of the firms. Though, its administrative control
rests with the financial manager, the effectiveness of a firm’s capital investments depends on inputs
from all major departments. All other departments (Accounting, Production, Engineering, Purchasing
etc) help in the estimation of the operating costs, and also in the estimation of initial outlay or
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investment cost. The Marketing Department helps in providing sales forecasts. All of these are key
contributions from other departments but obtaining funds and estimating their cost are major tasks of
the financial manager.
The various estimates of the departments are drawn together by the Finance Department in the form
of a project evaluation report while top management, ultimately sets the standards for acceptability.
II. The Problem
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 decision is
not usually well articulated. This is because their government 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 half-way and in some cases, are only executed on papers. In Nigeria, examples are: the
National Identity Card Project, hosting of international conferences such as commonwealth, Festival of
Arts and culture (FESTAC) National balloon project, to mention but a few. To worsen the situation,
the funds for the projects do not come handy through Internally Generated Revenue (IGR) but through
foreign loans such as borrowing from International Monetary Fund (IMF) or the World Bank. The
consequence of such decisions has led Nigeria in particular like other Africa Countries into deeper new
imperial substitute and antagonise.
The current efforts of the Nigerian government towards privatisation of hitherto government-owned
firms and corporations is an indirect concession to the fact that the former investment decision pattern
of the national government is not wise enough. No wonder the adamant posture, recalcitrance and
undaunted-ness of the government even against very rife oppositions and allegations that the leadership
has sold to neo-colonial impetus.
Considering the matter from the corporate perspective therefore, capital budgeting decision is one of
the decision-making areas of a financial manager that involves the commitment of large funds in longterm projects or activities. Consequently, it affects management decisions about the future that are not
certain.
The capital investment decision is usually an irreversible decision. Once an organization has
committed funds to a project, it must see to the end of the project or else, it might lose all the money
initially committed. For example, if a project will cost a certain sum of money and seventy-five percent
of this had been committed, for such a project to become operational, the promoter must look for the
balance of twenty-five percent or else he will lose the entire sum initially committed. The evaluation of
capital budgeting therefore lies in the fact that it assists management in making investment decisions
that will provide an adequate cash flow or return to compensate the investors over its investment and
also to achieve company’s financial objective of maximizing the wealth of shareholders. The study
therefore seeks to examine the importance of capital investment decisions; the basic steps in making
capital investment decisions and the techniques used in evaluating capital investment projects so that
the overall country’s economy can grow from the corporate sector investments.
Review of the Literature and Conceptual Framework
The problem of economic development in Nigeria manifests in the evidences that abound on the
systemic failure of a neo-colonial society in Nigeria (Nnoli 1993:1-26). Nnoli further argues as
follows:
… between 1980-1984, the Gross Domestic Product (GDP) declined. In 1983 the rate of
decline was a high as 6.3%. The GDP at current 1980 prices declined from just below
N55 billion in 1980 to around N45 billion in 1987. At constant 1977-78 factor cost in
1987 factor cost in 1986 it showed a drop of 3.3% when compared with the 1985
figure… Similarly, the current gross national product (GNP) per capita declined from
around US$960 in 1980 to around US$300 in 1987; output of the industrial sector
declined by 4.7% and 18.2% in 1983 and 1984 respectively; and the inflation rate which
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declined from 20.8% in 1981 to 7.7% in 1982 increased to 23.2% in 1983 and 43.6% in
1984 (Nnoli 1993:7).
Economic development in Africa has not been steady. In fact, when compared to the situation in the
West, the conclusion is that countries of the third world is either qualified as undeveloped or mildly put
underdeveloped. Africanists 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 UCDs’ condition is original “in relation to a so-called
non-achievement … (rather) 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 of Rasheed Sadig in “Africa at the
Doorstep of Twenty-First Century” Adebayo Adedeji (ed.), African within the world is,
…poverty increased in both the rural and urban areas: real earning 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, the a mess
vengeance (cited from Onigbinde, op. cit., 2003: 78-79) .
In Nigeria, a preponderant majority of about over 100 million is in a situation of misrule, instability,
poverty, hopelessness, corruption, moral decay, violence and general macro economic uncertainty. In
the reports of United States for International Development (USAID), 1988-1992 (cited from
Onigbinde, 2003:79-80):
… approximately 180 million of sub-Saharan Africa’s 500 million people can be
classified as poor, of whom 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 (.255 compared to .317 for South Asia,
the next poorest region), Africa is the poorest region in the world.
The solution to all these problems lie 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 this, the firm’s activities become more complex and management
assumes a sound financial position in the handling of problems and decisions therein. Modern
approach to financial techniques could be traceable to valuation models propounded by John Bur
Williams in 1938. Validity of these models did not manifest in finance until 1950s when series of
theories had to be established in solving un-tackled problems of investment projects.
In this period of unstable financial operation, companies retain policy through the maintenance of
sound financial structures, reflecting the proliferation of government financial regulations, backed up
by the aim of a controllable and dynamic investment pursuit for the sustenance of national economy.
Empirical studies emerging from established theoretical apparatus have filled up the vacuum in
business procedures, which continually arouse the interest of experts in making positive contributions
required to compare the financial condition and performance of various firms. It is also important to be
conscious of the fact that, the idea of rigorous pursuit of firm’s stabilization through debt funding
unravelled the negligence of financing decision in business organizations.
The Capital Budgeting Process
For survival in the face of competition, for growth and development a firm needs a constant flow of
ideas for new products and ways to make existing products better or at a lower cost. With imaginative
executives and employees, many ideas for capital investment will be advanced. Since some ideas will
be good ones, procedures must be established for screening projects. Moreover, a well managed firm
will go to great lengths to develop good capital budgeting proposals e.g. a sales representative may
report that customers are asking for a particular product which the company is not producing now, the
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sales manager will discuss the idea with the marketing research group to determine the market size for
the proposed product. If a substantial market does exist, cost accountants and engineers will estimate
production costs. If it appears that the product can be produced and sold to yield a sufficient profit, the
project will be undertaken.
The investment decision is one of the most significant decision areas. It might have effect the future
profitability either because it might result in an increase in revenue or because it can cause an increase
in efficiency and a reduction in costs. The important steps in the decision process are:
The practice of capital investment involves risk, the method of measuring the benefits, weighting
the strategic objectives of the investment against the predetermined risks, and in choosing the method
for the analysis is also risky.
Capital budgeting procedure is based on firm’s perception of planning for financial increment due
to successful market performance, customers’ satisfaction and retention, capacity to launch new
products or possibility of improving old ones. In view of the set goal, preparation of capital budgeting
is centred on firm’s main interdependent variables of available resources needed for investment
mobilization at a particular point in time. Management of firms are required to exhibit nearly an
effective prediction of capital budget with respect to minimum level of certainty or uncertainty as per
the propositions made to arrest the non-warranty atmosphere of business environment. As Dam (1979)
has observed if a nation has a stable economic prediction, capital investment demands could
significantly be financed and implemented according to the company’s designed goals and objectives.
Any nation facing un-quantifiable economic instability may transfer such impediment of growth to
organizational survival. Company’s investments suffer in a poorly controlled economy be it in a
developed or developing country. Future prediction of income becomes uncertain and risky in an unconducive socio-economic and political atmosphere.
Time preference and risk are intriguing ideas that decision makers cannot avoid in financial decision
making, the attempt to find solution to problem of risk and uncertainty has sparked up divergent views
in the literature. One of the proponents to discuss the difficulties emanating from Capital Budgeting is
Bodernhorn (1959). He notes the obstacle of making decision in budgeting of capital and observes that
the formulation of such decision is centred on the available investment opportunities that will make
firm to accept or reject a project. To make rational decisions firm must have specific objectives in the
sense of maximizing its profit based on the expected long-term returns to be acknowledged as an
increase or possibly a decrease in projected investment. We should note a gain that, a project is
acceptable to management only when it adds to the profit of the firm after all costs (including the cost
of capital) have been met. This statement agrees with the traditional theory objective of maximization
of wealth of firm’s owners. This involves increasing the shareholder’s wealth or yielding a rate of
return larger than the normal rate; because the normal rate is earned if the owners have invested in an
alternative venture.
i. Identifying possible investment projects
This is the project ideas’ generation stage. Projects ideas’ can originate from any level within the
organization. It can be from the operator in the factory or supervisor or production manager or
managing director. Employees should be encouraged to identify new products, new production
methods, new markets etc. Companies should also have in operation a system by which technical help
can be given to staff to develop project ideas into formal investment proposals. We should regard
project ideas’ generation stage as a continuous stage in any organisation not regarded as one which
should be undertaken over a long interval period.
ii. Identifying possible alternative to the projects being evaluated
This stage involves identifying possible alternative projects to the projects being evaluated.
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iii. Acquiring Relevant Data on the Projects under Consideration
This stage involves finding all the relevant data on the projects under consideration. This task should
be carried out without bias. Where possible an independent financial manager can carry out the task.
iv. Evaluating the projects from the data assembled
This stage involves carrying out a financial evaluation of the projects based on the criteria the firm
uses. It is advisable to use more than one criterion. We will describe the various criteria that can be
used in evaluating projects later in this paper.
