International Journal of Applied Research and Studies (iJARS)

ISSN: 2278-9480 Volume 3, Issue 3 (Mar - 2014)

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Manuscript Id: iJARS/782 1

Research Article
Suitable Techniques of Capital Budgeting in Growing or
Distressed Business

Author:
Silky Jain *

Address For correspondence:

Assistant Professor and Research Scholar, University of Delhi, Delhi

Abstract- There exist a wide range of techniques of
capital budgeting in advanced as well as basic text
books related to Corporate Finance and Financial
Management. Each technique has its merits and
demerits as a tool of decision making. This study
examines the decision making practices of growing
and distressed firms. The objectives of this study are
to highlight the need of capital budgeting in case of
growing and distressed firms, to review the studies
conducted and results suggested in the area of capital
budgeting in growing in growing and distressed
businesses, to suggest recommendations and
suggestions drawn there from. It was observed that
the firms with high growth are more inclined to use
IRR than the firms with low growth whereas firms
with low growth are more likely to use break-even
analysis than firms with high growth.

Keywords- Capital Budgeting, IRR, NPV, Payback
Period, Growing Business, Distressed Business

Introduction
Capital investment is one of the areas that not only
consumes a lot of resources in todays business, but
demands the attention of managers and all and sundry
from inception of a project through growth stage to
its maturity. However, in the finance literature,
capital investments are often described as long-term
investments. Long-term investments are difficult to
deal with because risk and uncertainty must be
accounted for, in addition to series of forecasting,
implementation and monitoring of long- range
decisions. Capital budgeting determines the shape
and structure of a company and affects its
competitive advantage. Levary and Seitz (1990)
describe complex capital investment as a strategic
decision with components and considerations of
resource limitations and goal trade-offs.
Consequently, given a certain scenario companies
evaluate their finances differently (Pandey, 2002);
with some companies requiring significant time and
strategic processing in order to approve capital
expenditures while other companies, however, use
simplistic analysis techniques that require nothing
more than the approval of a project by several
departments inside the company. Some companies
evaluate capital expenditures using capital budgeting
techniques, such as internal rate of return (IRR) and
net present value (NPV), while other companies use
payback period and average rate of return (ARR)
techniques. There are companies that have very
complicated capital budgeting systems in place, while
their competitors may agree on a project by a simple
majority vote of the board of directors (Phillips,
1997).
In recent times, capital expenditure planning has
assumed new dimension and has been given much
attention both in finance literature and in practice.
This is because capital expenditures involve
committing huge sum of money, whose benefits
extend well ahead into the future, and the future is
said to be beclouded with risk and uncertainty, and,
once committed, capital expenditure is irreversible.
Thus, capital expenditure has huge impact on the
future profitability and value creation of a company.
Farragher et al. (1999) note that for a successful and
effective capital expenditure planning, certain

silky.jain15@gmail.com *Corresponding Author Email-Id
International Journal of Applied Research and Studies (iJARS)
ISSN: 2278-9480 Volume 3, Issue 3 (Mar - 2014)
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Manuscript Id: iJARS/782 2

activities are necessary and shall be given attention.
These are strategic analysis, establishing investment
goals, searching for investment opportunities,
forecasting cash flows of the investment, evaluating
the risk of adjusted future cash flows, decision
making, and implementing accepted opportunities
and post audit procedures.
However, in the case of complex capital decisions
there is the need for an objective analysis and
evaluation of an investment together with a healthy
intelligent judgment that has a solid base of
knowledge about that investment, through the use of
quantitative methods, such as mathematical
programming (e.g., linear programming, goal
programming and new financial techniques), as
opposed to just a simple, sometimes subjective,
judgment. Otherwise the amount involved and all the
efforts put in nursing the project will become what
the accountants called sunk costs. Depending upon its
magnitude the survival of the enterprise may be at
stake.
It is against this background that this paper, focuses
on unveiling the current practices of capital
investment appraisal of growing and distressed firms.
Objectives of the study
The objectives of this study are as follows:
To highlight the need of capital budgeting in
case of growing and distressed firms.
To review the studies conducted and results
suggested in the area of capital budgeting in
growing in growing and distressed
businesses.
To suggest recommendations and
suggestions drawn there from.
Data and Methodology
This study is an observatory study based on
secondary data. The data has been collected from
various published sources, books and websites.
Review of literature
This section reviews the studies conducted and
results suggested in the area of capital budgeting. The
studies are bifurcated into four parts based on the
type of capital budgeting techniques examined. These
studies are as follows:
Non-DCF Techniques
Weingartner [1969] observed that the payback
reciprocal as a measure of the rate of return of a
project, had significance in the context of certainty. It
is more appropriate to regard payback as a constraint
which a project must satisfy, than as a criterion which
is to be optimized. It was shown that payback reduces
the information search by focussing on that time at
which the firm expects to "be made whole again" in
some sense, and hence it allows the decision maker to
judge whether the life of the project past the break-
even point is sufficient to make the undertaking
worthwhile.