As will be described later, the discounted cash flow method is the best-recommended approach
since it is consistent with the objective of maximizing shareholders’ wealth. The financial evaluation
will enable the firm to determine the worthwhile-ness of the project.
v. Project Selection
This is a stage where a final decision is taken on the project. The board of directors will usually take
the decision on projects to be selected. Possibly about three projects might be recommended to the
board after evaluation. The board of directors will use their experiences to decide the projects to be
selected.
vi. Project Implementation
This involves implementing the decision taken on the projects selected. Efforts should be made as
much as possible to carry out the decision taken. We will give more discussions on this later.
vii. Project Monitoring and Control
This involves monitoring the progress of the project to assess its effectiveness and whether the
expected benefits are being realized. Reviews such as a post audit might need to be carried out. We
will give more discussions on this later.
Conceptual Clarification
The term capital means the funds employed to finance fixed assets used in production. A budget is a
detailed plan of projected inflows and outflows over future periods. Capital Budgeting is therefore the
process of planning expenditure that generates cash flows expected to extend beyond one year.
Project Classifications
Capital expenditure proposals/investment decisions need to be carefully made.
Firms generally classify projects into categories so that projects in each categories are analysed
differently since their benefits and the level of expenditure requirements.
1. Replacement Projects/Maintenance of Business Projects
These include expenditures necessary to replace worn-out or damaged equipment used to produce
profitable products. To continue its current business, these projects are necessary for the firm to
embark upon, and such maintenance decisions are usually routine and are normally made without
going through an elaborate decision process.
2. Safety and Environmental Projects
These are mandatory, non-revenue producing investments made necessary by government regulation,
collective bargaining agreements, or insurance policy requirements. Most often, they are quite routine
too and need not go through an elaborate decision making process.
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3. Cost Reduction Projects
They are expenditure to replace serviceable but obsolete plant and equipment, to lower the cost of
labour, raw materials, electricity etc. A detailed analysis is needed here to support the expenditure.
4. Expansion Projects
Involves expenditures to increase the availability of existing products and services. These investment
decision are relatively complex because they require an explicit forecast of the firm’s future supply and
demand conditions. Mistakes are possible and could be expensive and so, detailed analysis is necessary
before the decision could be taken.
It also involves expansion into new products and services or to expand into new geographical areas.
These are strategic decisions that could change the fundamental nature of the firm’s business, hence,
very detailed and thorough analysis is invariably required.
III. Types of Investment Decisions
Independent Investment
Investments are independent when two or more investment can be taken together simultaneously and
the acceptance of one cannot delay or affect the other.
Mutually Exclusive Investment/Projects
These are investments that cannot be taken together. Accepting A means that B has to be ignored.
Contingent Investment
i.e. the acceptance of one will necessitate the inclusion of other projects e.g. establishing a company at
Iyanfoworogi village will necessitate road, water etc. projects.
The Criteria for Investment Decision
Criterion for measuring the viability of investment projects is highly imperative and these rules have
extensively explained the conditions required for accomplishing goal of revenue maximization.
However these rules or criteria are the
Payback Period
Accounting Rate of Return
Internal Rate of Return.
Net Present Value
Profitability Index
They provide a stable preference to firm’s financial position, as every manager is expected to
manage his funds competently. Quirin (1967) argues that capital budgeting procedures stipulate an
avenue for an organization to invest its present sum of money efficiently and effectively in the long
run. Often time capital investment procedure incorporates variables that cut across several financial
assets business expansion, acquisition and merger and any other assets with life span spreading beyond
one or two years. It is also important to note that the idea of strategic planning for capital investment
emanates from critical evaluation of financial models.
IV. The Payback Period Criterion (PBP)
The above criterion is classified under non-discounting appraisal and it depends on the number of
period (usually in years) taken for the future net cash flows on a capital investment to payback the
initial or original net cash outlay. Since it is based on an immediate retrieval of gain from the executed
project, formulation of this decision will consider specifically payback period. Any project with PB
above the specified PBP maximum is however rejected because it will take too long a time to retrieve
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initial capital. Application of PB rule on mutually exclusive projects will favour the choice of the best
alternative for the project having the shortest payback period which is ultimately acceptable.
Brealey and Myers (1988) support this idea when they tagged PBP as the simplest way to
communicate the degree of desirability of an investment project, and thus every individual commenting
on the viability of a project based on discounted cash flows alone may ignore the ideas of those
individuals with little knowledge about such rules.
As proponents and critics have stressed, the deficiency of the definition of Payback period makes
the model complex. Just like any other theory, it can only offer a partial understanding of what
constitutes its benefit to either the managers or owners of firms. Nonetheless it is defective because it
does not consider the time preference of fund, as it gives equal weight to all future net cash flows over
each project’s Payback period. It has therefore been agreed that the PBP rule is not fully accepted as a
desirable rule for evaluating capital project because it violates the following capital budget properties,
in the sense that:
(i) all cash flows should be considered and
(ii) these cash flows should be discounted at the opportunity cost of funds.
V. Accounting Rate of Return (ARR)
The accounting rate of return is described as the annual accounting profits from a capital project.
Divided by a defined annual average capital investment outlay over a project’s life span. The rule is
thus compared by the firm to certain arbitrarily set hurdle rate. It means, is simply the average after tax
profit divided by the initial cash outlay of the project, and has similarity with the return on assets. The
accounting rate of return as a non-discounting criterion is exposed to the same type of criticism like the
PB since it violates the two properties of capital flows, but considers all the accounting profits instead
of cash flows, over a given life of a capital investment. It however does not consider time value of
money. Managers would be indifferent in their choice between one project and other with after tax
profits, which may occur in the opposite chronological order because both projects would have similar
accounting rate of return. Apart from this, it is possible that, the use of accounting variables could
provide a misleading interpretation of net cash flows emerging from the project outlay. This may
happen, since depreciation of the initial cost of capital over the future life of a capital investment is
concisely treated as cash costs.
The defect may also arise from the accounting standards in force when a particular project
assessment is being made at that given period. Despite all these flaws accounting rate of return is
widely used to appraise capital budgeting decision by financial managers, but mostly side by side with
the discounted cash flows – especially the net present value.
VI. Internal Rate of Return (IRR)
The IRR is a discounting cash flow, which has been enhancing a set of decisions made, based on
capital budgeting. It is described as the rate of interest at which the present value of expected capital
investment outlays is exactly equivalent to the present value of expected cash earnings on that capital
project. It is in essence the rate, which equates the present value of the cash inflows, and also a rate
making the computed net present value exactly zero. Separately put, it is the rate of return on invested
capital, which the project is returning to the firm, when the net present value is equal to zero. The said
assertion agrees with the Keynes (1936) statement on marginal efficiency of capital. In other word
marginal efficiency of capital is equivalent to that rate of discount which would make the present value
of the series of annuities given by the expected returns of the capital asset during its life span just
equivalent to its supply price. Fisher (1907) states equally, that the rate of return over cost is that rate
which is employed in quantifying the present worth of all the costs and the present worth of all the
returns which will make these two the same. This means the IRR is the break even point of cost of
capital and thus a measure of investment liability with respect to rate of return rather than value.
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Specifically, IRR rule is simple and gives better understanding to decision-maker about convenient
evaluation of expected rate of return per unit of time during investment process. As risk depends on the
amount of capital exposed to its over time, IRR assists in measuring the project profitability with
regard to similarity of quantity and time of risky project. IRR is economically preserved; as such
management having the knowledge perceives consciously whether the rate of return is convincingly
greater that the required rate of return for different capital projects. Carsbery (1974) identifies the basic
problem of IRR rule as providing an assessment of the return relating to the cash outlay required from
a project and ignores the absolute size of the return on investment. Investors and financial analysts may
not find it difficult to explain appropriately what this rate of return stands for.
VII. The Net Present Value
The net present value of an investment or capital project is the aggregation of the present values of all
cash benefits by deducting the present value of all cash. In mathematical form the net present value is
explained as:
CFt
− I0
NPV = ∑ tn=1
(1 + r ) t
Where CFt = Cash flow at the end of the period t
R is the required return per period.
N = overall number of periods in the project’s life.
I0 = the initial fund project required
The net present value is thus the evaluation of the amount by which the project value is maximized;
this will in turn serve as gain for the wealth the owners used in future to come. A negative net present
value means the project is not desirable and vice versa. Every estimation of NPV of a project should
involve measuring the project’s future net cash flows, discounting these at the appropriate cost of
capital to procure their present value, deducting the initial capital cost or net investment outlay, at the
project commencement period. This expression supports the submission of Porterfield (1966) that the
NPV of a project as the present value of cash inflows minus the present value of the cash outflows,
Bierman and Smidt (1980) have argued that, the present value of a project should depend on the ratio
of interest used, as there is not a single present value estimate but a group of estimates focusing on
what rate of interest is selected. In the real world the present value is evaluated, by employing a single,
pre-determined interest rate which reflects the view of the firm’s cost of capital. Assumption to
reinvest is often the objective of both NPV and IRR. Thus it has been noted that both the stated
techniques are superior over the non-discounted rules in appraising the desirability of a capital project
have judged the NPV and IRR to be effective either to accept or reject a capital investment. Merret and
Sykes (1963) feel, the respective advantages of the two techniques could be examined in respect of
practical approach to decision making and which might have reflected in the assessment of their
usefulness by the investors. Moreover, problems arising in tackling negative cash flows, which do
occur during the spanning life of a capital project favour the net present value, because it is
incorporated with a term; reject or accept.
PI = Present Value of Cash Inflows
Present Value of Cash Outflows
n
=
∑
t =1
E(cf) it
(ifk ) ti
n
Cit
∑ (itk )
t =1
i
t
= PV Benefit
PV Costs
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International Research Journal of Finance and Economics - Issue 2 (2006)
VIII. Profitability Index (PI)
The Profitability Index (PI) also known as the “Benefits-Cost Ratio” is the ratio of the present value of
future cash benefits, at the required rate of return to the initial cash outlay of the investment. It is
another technique at the disposal of an entrepreneurs or decision makers to assist in choosing among
several causes of actions. In a layman language, if is the monetary cost of a project/programme is
ascertained and is also compared with its expected benefits in monetary terms. For a project to be
acceptable, its benefits must outweight its costs.
IX. Methodology of the Study
It has been critically observed that investment decisions of corporate companies in Nigeria are
seriously affected by the uncertain economic climate. The unstable economic climate makes policy on
firms’ anticipatory project highly subjective to the attributes of financial repression, foreign exchange
shortage, inaccurate forecast for aggregate demand of goods, relative capital market pricing of stock,
adequate funds for lending and borrowing and so forth. This study is therefore intended to look into
capital budgeting decisions of public quoted companies in Nigeria.
The study applied both primary and secondary sources to collect the data. For the primary source
questionnaires were administered and this was supplemented by oral interviews. The secondary data
used had been sourced from the Nigerian Stock Exchange Fact Books (1980, 1984, 1988/89, 1992 and
1995) and related literatures.
This study was conducted in ninety-four firms that responded to our questionnaire out of one
hundred and eighty-four companies earlier identified through preliminary surveys. The selection was
further based on the fact that the firms so selected have their head offices situated in Lagos for easy
coordination and these firms also cut across eleven sub-sectors of the economy namely: Agriculture,
Banking, Breweries, Building, Materials, Conglomerates, Construction, Food/Beverages and Tobacco,
Healthcare, Insurance, Petroleum (Marketing) and Textiles.
International Research Journal of Finance and Economics - Issue 2 (2006)
147
Table 1: Percentage of responding companies employing models of capital budgeting techniques
Model Employed
PBP, ARR, NPV
PBP, ARR, IRR
PBP, IRR
PBP, NPV
PBP, ARR, NPV, IRR
Mathematical Programming
None applicable
Total
Frequency
Percentage of company
Employing Models
27
22
19
21
4
1
0
94
28.7
23.4
20.2
22.3
4.3
1.1
0
100
Source: Field Survey
From Table 1 above, it shows that Payback Period model was increasingly being used together with
ARR and NPV as the main measuring standard of the total percentage, respondents combining the
models of PBP, ARR and NPV held the highest (27%). 22% of the respondents combined PBP, ARR
and IRR, 19% applied IRR and PBK, 21% combined NPV with PBP, 4% used PBP, NPV, IRR, ARR
and Mathematical programming approach while one percent of the respondents did not indicate their
interest. With this development, public companies did fully make use of capital budgeting models to
evaluate capital project expenditures.
Table 2: Percentage and Frequency distribution of companies using discount rate for cost of capital technique
Apply as independent
Evaluation method
Frequency
%
Cost of Debt
Cost of Equity
Weighted/Average Cost of Capital
A measure depended on past
Experience
Expectation with regard to growth
and dividend payment
Return from risk free Assets plus a
premium related to Risk Class
Not applicable
Overall total
Frequency
Total
Other methods
%
Frequency
%
8
14
18
31
8.5
14.9
19.2
33.0
11
12
16
14
11.7
12.8
17.0
14.9
19
26
34
45
10.1
13.8
18.1
23.9
11
11.7
23
24.5
34
18.1
7
7.5
13
13.8
20
10.6
5
94
5.3
100
5
94
5.3
100
10
188
5.3
100
Source: Field Survey
From Table 2 above, out of two methods by which projects are financed namely equity and debt, the
respondents provided answers to varying avenues by which funds were sourced to implement capital
investments. Of the 94 companies shown in the table, 33% employed measure based on past
experience if exclusive but 14% when used with other methods and 11.7% when combined with other
measures, 14.9% employed cost of equity as an exclusive standard and 12.8 % a combined measure.
19.2% employed weighted average cost of capital, while 17.0% used it when combined with other
methods. Growth and dividend payout techniques were used by a total of 11.7% firms and 24.5 %
when combined with other measures.
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International Research Journal of Finance and Economics - Issue 2 (2006)
Table 3: Analysis of corporate risk in decision-making
Criteria Used for Measuring Risk
a. Criteria Used for Measuring Risk
i. Ignore risk and use simple standard for all project
ii. Assessment of project riskiness based on
subjective approach
iii. Probability distribution of project’s cash flow
iv. Probability of loan
v. Risk not assessed
Total
b. Risk Classification
i. Depends on project financed exclusively by
equity
ii. Based on project funded exclusively by equity
ii. Based on project funded by both equity and debt
Total
c. Accounting for Risk in CBT
i. Shortening the required pay back
ii. Raising the required rate of return
iii. Raising the discount rate while computing present
value
Total
d. Expected Market Interest Rate
i. Changes in interest rates on security values
ii. Possibility of evaluating capital project viability
iii. Assess minimum expected return on investment
iv. Sudden change in interest rate disallows project
execution
Total
No of Forms
Percentage
18
31
19.1
33
11
21
13
94
11.7
22.3
13.8
100
17
42
35
94
18.1
44.7
37.2
100
47
29
18
50
30.9
19.2
94
100
21
33
21
19
22.3
35.1
22.3
20.2
94
100
Source: Field Survey
Table 3 (a) Risk Criteria
Table 3(a) presents the response of companies to the criteria used for measuring risk. 18 among the
respondents did ignore risk and used simple standard purely on returns (19.1%). 31 of the respondents
assessed the risk of projects based on subjective approach, (33%), 11 involved in probability
distribution of project cash flows (11.7%) 21 depended on probability of loss (22.3%) while 13 did not
evaluate risk in capital investment decision (13.8%). It was concluded that many of these public
companies (33%) predicted for risk subjectivity.
Table 3(b) Risk Classification
Classifying risk level characterized by divergent methods of funding was found to be associated with
greater exposure to debt or equity capital.
This was true in all companies. Table 3(b) shows that 17 companies depended on project financed
exclusively by debt (18.1%) while 42 companies exclusively financed their projects by equity (44.7%)
and 35 responding forms considered risk classification by combining both equity and debt financing
(37.2%).
Table 3 (c) Accounting for Risk in Capital Budgeting Techniques
Table 3 (c) has shown that 47 companies out of 94 preferred shortening the required payback (50%),
29 did often raise the required rate of return (30.9%) and 18 raised the discount rate while calculating
the present value. Many authors have not supported the use of payback in this regard because of its
inability to forecast beyond the stipulated period, unlike the net present value or internal rate of return
which possess the stronger standard for deciding long term project.
International Research Journal of Finance and Economics - Issue 2 (2006)
149
Table 3(d) Expected Market Interest Rates
The market interest rates viewed as being affected by four factors these factors have been enhancing
the efficiency of respondents to judge their capability in taking up investments. Table 3 (d) has
depicted companies’ positions in the choice of such factors. As indicated, 21 companies agreed to
changes in interest rates on security values (22.3%).
Security value explains the strength level of every organization to customers and other competitors
in the external environment. Generally, companies adhering to this phenomenon are leaders which
other firms emulate. 33 of the respondents (35.1%) were of the opinion that possibility of evaluating
capital project viability could not affect their growth when the market interest rate remained
fluctuating. 21 companies based their assessment on minimum expected on investment (22.3%) and 19
of the respondents (20.2%) refused to operate and execute capital investment when there was a sudden
change in interest rates.
The conclusion that can be drawn here is that in an uncertain environment, the anxiety to press
ahead by ignoring the consequences of risk taking often contributes to growth in subsequent years if a
project is properly managed.
Table 4: Distribution of responding firms through corporate dimensions in decision-making.
S/N
a
b
c
d
Corporate Dimension of Capital Investment
Allocating funds to capital Investment
5 million – 10 million
11 million – 15 million
16 million – 15 million
21 million – 25 million
26 million and above
Total
Span of years for new project implementation
1-5 years
6-10 years
11-15 years
16-20 years
Above 20 years
None applicable
Total
Target growth rate of firm
5 - 10 %
11 -15 %
16 – 20 %
Above 21 %
None Applicable
Total
Source of funds for Capital
i.
Retained earnings or profits
ii.
Equity capital through the Stocks Market
iii.
Long term loan only
iv.
Equity and Debt
v.
None applicable
Total
No of Firms
Percentage
5
6
8
20
55
94
5.3
6.4
8.5
21.3
58.5
100
39
28
16
6
4
1
94
41.5
29.8
17.0
12.8
9.6
5.3
100
47
21
12
9
5
94
30.9
28.7
18.1
21.3
1.1
100
29
27
17
20
1
94
30.9
28.7
18.1
21.3
1.1
100
Source: Field Work
*Capital investment is referred to as funds committed to a long-term project with the purpose of making profit in
unforeseeable future.