DCF Techniques
Hirshleifer [1958] observed that the present-value
rule for investment decisions is correct in a wide
variety of cases (though not universally) and in a
limited sense but it fails to give correct answers only
for certain cases which combine the difficulties of
non-independent investments and absence of a
perfect capital market. He also argued that the will
only give correct answers if restricted to two-period
comparisons. Gould [1972] observed that which of
the two projects is the better clearly depends on the
investor's time preference function. Comparison of
NPVs is insufficient to determine the correct choice
of project. Consideration of differences in lives,
outlays or re-investment rates does not affect the
validity of the analysis. These features become
relevant to investment decisions only when
complications, such as imperfection in capital
markets or interdependence between projects, are
present; and in these circumstances the problem
seems likely to be more complex than can be handled
by simple tests using NPV or IRR. Dudley [1972]
demonstrated that if the reinvestment rate of return is
greater than Fishers rate of return over cost, the IRR
method will provide optimal decisions while if it is
less than Fishers rate, the NPV method will prove
optimal. Meyer [1979] suggested that in case of no
capital rationing, the correct assumption for
reinvestment rate is the average rate of return on new
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investment and not the marginal cost of capital.
Therefore, if the average rate of return lies to the left
of Fisher's rate, NPV will give the most appropriate
ranking of mutually exclusive proposals and if the
average rate of return lies to the right of Fisher's rate,
IRR will give the most appropriate ranking of
mutually exclusive proposals. However, Nicol [1981]
demonstrated that the appropriate rate for
reinvestment in case of no capital rationing, is in fact
the marginal cost of capital.
Dorfman [1981] asserted that in the choice between
the IRR and NPV criteria, the question is whether the
firm or firms under consideration are more like firms
which are interested primarily in growing, or whether
they are more like firms interested primarily in net
payouts to their proprietors who have access to
perfect capital markets. Businessmen do pay attention
to the internal rate of return of prospective
investment projects, and often justify doing so by
emphasizing the importance of reinvestment and
affirming their confidence that opportunities similar
to those now available will continue to open up in the
future. Greenfield, Randall and Wood [1983] tried to
show that financing the project by issuing debt and
equity in amounts whose ratio equals the firm's target
debt-equity ratio causes the net present value
calculation to inaccurately assess the wealth that
accrues to the benefit of present ownership in the
firm. The evaluation of a prospective investment
project in terms of its net present value provides a
meaningful assessment of the project's ability to
contribute to shareholder wealth if the project is
financed at the firm's current (and presumably target)
market-value debt-equity ratio.

A critical appraisal of both DCF and non-DCF
techniques

Following are the studies conducted on both the DCF
and non-DCF techniques:
Mao [1970] compared current theory with practice
and found that the current theory generally regards
IRR, or NPV, as a better measure of return than
either the payback period or the accounting profit.
But Maos study confirmed the prevalence of the
payback period and the accounting profit criteria in
practice. Schall, Sundem and Geijsbeek [1978]
discussed the results of a survey of large U.S. firms
and observed that the trend toward use of more
sophisticated capital budgeting techniques continues,
with this survey indicating that 86% of the sample
firms use discounted cash flow methods, most of
them combining this with a payback or accounting
rate of return analysis. Oblak and Helm [1980]
examined the foreign project evaluation of MNCs
and found that MNCs conduct more comprehensive
scrutiny of their outdoor projects. It was observed
that a greater proportion of MNCs now employs DCF
methods and accommodates for risk in the evaluation
of foreign projects. The internal rate of return method
was the favourite as the primary evaluation method,
while the payback period was most frequently
mentioned as the secondary criterion.