Table 4 (a) above shows how many companies allocated money to capital investment. The highest
number of firms (55) allocated funds in the range of N26 m and above representing (55.5%). 20
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International Research Journal of Finance and Economics - Issue 2 (2006)
respondents allocated between N21 m – N25 m to capital projects representing (21.3%). 8 companies
did allocate between N16 m – N 21 m to capital investment (8.59%) while 6 and 5 respondents
allocated money between N11 m – N15 m (6.4%) and N5 m – N10 m (5.3%) to capital projects
respectively. The outcome of these companies testified to the importance attached at corporate level to
long term capital projects.
Table 4 (b) is concerned with span for the new project implementations. Because of the economic
instability quoted companies expectations in terms of profits seemed high within the possible shortest
period. 39 companies that involved in new project implementation restricted their period of decision to
between 1 – 5 years (41.5%). 28 companies supported 6 – 10 years (17.0%) 16 – 20 years (6.4%) and
above 20 years (4.1%) respectively. Only one company failed to respond.
Table 4 (c) shows the rate of the companies’ growth as it affects their investments decisions. The
majority of 47 companies (50%) assigned 5 – 10%, 21 companies (22.3%) assigned 11 - 15%, 12
companies (12.8%) assigned 16 - 20% and only 9 companies (9.6%) assigned a rate above 21% while
only 5 firms (5.3%) did not indicate their interest.
Table 4 (d) shows the preference for sources of funds for capital projects. The importance of sources
of funds cannot be over-emphasized because, to certain extent the source of capital determines the
level of confidence and degree to which risk can be accommodated. The number of firms that support
equity are 56 i.e. (29 + 27) representing (59.6 %) while only 17 companies (18.1%) preferred debt
finance. The number of companies that favoured the combination of equity and debt are 20
representing 21.3 %. This shows the management of Nigerian firms prefers an equity of finance.
X. Summary of Findings
Concerning the use of capital budgeting techniques, it was revealed that virtually all the companies
surveyed used one form of the criteria or another for selecting optimum investment. It was revealed
further the most common method is payback period. However with the present opportunity open to top
management, it has become possible to combine payback other criteria such as NPV, IRR and linear
programming to choose the optimum alternative project an outcome of corporate decision.
The study further highlights the core rule of capital market as the type, which allows free entry and
exit of investors. Similarly the function of the Nigeria Stock Exchange and Security and Exchange
Commission is to put in place enough liquidity for an efficient market operation by these inventors.
The study revealed that dividends and taxation payouts as well as shareholders funds and share
capital strongly influenced public companies growth performance when related with retained earnings
and credit investment. Furthermore, overall strongly positive impact of net cash inflows on investment
return was also consistent with other findings that net cash inflow should be regarded as a desirable
determination of performance, since higher income dictates better investment return and vice versa.
The result then showed that low investment return was a signal of poor growth performance level.
XI. Conclusions and Recommendations
Claude Ake is of the view that the people at the end of development and that their well-being is the
supreme law of development. He further opines that “development strategy is always contextualized in
a particular state, social structure, culture, and meaning. It implies a structure of politics, but it also
influences political interactions, practices, and outcomes” (Ake, 2001:126-127). Development, being
the supreme goal of every society must be pursued from both the public and private sectors. However,
since the current trend is that the state is withdrawing from active participation in economic sector in
the favour of the private sector, which has led to the phenomenon of privatisation of hitherto owned
state corporations and enterprises, the private sector as nowadays occupied a focal position. In other
words, the private sector needs to do everything humanly possible to breakeven and to achieve the
overall societal goal whose onus now rest on private sector performance. Capital budgeting decision,
therefore, is an un-negotiable investment decision making process that must be taken seriously. To this
end, this study has demonstrated through a careful analysis of the performance of private sector firms,
International Research Journal of Finance and Economics - Issue 2 (2006)
151
how capital budgeting can be used to facilitate and accelerate economic development within corporate
firms and by extension to the large society.
The study also showed the effectiveness of the Nigeria Stock Exchange and the Security and
Exchange Commission in controlling the activities of public companies. Most of the general financial
economic policies relating to investment manifest from the advisory note were emphasized consistently
by these agencies. It was obviously shown that the growth performance of public company is
influenced by retained earnings and investment returns subject to practical knowledge and experience
of management and some other factors like shareholders equity dividends and taxation, total assets and
net cash inflows which also determine the level of performance.
From the evidence in the study, cash inflows generated through effective management of business
activities and investors eagerness to deal in stock with a particular company reveal the degree of capital
base of that firm which is also the cornerstone of satisfying the shareholders with respect to dividends
pay out.
Departing a little from the above ideals, it might be worthwhile to recommend that economics
rhetoric must be matched with economic action. Enabling legislations and conducive social climate
must be provided for economic activities in Nigeria. Besides, technological competence and know how
must be encouraged, developed and stepped up. Moreover, the political climate must be sanitized of
corruption, greed and avarice. Fulfilling these recommendations, the pace is set for the realization of
economic development that Africa and indeed a third world desires.
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International Research Journal of Finance and Economics - Issue 2 (2006)
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Plc. Bi-annual Review, Vol. 4, No. 9 pp. 40-44
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Porterfield J.S. (1966), Investment Decisions and Capital Finance. Prentice Hall.
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ISSN 1450-2887 Issue 2 (2006)
© EuroJournals Publishing, Inc. 2006
http://www.eurojournals.com/finance.htm
Capital Budgeting and Economic Development in the Third
World: The Case of Nigeria
D. O. Elumilade, T. O. Asaolu and A. O. Ologunde
Department of Management and Accounting
Faculty of Administration
Obafemi Awolowo University
Ile-Ife, Osun State
Nigeria
Abstract
Poor and Unrealistic capital budgeting has long been the bane of socio-economic
development in Africa and of course, Nigeria. The issue of capital, investment and how it
was undertaken in the capital budgeting process thus constitutes a major concern of this
paper. Even in the midst of vast economic and resources cum endowment, African
countries are not only technologically backward but wallow in neckdeep poverty and
indebtedness.In the bid to resolve this nagging problem, this paper looked at the form and
approach of the Nigeria government to capital budgeting. It tried to unravel the causes of
project abandonment, capital disappearance and inhibition placed on capital budgeting as
the country related to other countries outside her borders (particularly in the Western
world). The paper adopted a basic research approach whereby it collected primary data
from questionnaires administered on 94 firms primarily and they were complemented with
vast secondary data extracted from Nigerian stock exchange fact books from 1980-1999.
The analysed data were presented in tables, percentages and were critically discussed.
Basically, the study found out that most firms used one form of the criteria or another for
selecting optimum investment. However, the study revealed that the most common method
is the payback period. The study also revealed that dividends and taxation payouts as well
as shareholders’ funds and share capital strongly influenced public companies growth
performance when juxtaposed with retained earnings and credit investment. Moreover, net
cash flow on investment is found to be a strong determinant of performance since higher
income dictates better investment returns and vice-versa.The paper concluded that capital
budgeting decision is an unnegotiable investment decision making strategy that must be
taken very seriously. Given the fact that only private sectors made use of various methods
of project valuation, which accounts for the reason why the little development visible in
Nigeria are from the private sectors, the study therefore pushes that the government should
embrace capital budgeting if it is to witness appreciable economic development.
Key words: Capital Budgeting, Economic growth
JEL classification: E24, C22
I. Introduction
Capital budgeting in a developing economy is very vital and must be approached with all sense of
diligence. The rate of economic development in the third world has been relatively slow and it needs to
International Research Journal of Finance and Economics - Issue 2 (2006)
137
be accelerated. Gone were the days when a community would say that she will keep to herself. The
modern world is not only a competitive world but a globally captured village. As such, it is either a
society or community braces up with modern requirements for development or suffers self-inflicted
setbacks. Capital budgeting involves making investment decisions concerning the financing of capital
projects by firms. Making a good investment decision is important since funds are scarce and it will
add to the value of the firm especially in Less Developed Countries LDCs and Third World poor
nations of the world. Capital investment decision is thus one of the requirements, if properly applied,
that can accelerate economic development
The forty-eight countries of the sub-Saharan Africa expend an upward of 13.5 billion dollars per
annum on foreign debt payment to rich foreign creditors. The origins of this debt trap for poor states lie
in the formation of the Organization of Petroleum-Expecting Countries (OPEC) in 1973 and the
dramatic rise in oil prices that year. The OPEC states deposited their new oil wealth in Western banks.
Since idle money loses against inflation, which was rising rapidly at the time, the banks needed to find
countries to take loans. Many states in Eastern Europe and 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.
On the side of the creditors as well, in context of the cold war, little thought was given to the
purpose of the developing countries for collecting loans. More so, many of these loans were given in
order to gain and or retain the loyalty of corrupt regimes, which was characteristic of Africa at that
time. The expectation of the third world states, that Interest rates will remain stable, was shattered by
two major trends in global economy over the two decades;
First, the fixed exchange rate system that had been established after the second world war collapsed,
and state began to use interest rates to stabilize their exchange rate. Secondly, interest rates rose in the
1980s in response to trade and budget deficits in the United States. This caused a downturn in the
economies of industrialized states, thereby reducing export markets for poor states. The global prices
for primary commodities, which formed a large bulk of third world’s export earnings, collapsed as
well. These left many of these states in abject financial bankruptcy. Debts incurred were so large that
they needed new loans to finance them. This brings the other side of the debt story to high
Debt Servicing
This debt trap or debt ‘cancer’ as some writers have put it, represents a continuing humanitarian
disaster for some over seven hundred million of the world’s poorest people. These debtor states were
under-developed and their debt crisis further plunge them into deeper economic crisis and abject
underdevelopment.
Before solutions can be proffered to problems, apart from understanding the nature of the problem it
is important to analyse the cause or causes (if it is multifaceted) of the problem. The same thing goes
for the debt crisis in Africa. Apart from the historic cause that is the international economic regression
of the 1960s and 1970s, there are some other causes that can be regarded as important even though
they are indirect causes. They include:
Mismanaged lending and spending. In the 1960s United States’ expenditure was more than its
revenue. This made the country print out more dollars, thereby devaluing the dollar. Consequently, oilproducing state which had their economies pegged to the dollar were affected by these decrease in
dollar value. In 1973, the oil-producing countries hiked their prices in response, thereby earning a lot
of money, which they put in Western banks. Interest rates increased alongside and more lending
ensued by banks so as to prevent crisis.
Second, corrupt-leadership in borrower states. Due to the fact that these loans were thoughtlessly
accepted, and they were collected by western-backed dictators, they had little or no implications for
development nor benefit for the masses. Most of these leaders siphoned these loans for personal
aggrandisement.
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International Research Journal of Finance and Economics - Issue 2 (2006)
Thirdly, in 1982, Mexico defaulted on its debt payment, threatening the international credit system.
These moved IMF and World Banks to introduce Structural Adjustment Policies to help Mexico and
other Third World States facing these problems repay their debt. The harsh conditionality that came
with these policies have only further entrenched these debtor states in the indebtedness. Structural
adjustment advice in the past has led to the cut back on important spending such as health education in
order to be able repay loans. This has implied downward spiral turn and further crash down into
poverty in African states.
Finally the protection in the world’s market for agricultural products and low-technology
manufactures, which make it particularly difficult for African countries to diversify and increase
exports to hard currency markets, thus making it doubly difficulty for them to earn their way out of the
debt trap.
The danger of the debt crisis to North and South led both of them to seek ways out. The United
States, as the world’s leading economy and the largest single holder of Less Developed Countries’
(LDC) debt, has been at the vanguard of this effort. Some of which include Nicholas Brandy’s plan of
1989 when over 100 billion debt owed by LDCs was forgiven, interest rates lowered, and now loans
given. There has been increased flow of concessional aids from creditors. Sub-Saharan Africa has
emerged over the last two decades as the major aid-receiving region.
In October 1996, the first real attempt was made to deal with the problem when the World Bank and
the IMF won agreement from their Boards of Governors for the establishment of the Highly Indebted
Poor Country Initiative. At its launch, the policy offered the promise of poor countries achieving a
“robust exit” from the burden of unsustainable debts. This comprehensive approach to debt write-offs
with an enormous potential for poverty reduction is open to the poorest countries, which are eligible
for highly concessional assistance such as from World Bank’s International Development Association
and the IMF’s poverty Reduction and Growth Facilities; which after having applied full traditional debt
relief mechanism still face unsustainable debt situation and which have proven record in implementing
strategies focused on reducing poverty and building the foundation for sustainable economic growth.
The debt-ridden states however are expected to make attempts at helping themselves. The concern
of the northern states may be to no avail if these debtor states do not take steps that will help relief their
situation. Some of these measures may be long term. That is they may be foundational solutions, which
will require consistent build-up and development.
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. Since economic development
depends on the multiplicity of viable corporate firms and enterprises in the country, the approach
adopted here is to demonstrate how capital budgeting, as an investment decision can promote corporate
organisational growth. 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 is
more than investment in capital assets such as fixed assets, e.g., land and buildings, plant and
equipments etc.; it can include intangible fixed assets (e.g., research and development) and working
capital. Thus, the capital investment decision involves large sums of money and may introduce a
drastic change in a company. For instance, acceptance of a project may significantly change a
company’s operation, profitability and risk complexion (since the benefits will accrue in the future).
These changes might also affect investors’ evaluation of a company (Osaze, B.E. 1996:40-44).
Firms invest very heavily annually in fixed assets. These investment decisions can affect the firms’
turnover for years. A good decision will boost earnings sharply and dramatically increase the firms’
value. A bad decision can lead to bankruptcy. Hence, effective planning and control are essential if the
health and long-run viability of the firm is to be assured.
Capital Budgeting integrated the various elements of the firms. Though, its administrative control
rests with the financial manager, the effectiveness of a firm’s capital investments depends on inputs
from all major departments. All other departments (Accounting, Production, Engineering, Purchasing
etc) help in the estimation of the operating costs, and also in the estimation of initial outlay or
International Research Journal of Finance and Economics - Issue 2 (2006)
139
investment cost. The Marketing Department helps in providing sales forecasts. All of these are key
contributions from other departments but obtaining funds and estimating their cost are major tasks of
the financial manager.
The various estimates of the departments are drawn together by the Finance Department in the form
of a project evaluation report while top management, ultimately sets the standards for acceptability.
II. The Problem
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 decision is
not usually well articulated. This is because their government 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 half-way and in some cases, are only executed on papers. In Nigeria, examples are: the
National Identity Card Project, hosting of international conferences such as commonwealth, Festival of
Arts and culture (FESTAC) National balloon project, to mention but a few. To worsen the situation,
the funds for the projects do not come handy through Internally Generated Revenue (IGR) but through
foreign loans such as borrowing from International Monetary Fund (IMF) or the World Bank. The
consequence of such decisions has led Nigeria in particular like other Africa Countries into deeper new
imperial substitute and antagonise.
The current efforts of the Nigerian government towards privatisation of hitherto government-owned
firms and corporations is an indirect concession to the fact that the former investment decision pattern
of the national government is not wise enough. No wonder the adamant posture, recalcitrance and
undaunted-ness of the government even against very rife oppositions and allegations that the leadership
has sold to neo-colonial impetus.
Considering the matter from the corporate perspective therefore, capital budgeting decision is one of
the decision-making areas of a financial manager that involves the commitment of large funds in longterm projects or activities. Consequently, it affects management decisions about the future that are not
certain.
The capital investment decision is usually an irreversible decision. Once an organization has
committed funds to a project, it must see to the end of the project or else, it might lose all the money
initially committed. For example, if a project will cost a certain sum of money and seventy-five percent
of this had been committed, for such a project to become operational, the promoter must look for the
balance of twenty-five percent or else he will lose the entire sum initially committed. The evaluation of
capital budgeting therefore lies in the fact that it assists management in making investment decisions
that will provide an adequate cash flow or return to compensate the investors over its investment and
also to achieve company’s financial objective of maximizing the wealth of shareholders. The study
therefore seeks to examine the importance of capital investment decisions; the basic steps in making
capital investment decisions and the techniques used in evaluating capital investment projects so that
the overall country’s economy can grow from the corporate sector investments.
Review of the Literature and Conceptual Framework
The problem of economic development in Nigeria manifests in the evidences that abound on the
systemic failure of a neo-colonial society in Nigeria (Nnoli 1993:1-26). Nnoli further argues as
follows:
… between 1980-1984, the Gross Domestic Product (GDP) declined. In 1983 the rate of
decline was a high as 6.3%. The GDP at current 1980 prices declined from just below
N55 billion in 1980 to around N45 billion in 1987. At constant 1977-78 factor cost in
1987 factor cost in 1986 it showed a drop of 3.3% when compared with the 1985
figure… Similarly, the current gross national product (GNP) per capita declined from
around US$960 in 1980 to around US$300 in 1987; output of the industrial sector
declined by 4.7% and 18.2% in 1983 and 1984 respectively; and the inflation rate which
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International Research Journal of Finance and Economics - Issue 2 (2006)
declined from 20.8% in 1981 to 7.7% in 1982 increased to 23.2% in 1983 and 43.6% in
1984 (Nnoli 1993:7).
Economic development in Africa has not been steady. In fact, when compared to the situation in the
West, the conclusion is that countries of the third world is either qualified as undeveloped or mildly put
underdeveloped. Africanists 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 UCDs’ condition is original “in relation to a so-called
non-achievement … (rather) 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 of Rasheed Sadig in “Africa at the
Doorstep of Twenty-First Century” Adebayo Adedeji (ed.), African within the world is,
…poverty increased in both the rural and urban areas: real earning 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, the a mess
vengeance (cited from Onigbinde, op. cit., 2003: 78-79) .
In Nigeria, a preponderant majority of about over 100 million is in a situation of misrule, instability,
poverty, hopelessness, corruption, moral decay, violence and general macro economic uncertainty. In
the reports of United States for International Development (USAID), 1988-1992 (cited from
Onigbinde, 2003:79-80):
… approximately 180 million of sub-Saharan Africa’s 500 million people can be
classified as poor, of whom 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 (.255 compared to .317 for South Asia,
the next poorest region), Africa is the poorest region in the world.
The solution to all these problems lie 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 this, the firm’s activities become more complex and management
assumes a sound financial position in the handling of problems and decisions therein. Modern
approach to financial techniques could be traceable to valuation models propounded by John Bur
Williams in 1938. Validity of these models did not manifest in finance until 1950s when series of
theories had to be established in solving un-tackled problems of investment projects.
In this period of unstable financial operation, companies retain policy through the maintenance of
sound financial structures, reflecting the proliferation of government financial regulations, backed up
by the aim of a controllable and dynamic investment pursuit for the sustenance of national economy.