Haka, Gordon and Pincher [1985] seek to determine
the effect of switching from naive to sophisticated
capital budgeting selection techniques on a firms
market performance. While the authors found no long
run effects on relative market returns for adopting
firms, their results do suggest, that there is a short run
positive effect when the firms adopt sophisticated
capital budgeting selection procedures. Pandey
[1989] tried to document the capital budgeting
policies and practices of companies in India, a
developing" country, and contrasted them with those
of USA and UK, the developed countries. He
observed that the investment idea generation is
primarily a bottom-up process in India. In UK, both
bottom-up as well as top-down processes exist
whereas in USA, a bottom-up process exists. As
regards the use of evaluation methods in India, all
sample companies, with one exception, were found to
use payback criterion. IRR was found to be the next
most attractive technique. The primary reason for
DCF techniques not being as popular as payback was
the lack of familiarity with DCF on the part of
executives. Other factors were inadequacy of
technical personnel and sometimes reluctance of top
management to employ DCF techniques. Anand
[2002] found that presently DCF methodology was
used by the firms more than in the earlier times. In
fact, multiple criteria were used by them in their
project choice decisions. Most respondents choose
International Journal of Applied Research and Studies (iJARS)
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NPV and IRR as their most repeatedly used capital
budgeting techniques. The payback period method is
also popular. The most interesting results come from
examining the responses conditional on firm size and
growth characteristics. Large firms are significantly
more inclined to employ NPV as compared to small
firms. However, small firms are more inclined to
employ payback period method than large firms.
Firms with high growth use IRR more often than the
firms having low growth whereas low growth firms
are more probable to use break-even analysis than
high growth firms. Danielson and Scott [2006]
analyzed the capital budgeting practices of small
firms. The authors concluded that the firms with
fewer than 250 employees analyze potential
investments using much less sophisticated methods
like gut feel, payback period, and accounting rate of
return. Kantudu [2007] found that even though firms
in Nigeria favored a blend of capital budgeting
techniques but the technique payback period was
ranked high among other techniques. Also, while
choosing a particular project appraisal technique,
simplicity, understandability and effectiveness were
found to be the crucial factors.
Brijlal [2008] revealed the nature of investment
appraisal practices in the Western Cape. The research
findings suggested that the most famous technique
followed by managers in evaluating investment
decisions was the Payback Period (PP) technique as it
was used by 39% of respondents. Other popular
techniques were Net Present Value (NPV) technique
(36%), Internal Rate of Return (28%), Profitability
Index (28%) and Accounting Rate of Return (22%).
However, 10% of the respondents reported that they
used their gut feel or rely on their intuition to make
decisions and thus, did not use any of the capital
budgeting techniques. The research further confirmed
the theory that says as businesses increase in size
they begin to use more complicated methods as
compared to when they are small businesses.
Hanaeda and Serita [2013] carried a survey about the
cost of capital and capital budgeting techniques for
Japanese firms and found that payback period method
was more frequently used by these firms than NPV
and IRR.


Augmented Techniques
Following are the studies conducted on augmented
techniques and approaches:
Baumol and Quandt [1965] explored the choice of
optimal investment project combinations under
capital rationing and argued that in the absence of
any external discounting criterion the appropriate
discount rate must be determined subjectively by the
decision maker in a manner which is consistent with
his utility function. Lusztig and Schwab [1968]
focused on one particular problem peculiar to the
application of programming techniques to capital
budgeting, namely the mutual dependence between
the optimal solution of the linear programming model
and the discount rate used to calculate the
coefficients of its objective function. The authors
found that the dilemma created by the mutual
dependence of the discount rate to be opted on the
optimality estimation and vice versa was needed to
be acknowledged as it may severely limit the
suitability of the initial solution given by a linear
programming model. However, in numerous cases
the solution obtained will remain optimal in spite of
adjusting the initial discount rate to the value
prescribed by this optimal solution. Sensitivity
analysis provides the answer as to which of these two
categories a particular problem belongs; it thus
enables us to know whether we are justified to place
confidence in the solution obtained from the linear
programming model, or whether further analysis--
e.g., additional iterations through the model is
indicated.
Kierulff [2008] observed that currently, IRR and
NPV are the preferred techniques of investment
appraisal. Most often, NPV is used by practitioners
and academics, yet executives have shown an
instinctive preference for IRR. But both NPV and
IRR have significant drawbacks. MIRR deals with
these problems by specifically recognizing that cash
flows produced by an investment can be reinvested.
Significance of Capital Budgeting for Growing
and Distressed businesses
The success and failure of any business depends upon
how the available funds are utilized since capital
budgeting is important for every firm. The
importance of capital budgeting do not lies only in
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the mechanics used, such as NPV and IRR, but is
lying in the varying key involved in forecasting cash
flow. Capital expenditures can be substantial and
significantly impact the financial performance of the
firm. In addition, the investments need time to grow-
up and capital assets are longstanding, therefore, if a
mistake is committed in the investment appraisal
process, it will have long term effects on the firm.
However, the significance of capital budgeting
decisions varies for a growing and for a distressed
business. The needs of growing businesses and
distressed businesses are different regarding the
working capital and cash flows. A growing firm can
be described as any firm which generates ample
positive earnings or cash flows, which grow at
significantly rapid pace than the overall economy.
Such a firm normally reinvests more of its profits as
retained earnings instead of distributing dividends. A
growth company is likely to have for its own retained
earnings very promising reinvestment opportunities.
Capital budgeting is important for growing firm
because of the following reasons:
A growing firm enjoys access to funds. In
such a case there is a danger of over
investment. If the firms investments are
excessive it will cause higher expenses and
depreciation. Capital budgeting helps the
management to avoid over investment.
Growing businesses normally face stiff
competition. The capital budgeting decisions
have an impact on the firms capacity and
strength to face the competition.
Competitiveness may be lost if the decision
of the firm to modernize is deferred or not
rightly taken.
Growing firms choose proposals keeping in
mind the objective of shareholders wealth
maximization. Various sophisticated capital
budgeting techniques like IRR, NPV, etc.,
helps the firm in doing so.
Proper analysis of capital budgeting is
crucial for the successful performance of a
firm because investment decisions can
enhance cash flows and result in higher
stock prices.
On the other hand, financially distressed businesses
face different circumstances. A firm is called
financially distressed firm when it cannot meet or has
difficulty paying off its debts. The probability of
financial distress increases when a firm has illiquid
assets, high fixed costs, or revenues which are
hypersensitive to economic plunges. Capital
budgeting is important for distressed firm because of
the following reasons:
Capital rationing
1
is one of the most
important features of a distressed business
firm. Capital rationing gives sufficient scope
for financial manager to evaluate different
proposals and only viable projects must be
taken up.
Such a firm faces difficulty in raising funds.
In such a case there is a danger of under
investment. If the firms investments are
inadequate, it will face a difficulty of
inadequate capacity and therefore, lose its
share of market to its rivals. Capital
budgeting helps the management to avoid
under investment.
Capital budgeting offers effective control
over the expenditure incurred on the
projects.
Financially distressed firm focuses on early
recovery of the initial investment. Various
capital budgeting techniques like payback
period and discounted payback period helps
the firm in selecting such projects.
Suggestions and Recommendations
All the capital budgeting techniques attempt to
allocate the firms resources in the most efficient
way, although they sometimes do not agree on the
right choice to make. Each of these techniques has its
own decision rule. A decision maker has to select a
particular technique of evaluation of capital
budgeting proposal. It may be logically stated that
much of a choice of the technique depends upon the
situational factors, particularly the firm, the funds