Empirical studies emerging from established theoretical apparatus have filled up the vacuum in
business procedures, which continually arouse the interest of experts in making positive contributions
required to compare the financial condition and performance of various firms. It is also important to be
conscious of the fact that, the idea of rigorous pursuit of firm’s stabilization through debt funding
unravelled the negligence of financing decision in business organizations.
The Capital Budgeting Process
For survival in the face of competition, for growth and development a firm needs a constant flow of
ideas for new products and ways to make existing products better or at a lower cost. With imaginative
executives and employees, many ideas for capital investment will be advanced. Since some ideas will
be good ones, procedures must be established for screening projects. Moreover, a well managed firm
will go to great lengths to develop good capital budgeting proposals e.g. a sales representative may
report that customers are asking for a particular product which the company is not producing now, the
International Research Journal of Finance and Economics - Issue 2 (2006)
141
sales manager will discuss the idea with the marketing research group to determine the market size for
the proposed product. If a substantial market does exist, cost accountants and engineers will estimate
production costs. If it appears that the product can be produced and sold to yield a sufficient profit, the
project will be undertaken.
The investment decision is one of the most significant decision areas. It might have effect the future
profitability either because it might result in an increase in revenue or because it can cause an increase
in efficiency and a reduction in costs. The important steps in the decision process are:
The practice of capital investment involves risk, the method of measuring the benefits, weighting
the strategic objectives of the investment against the predetermined risks, and in choosing the method
for the analysis is also risky.
Capital budgeting procedure is based on firm’s perception of planning for financial increment due
to successful market performance, customers’ satisfaction and retention, capacity to launch new
products or possibility of improving old ones. In view of the set goal, preparation of capital budgeting
is centred on firm’s main interdependent variables of available resources needed for investment
mobilization at a particular point in time. Management of firms are required to exhibit nearly an
effective prediction of capital budget with respect to minimum level of certainty or uncertainty as per
the propositions made to arrest the non-warranty atmosphere of business environment. As Dam (1979)
has observed if a nation has a stable economic prediction, capital investment demands could
significantly be financed and implemented according to the company’s designed goals and objectives.
Any nation facing un-quantifiable economic instability may transfer such impediment of growth to
organizational survival. Company’s investments suffer in a poorly controlled economy be it in a
developed or developing country. Future prediction of income becomes uncertain and risky in an unconducive socio-economic and political atmosphere.
Time preference and risk are intriguing ideas that decision makers cannot avoid in financial decision
making, the attempt to find solution to problem of risk and uncertainty has sparked up divergent views
in the literature. One of the proponents to discuss the difficulties emanating from Capital Budgeting is
Bodernhorn (1959). He notes the obstacle of making decision in budgeting of capital and observes that
the formulation of such decision is centred on the available investment opportunities that will make
firm to accept or reject a project. To make rational decisions firm must have specific objectives in the
sense of maximizing its profit based on the expected long-term returns to be acknowledged as an
increase or possibly a decrease in projected investment. We should note a gain that, a project is
acceptable to management only when it adds to the profit of the firm after all costs (including the cost
of capital) have been met. This statement agrees with the traditional theory objective of maximization
of wealth of firm’s owners. This involves increasing the shareholder’s wealth or yielding a rate of
return larger than the normal rate; because the normal rate is earned if the owners have invested in an
alternative venture.
i. Identifying possible investment projects
This is the project ideas’ generation stage. Projects ideas’ can originate from any level within the
organization. It can be from the operator in the factory or supervisor or production manager or
managing director. Employees should be encouraged to identify new products, new production
methods, new markets etc. Companies should also have in operation a system by which technical help
can be given to staff to develop project ideas into formal investment proposals. We should regard
project ideas’ generation stage as a continuous stage in any organisation not regarded as one which
should be undertaken over a long interval period.
ii. Identifying possible alternative to the projects being evaluated
This stage involves identifying possible alternative projects to the projects being evaluated.
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iii. Acquiring Relevant Data on the Projects under Consideration
This stage involves finding all the relevant data on the projects under consideration. This task should
be carried out without bias. Where possible an independent financial manager can carry out the task.
iv. Evaluating the projects from the data assembled
This stage involves carrying out a financial evaluation of the projects based on the criteria the firm
uses. It is advisable to use more than one criterion. We will describe the various criteria that can be
used in evaluating projects later in this paper.
As will be described later, the discounted cash flow method is the best-recommended approach
since it is consistent with the objective of maximizing shareholders’ wealth. The financial evaluation
will enable the firm to determine the worthwhile-ness of the project.
v. Project Selection
This is a stage where a final decision is taken on the project. The board of directors will usually take
the decision on projects to be selected. Possibly about three projects might be recommended to the
board after evaluation. The board of directors will use their experiences to decide the projects to be
selected.
vi. Project Implementation
This involves implementing the decision taken on the projects selected. Efforts should be made as
much as possible to carry out the decision taken. We will give more discussions on this later.
vii. Project Monitoring and Control
This involves monitoring the progress of the project to assess its effectiveness and whether the
expected benefits are being realized. Reviews such as a post audit might need to be carried out. We
will give more discussions on this later.
Conceptual Clarification
The term capital means the funds employed to finance fixed assets used in production. A budget is a
detailed plan of projected inflows and outflows over future periods. Capital Budgeting is therefore the
process of planning expenditure that generates cash flows expected to extend beyond one year.
Project Classifications
Capital expenditure proposals/investment decisions need to be carefully made.
Firms generally classify projects into categories so that projects in each categories are analysed
differently since their benefits and the level of expenditure requirements.
1. Replacement Projects/Maintenance of Business Projects
These include expenditures necessary to replace worn-out or damaged equipment used to produce
profitable products. To continue its current business, these projects are necessary for the firm to
embark upon, and such maintenance decisions are usually routine and are normally made without
going through an elaborate decision process.
2. Safety and Environmental Projects
These are mandatory, non-revenue producing investments made necessary by government regulation,
collective bargaining agreements, or insurance policy requirements. Most often, they are quite routine
too and need not go through an elaborate decision making process.
International Research Journal of Finance and Economics - Issue 2 (2006)
143
3. Cost Reduction Projects
They are expenditure to replace serviceable but obsolete plant and equipment, to lower the cost of
labour, raw materials, electricity etc. A detailed analysis is needed here to support the expenditure.
4. Expansion Projects
Involves expenditures to increase the availability of existing products and services. These investment
decision are relatively complex because they require an explicit forecast of the firm’s future supply and
demand conditions. Mistakes are possible and could be expensive and so, detailed analysis is necessary
before the decision could be taken.
It also involves expansion into new products and services or to expand into new geographical areas.
These are strategic decisions that could change the fundamental nature of the firm’s business, hence,
very detailed and thorough analysis is invariably required.
III. Types of Investment Decisions
Independent Investment
Investments are independent when two or more investment can be taken together simultaneously and
the acceptance of one cannot delay or affect the other.
Mutually Exclusive Investment/Projects
These are investments that cannot be taken together. Accepting A means that B has to be ignored.
Contingent Investment
i.e. the acceptance of one will necessitate the inclusion of other projects e.g. establishing a company at
Iyanfoworogi village will necessitate road, water etc. projects.
The Criteria for Investment Decision
Criterion for measuring the viability of investment projects is highly imperative and these rules have
extensively explained the conditions required for accomplishing goal of revenue maximization.
However these rules or criteria are the
Payback Period
Accounting Rate of Return
Internal Rate of Return.
Net Present Value
Profitability Index
They provide a stable preference to firm’s financial position, as every manager is expected to
manage his funds competently. Quirin (1967) argues that capital budgeting procedures stipulate an
avenue for an organization to invest its present sum of money efficiently and effectively in the long
run. Often time capital investment procedure incorporates variables that cut across several financial
assets business expansion, acquisition and merger and any other assets with life span spreading beyond
one or two years. It is also important to note that the idea of strategic planning for capital investment
emanates from critical evaluation of financial models.
IV. The Payback Period Criterion (PBP)
The above criterion is classified under non-discounting appraisal and it depends on the number of
period (usually in years) taken for the future net cash flows on a capital investment to payback the
initial or original net cash outlay. Since it is based on an immediate retrieval of gain from the executed
project, formulation of this decision will consider specifically payback period. Any project with PB
above the specified PBP maximum is however rejected because it will take too long a time to retrieve
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initial capital. Application of PB rule on mutually exclusive projects will favour the choice of the best
alternative for the project having the shortest payback period which is ultimately acceptable.
Brealey and Myers (1988) support this idea when they tagged PBP as the simplest way to
communicate the degree of desirability of an investment project, and thus every individual commenting
on the viability of a project based on discounted cash flows alone may ignore the ideas of those
individuals with little knowledge about such rules.
As proponents and critics have stressed, the deficiency of the definition of Payback period makes
the model complex. Just like any other theory, it can only offer a partial understanding of what
constitutes its benefit to either the managers or owners of firms. Nonetheless it is defective because it
does not consider the time preference of fund, as it gives equal weight to all future net cash flows over
each project’s Payback period. It has therefore been agreed that the PBP rule is not fully accepted as a
desirable rule for evaluating capital project because it violates the following capital budget properties,
in the sense that:
(i) all cash flows should be considered and
(ii) these cash flows should be discounted at the opportunity cost of funds.
V. Accounting Rate of Return (ARR)
The accounting rate of return is described as the annual accounting profits from a capital project.
Divided by a defined annual average capital investment outlay over a project’s life span. The rule is
thus compared by the firm to certain arbitrarily set hurdle rate. It means, is simply the average after tax
profit divided by the initial cash outlay of the project, and has similarity with the return on assets. The
accounting rate of return as a non-discounting criterion is exposed to the same type of criticism like the
PB since it violates the two properties of capital flows, but considers all the accounting profits instead
of cash flows, over a given life of a capital investment. It however does not consider time value of
money. Managers would be indifferent in their choice between one project and other with after tax
profits, which may occur in the opposite chronological order because both projects would have similar
accounting rate of return. Apart from this, it is possible that, the use of accounting variables could
provide a misleading interpretation of net cash flows emerging from the project outlay. This may
happen, since depreciation of the initial cost of capital over the future life of a capital investment is
concisely treated as cash costs.
The defect may also arise from the accounting standards in force when a particular project
assessment is being made at that given period. Despite all these flaws accounting rate of return is
widely used to appraise capital budgeting decision by financial managers, but mostly side by side with
the discounted cash flows – especially the net present value.
VI. Internal Rate of Return (IRR)
The IRR is a discounting cash flow, which has been enhancing a set of decisions made, based on
capital budgeting. It is described as the rate of interest at which the present value of expected capital
investment outlays is exactly equivalent to the present value of expected cash earnings on that capital
project. It is in essence the rate, which equates the present value of the cash inflows, and also a rate
making the computed net present value exactly zero. Separately put, it is the rate of return on invested
capital, which the project is returning to the firm, when the net present value is equal to zero. The said
assertion agrees with the Keynes (1936) statement on marginal efficiency of capital. In other word
marginal efficiency of capital is equivalent to that rate of discount which would make the present value
of the series of annuities given by the expected returns of the capital asset during its life span just
equivalent to its supply price. Fisher (1907) states equally, that the rate of return over cost is that rate
which is employed in quantifying the present worth of all the costs and the present worth of all the
returns which will make these two the same. This means the IRR is the break even point of cost of
capital and thus a measure of investment liability with respect to rate of return rather than value.
International Research Journal of Finance and Economics - Issue 2 (2006)
145
Specifically, IRR rule is simple and gives better understanding to decision-maker about convenient
evaluation of expected rate of return per unit of time during investment process. As risk depends on the
amount of capital exposed to its over time, IRR assists in measuring the project profitability with
regard to similarity of quantity and time of risky project. IRR is economically preserved; as such
management having the knowledge perceives consciously whether the rate of return is convincingly
greater that the required rate of return for different capital projects. Carsbery (1974) identifies the basic
problem of IRR rule as providing an assessment of the return relating to the cash outlay required from
a project and ignores the absolute size of the return on investment. Investors and financial analysts may
not find it difficult to explain appropriately what this rate of return stands for.
VII. The Net Present Value
The net present value of an investment or capital project is the aggregation of the present values of all
cash benefits by deducting the present value of all cash. In mathematical form the net present value is
explained as:
CFt
− I0
NPV = ∑ tn=1
(1 + r ) t
Where CFt = Cash flow at the end of the period t
R is the required return per period.
N = overall number of periods in the project’s life.
I0 = the initial fund project required
The net present value is thus the evaluation of the amount by which the project value is maximized;
this will in turn serve as gain for the wealth the owners used in future to come. A negative net present
value means the project is not desirable and vice versa. Every estimation of NPV of a project should
involve measuring the project’s future net cash flows, discounting these at the appropriate cost of
capital to procure their present value, deducting the initial capital cost or net investment outlay, at the
project commencement period. This expression supports the submission of Porterfield (1966) that the
NPV of a project as the present value of cash inflows minus the present value of the cash outflows,
Bierman and Smidt (1980) have argued that, the present value of a project should depend on the ratio
of interest used, as there is not a single present value estimate but a group of estimates focusing on
what rate of interest is selected. In the real world the present value is evaluated, by employing a single,
pre-determined interest rate which reflects the view of the firm’s cost of capital. Assumption to
reinvest is often the objective of both NPV and IRR. Thus it has been noted that both the stated
techniques are superior over the non-discounted rules in appraising the desirability of a capital project
have judged the NPV and IRR to be effective either to accept or reject a capital investment. Merret and
Sykes (1963) feel, the respective advantages of the two techniques could be examined in respect of
practical approach to decision making and which might have reflected in the assessment of their
usefulness by the investors. Moreover, problems arising in tackling negative cash flows, which do
occur during the spanning life of a capital project favour the net present value, because it is
incorporated with a term; reject or accept.
PI = Present Value of Cash Inflows
Present Value of Cash Outflows
n
=
∑
t =1
E(cf) it
(ifk ) ti
n
Cit
∑ (itk )
t =1
i
t
= PV Benefit
PV Costs
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International Research Journal of Finance and Economics - Issue 2 (2006)
VIII. Profitability Index (PI)
The Profitability Index (PI) also known as the “Benefits-Cost Ratio” is the ratio of the present value of
future cash benefits, at the required rate of return to the initial cash outlay of the investment. It is
another technique at the disposal of an entrepreneurs or decision makers to assist in choosing among
several causes of actions. In a layman language, if is the monetary cost of a project/programme is
ascertained and is also compared with its expected benefits in monetary terms. For a project to be
acceptable, its benefits must outweight its costs.
IX. Methodology of the Study
It has been critically observed that investment decisions of corporate companies in Nigeria are
seriously affected by the uncertain economic climate. The unstable economic climate makes policy on
firms’ anticipatory project highly subjective to the attributes of financial repression, foreign exchange
shortage, inaccurate forecast for aggregate demand of goods, relative capital market pricing of stock,
adequate funds for lending and borrowing and so forth. This study is therefore intended to look into
capital budgeting decisions of public quoted companies in Nigeria.
The study applied both primary and secondary sources to collect the data. For the primary source
questionnaires were administered and this was supplemented by oral interviews. The secondary data
used had been sourced from the Nigerian Stock Exchange Fact Books (1980, 1984, 1988/89, 1992 and
1995) and related literatures.
This study was conducted in ninety-four firms that responded to our questionnaire out of one
hundred and eighty-four companies earlier identified through preliminary surveys. The selection was
further based on the fact that the firms so selected have their head offices situated in Lagos for easy
coordination and these firms also cut across eleven sub-sectors of the economy namely: Agriculture,
Banking, Breweries, Building, Materials, Conglomerates, Construction, Food/Beverages and Tobacco,
Healthcare, Insurance, Petroleum (Marketing) and Textiles.
International Research Journal of Finance and Economics - Issue 2 (2006)
147
Table 1: Percentage of responding companies employing models of capital budgeting techniques
Model Employed
PBP, ARR, NPV
PBP, ARR, IRR
PBP, IRR
PBP, NPV
PBP, ARR, NPV, IRR
Mathematical Programming
None applicable
Total
Frequency
Percentage of company
Employing Models
27
22
19
21
4
1
0
94
28.7
23.4
20.2
22.3
4.3
1.1
0
100
Source: Field Survey
From Table 1 above, it shows that Payback Period model was increasingly being used together with
ARR and NPV as the main measuring standard of the total percentage, respondents combining the
models of PBP, ARR and NPV held the highest (27%). 22% of the respondents combined PBP, ARR
and IRR, 19% applied IRR and PBK, 21% combined NPV with PBP, 4% used PBP, NPV, IRR, ARR
and Mathematical programming approach while one percent of the respondents did not indicate their
interest. With this development, public companies did fully make use of capital budgeting models to
evaluate capital project expenditures.
Table 2: Percentage and Frequency distribution of companies using discount rate for cost of capital technique
Apply as independent
Evaluation method
Frequency
%
Cost of Debt
Cost of Equity
Weighted/Average Cost of Capital
A measure depended on past
Experience
Expectation with regard to growth
and dividend payment
Return from risk free Assets plus a
premium related to Risk Class
Not applicable
Overall total
Frequency
Total
Other methods
%
Frequency
%
8
14
18
31
8.5
14.9
19.2
33.0
11
12
16
14
11.7
12.8
17.0
14.9
19
26
34
45
10.1
13.8
18.1
23.9
11
11.7
23
24.5
34
18.1
7
7.5
13
13.8
20
10.6
5
94
5.3
100
5
94
5.3
100
10
188
5.3
100
Source: Field Survey
From Table 2 above, out of two methods by which projects are financed namely equity and debt, the
respondents provided answers to varying avenues by which funds were sourced to implement capital
investments. Of the 94 companies shown in the table, 33% employed measure based on past
experience if exclusive but 14% when used with other methods and 11.7% when combined with other
measures, 14.9% employed cost of equity as an exclusive standard and 12.8 % a combined measure.
19.2% employed weighted average cost of capital, while 17.0% used it when combined with other
methods. Growth and dividend payout techniques were used by a total of 11.7% firms and 24.5 %
when combined with other measures.