1
Capital rationing is the situation where a firm is
unable to undertake all the profitable investment
opportunities because of financial problems.
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availability and the relative importance of a decision,
etc. moreover, different firms and different finance
managers may have different acceptance standards.
However, our focus is the suitability of capital
budgeting techniques in case of growing and
distressed firms. These are the two extreme situations
of any firm. Therefore, the circumstances and
conditions they face totally differ. Growing firms
normally face stiff competition. There is a need for
continuous expansion and modernization for such
firms. The capital budgeting decisions have an
impact on the firms capacity and strength to face the
competition. Competitiveness may be lost if the
decision of the firm to modernize is deferred or not
rightly taken. These companies have substantial need
for funds for investment in projects. For this purpose,
these companies retain a part of their profits to be
reinvested.
Large firms and growth firms place substantial
emphasis on the EVA maximization objective. On a
purely hypothetical grounds, NPV is the superior
approach of capital budgeting. However, the
evidence suggests that in spite of hypothetical
superiority of NPV, IRR is preferred by the financial
managers. The reason for the preference for IRR is
the general inclination of businesspersons toward
relative returns instead of actual absolute returns.
Since profitability, interest rates, and so on are
generally expressed as yearly rates of return, the IRR
becomes more appealing to financial decision
makers. They are likely to find NPV less instinctive
as it does not measure gains relative to the amount of
investment.
Some growth firms have the objective of
maximization of growth rate. As revealed by
Dorfman (1981), in certain circumstances this
objective was best achieved by adopting an internal
rate of return criterion. The reason was that when
growth is the objective, the critical consideration in
choosing among opportunities is the extent to which
they generate funds available for reinvestment, and
the best opportunity from this point of view is not
necessarily the one with the greatest net present value
of cash flows.
In the choice between the IRR and the NPV criteria,
the question is whether the firm or firms under
consideration are more like firms which are interested
primarily in growing, or whether they are more like
firms interested primarily in net payouts to their
proprietors who have access to perfect capital
markets. Corporations do pay attention to the internal
rate of return of prospective investment projects, and
often justify doing so by emphasizing the importance
of reinvestment and affirming their confidence that
opportunities similar to those now available will
continue to open up in the future.
On the other hand, financially distressed firms face
different circumstances. Financially distressed firms
face liquidity problems. The probability of financial
distress increases when a firm has illiquid assets, high
fixed costs, or revenues which are hypersensitive to
economic plunges. The major concern of such firms
is early recovery of capital. Therefore, payback
period technique is best suited for such firms.
Many of these firms generally do not resort to
sophisticated capital budgeting techniques. They may
simply confine themselves to break even analysis.
Weingartner (1969) has shown that payback reduces
the information search by focussing on that time at
which the firm expects to "be made whole again" in
some sense, and hence it allows the decision maker to
judge whether the life of the project past the break-
even point is sufficient to make the undertaking
worthwhile. The appeal of payback for the decision
maker is that it indicates how rapidly he can expect
confirmation that he has made a good choice, and for
which he can expect to benefit personally. One of the
reasons for the distressed firms using payback period
may be lack of efficient staff capable of using some
DCF techniques. In a wider sense, the technique of
payback period takes care of risk also. In comparison
with the project having a longer payback period, the
project having a shorter payback period will have
lesser risk, since the cash inflows which occur later
will be more uncertain and thus more risky. So, the
payback period helps in weeding out the risky
proposals by assigning lower priority. Capital
rationing is also one of the most important features of
distressed firms. Under such a situation, a firm looks
for the proposals which will contribute more per
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rupee spent. Therefore, the best suited technique will
be Profitability Index. Thus, for distressed firms,
Payback period technique can be used in conjunction
with the Profitability Index technique.
Conclusion
Capital budgeting is a process of planning capital
expenditure which is to be made to maximize the
long term profitability of the organization. The
success and failure of any business depends upon
how the available funds are utilized. However, the
significance of capital budgeting decisions varies for
a growing and for a distressed firm. Large firms and
growth firms place substantial emphasis on the EVA
maximization objective. On a purely hypothetical
grounds, NPV is the superior approach of capital
budgeting. However, the evidence suggests that in
spite of hypothetical superiority of NPV, IRR is
preferred by the financial managers. For distressed
firms, Payback period technique can be used in
conjunction with the Profitability Index technique.
Thus, in short we can conclude that, the firms with
high growth are more inclined to use IRR than the
firms with low growth whereas firms with low
growth are more likely to use break-even analysis
than firms with high growth.
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