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International Research Journal of Finance and Economics - Issue 2 (2006)
Table 3: Analysis of corporate risk in decision-making
Criteria Used for Measuring Risk
a. Criteria Used for Measuring Risk
i. Ignore risk and use simple standard for all project
ii. Assessment of project riskiness based on
subjective approach
iii. Probability distribution of project’s cash flow
iv. Probability of loan
v. Risk not assessed
Total
b. Risk Classification
i. Depends on project financed exclusively by
equity
ii. Based on project funded exclusively by equity
ii. Based on project funded by both equity and debt
Total
c. Accounting for Risk in CBT
i. Shortening the required pay back
ii. Raising the required rate of return
iii. Raising the discount rate while computing present
value
Total
d. Expected Market Interest Rate
i. Changes in interest rates on security values
ii. Possibility of evaluating capital project viability
iii. Assess minimum expected return on investment
iv. Sudden change in interest rate disallows project
execution
Total
No of Forms
Percentage
18
31
19.1
33
11
21
13
94
11.7
22.3
13.8
100
17
42
35
94
18.1
44.7
37.2
100
47
29
18
50
30.9
19.2
94
100
21
33
21
19
22.3
35.1
22.3
20.2
94
100
Source: Field Survey
Table 3 (a) Risk Criteria
Table 3(a) presents the response of companies to the criteria used for measuring risk. 18 among the
respondents did ignore risk and used simple standard purely on returns (19.1%). 31 of the respondents
assessed the risk of projects based on subjective approach, (33%), 11 involved in probability
distribution of project cash flows (11.7%) 21 depended on probability of loss (22.3%) while 13 did not
evaluate risk in capital investment decision (13.8%). It was concluded that many of these public
companies (33%) predicted for risk subjectivity.
Table 3(b) Risk Classification
Classifying risk level characterized by divergent methods of funding was found to be associated with
greater exposure to debt or equity capital.
This was true in all companies. Table 3(b) shows that 17 companies depended on project financed
exclusively by debt (18.1%) while 42 companies exclusively financed their projects by equity (44.7%)
and 35 responding forms considered risk classification by combining both equity and debt financing
(37.2%).
Table 3 (c) Accounting for Risk in Capital Budgeting Techniques
Table 3 (c) has shown that 47 companies out of 94 preferred shortening the required payback (50%),
29 did often raise the required rate of return (30.9%) and 18 raised the discount rate while calculating
the present value. Many authors have not supported the use of payback in this regard because of its
inability to forecast beyond the stipulated period, unlike the net present value or internal rate of return
which possess the stronger standard for deciding long term project.
International Research Journal of Finance and Economics - Issue 2 (2006)
149
Table 3(d) Expected Market Interest Rates
The market interest rates viewed as being affected by four factors these factors have been enhancing
the efficiency of respondents to judge their capability in taking up investments. Table 3 (d) has
depicted companies’ positions in the choice of such factors. As indicated, 21 companies agreed to
changes in interest rates on security values (22.3%).
Security value explains the strength level of every organization to customers and other competitors
in the external environment. Generally, companies adhering to this phenomenon are leaders which
other firms emulate. 33 of the respondents (35.1%) were of the opinion that possibility of evaluating
capital project viability could not affect their growth when the market interest rate remained
fluctuating. 21 companies based their assessment on minimum expected on investment (22.3%) and 19
of the respondents (20.2%) refused to operate and execute capital investment when there was a sudden
change in interest rates.
The conclusion that can be drawn here is that in an uncertain environment, the anxiety to press
ahead by ignoring the consequences of risk taking often contributes to growth in subsequent years if a
project is properly managed.
Table 4: Distribution of responding firms through corporate dimensions in decision-making.
S/N
a
b
c
d
Corporate Dimension of Capital Investment
Allocating funds to capital Investment
5 million – 10 million
11 million – 15 million
16 million – 15 million
21 million – 25 million
26 million and above
Total
Span of years for new project implementation
1-5 years
6-10 years
11-15 years
16-20 years
Above 20 years
None applicable
Total
Target growth rate of firm
5 - 10 %
11 -15 %
16 – 20 %
Above 21 %
None Applicable
Total
Source of funds for Capital
i.
Retained earnings or profits
ii.
Equity capital through the Stocks Market
iii.
Long term loan only
iv.
Equity and Debt
v.
None applicable
Total
No of Firms
Percentage
5
6
8
20
55
94
5.3
6.4
8.5
21.3
58.5
100
39
28
16
6
4
1
94
41.5
29.8
17.0
12.8
9.6
5.3
100
47
21
12
9
5
94
30.9
28.7
18.1
21.3
1.1
100
29
27
17
20
1
94
30.9
28.7
18.1
21.3
1.1
100
Source: Field Work
*Capital investment is referred to as funds committed to a long-term project with the purpose of making profit in
unforeseeable future.
Table 4 (a) above shows how many companies allocated money to capital investment. The highest
number of firms (55) allocated funds in the range of N26 m and above representing (55.5%). 20
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International Research Journal of Finance and Economics - Issue 2 (2006)
respondents allocated between N21 m – N25 m to capital projects representing (21.3%). 8 companies
did allocate between N16 m – N 21 m to capital investment (8.59%) while 6 and 5 respondents
allocated money between N11 m – N15 m (6.4%) and N5 m – N10 m (5.3%) to capital projects
respectively. The outcome of these companies testified to the importance attached at corporate level to
long term capital projects.
Table 4 (b) is concerned with span for the new project implementations. Because of the economic
instability quoted companies expectations in terms of profits seemed high within the possible shortest
period. 39 companies that involved in new project implementation restricted their period of decision to
between 1 – 5 years (41.5%). 28 companies supported 6 – 10 years (17.0%) 16 – 20 years (6.4%) and
above 20 years (4.1%) respectively. Only one company failed to respond.
Table 4 (c) shows the rate of the companies’ growth as it affects their investments decisions. The
majority of 47 companies (50%) assigned 5 – 10%, 21 companies (22.3%) assigned 11 - 15%, 12
companies (12.8%) assigned 16 - 20% and only 9 companies (9.6%) assigned a rate above 21% while
only 5 firms (5.3%) did not indicate their interest.
Table 4 (d) shows the preference for sources of funds for capital projects. The importance of sources
of funds cannot be over-emphasized because, to certain extent the source of capital determines the
level of confidence and degree to which risk can be accommodated. The number of firms that support
equity are 56 i.e. (29 + 27) representing (59.6 %) while only 17 companies (18.1%) preferred debt
finance. The number of companies that favoured the combination of equity and debt are 20
representing 21.3 %. This shows the management of Nigerian firms prefers an equity of finance.
X. Summary of Findings
Concerning the use of capital budgeting techniques, it was revealed that virtually all the companies
surveyed used one form of the criteria or another for selecting optimum investment. It was revealed
further the most common method is payback period. However with the present opportunity open to top
management, it has become possible to combine payback other criteria such as NPV, IRR and linear
programming to choose the optimum alternative project an outcome of corporate decision.
The study further highlights the core rule of capital market as the type, which allows free entry and
exit of investors. Similarly the function of the Nigeria Stock Exchange and Security and Exchange
Commission is to put in place enough liquidity for an efficient market operation by these inventors.
The study revealed that dividends and taxation payouts as well as shareholders funds and share
capital strongly influenced public companies growth performance when related with retained earnings
and credit investment. Furthermore, overall strongly positive impact of net cash inflows on investment
return was also consistent with other findings that net cash inflow should be regarded as a desirable
determination of performance, since higher income dictates better investment return and vice versa.
The result then showed that low investment return was a signal of poor growth performance level.
XI. Conclusions and Recommendations
Claude Ake is of the view that the people at the end of development and that their well-being is the
supreme law of development. He further opines that “development strategy is always contextualized in
a particular state, social structure, culture, and meaning. It implies a structure of politics, but it also
influences political interactions, practices, and outcomes” (Ake, 2001:126-127). Development, being
the supreme goal of every society must be pursued from both the public and private sectors. However,
since the current trend is that the state is withdrawing from active participation in economic sector in
the favour of the private sector, which has led to the phenomenon of privatisation of hitherto owned
state corporations and enterprises, the private sector as nowadays occupied a focal position. In other
words, the private sector needs to do everything humanly possible to breakeven and to achieve the
overall societal goal whose onus now rest on private sector performance. Capital budgeting decision,
therefore, is an un-negotiable investment decision making process that must be taken seriously. To this
end, this study has demonstrated through a careful analysis of the performance of private sector firms,
International Research Journal of Finance and Economics - Issue 2 (2006)
151
how capital budgeting can be used to facilitate and accelerate economic development within corporate
firms and by extension to the large society.
The study also showed the effectiveness of the Nigeria Stock Exchange and the Security and
Exchange Commission in controlling the activities of public companies. Most of the general financial
economic policies relating to investment manifest from the advisory note were emphasized consistently
by these agencies. It was obviously shown that the growth performance of public company is
influenced by retained earnings and investment returns subject to practical knowledge and experience
of management and some other factors like shareholders equity dividends and taxation, total assets and
net cash inflows which also determine the level of performance.
From the evidence in the study, cash inflows generated through effective management of business
activities and investors eagerness to deal in stock with a particular company reveal the degree of capital
base of that firm which is also the cornerstone of satisfying the shareholders with respect to dividends
pay out.
Departing a little from the above ideals, it might be worthwhile to recommend that economics
rhetoric must be matched with economic action. Enabling legislations and conducive social climate
must be provided for economic activities in Nigeria. Besides, technological competence and know how
must be encouraged, developed and stepped up. Moreover, the political climate must be sanitized of
corruption, greed and avarice. Fulfilling these recommendations, the pace is set for the realization of
economic development that Africa and indeed a third world desires.
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International Research Journal of Finance and Economics - Issue 2 (2006)
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