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finance dissertation on capital budgeting practices
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University of Leicester
Centre for Management Studies
MBA (Finance) – October 2008
“Capital Budgeting Practices and Economic Development: A
Comparative Study of Companies in Europe and West Africa”
By
George Ekegey Ekeha Email: [email protected]
March 2007
THIS DISSERTATION IS PRESENTED TO THE CENTRE FOR MANAGEMENT STUDIES, UNIVERSITY OF LEICESTER, UNITED KINGDOM. AND IT IS IN PART FULFILMENTS OF THE COMPLETION OF STUDIES TOWARDS THE AWARDS OF MASTERS OF BUSINESS ADMINISTRATION DEGREE (FINANCE OPTION).
NO PART OF THIS THESIS IS TO BE USED FOR ANY PURPOSES, OTHER THAN ACADEMIC, WITHOUT THE OFFICIAL CONSULTATION WITH THE AUTHOR AND/OR THE UNIVERSITY AUTHORITIES.
GEORGE E EKEHA 1 MBA –OCT. 2007
TABLE OF CONTENT
LIST OF FIGURES AND TABLES................................................................................ 4
ABSTRACT....................................................................................................................... 5
PREFACE.......................................................................................................................... 7
1.0 INTRODUCTION....................................................................................................... 8
1.1 MOTIVATION OF THE STUDY ...................................................................................... 9
1.2 THE DEBT SERVICING CYCLE OF LESS DEVELOPED COUNTRIES.............................. 10
1.3 THE PROBLEMS AND RESEARCH HYPOTHESIS.......................................................... 11
1.4 ORGANISATION OF THE STUDY ................................................................................. 12
2.0 LITERATURE REVIEW ........................................................................................ 13
2.1 ECONOMIC DEVELOPMENT IN AFRICA ..................................................................... 13
2.2 THE CAPITAL BUDGETING DECISION ....................................................................... 15
2.3 STUDIES ON CAPITAL BUDGETING PRACTICES IN DEVELOPING COUNTRIES ............ 17
3.0 CAPITAL BUDGETING PROCESS AND PROJECT CLASSIFICATIONS... 18
3.1 CLASSIFICATION OF INVESTMENT PROJECTS ............................................................ 18
3.1.1Independent Projects ........................................................................................ 18
3.1.2 Mutually Exclusive Projects ............................................................................ 18
3.1.3 Contingent Projects ......................................................................................... 18
3.2 THE CAPITAL BUDGETING PROCESS .......................................................................... 19
3.2.1 Strategic planning............................................................................................ 20
3.2.2 Identification of investment opportunities ....................................................... 21
3.2.3 Preliminary screening of projects.................................................................... 21
3.2.4 Financial appraisal of projects........................................................................ 22
3.2.5 Qualitative factors in project evaluation ......................................................... 22
3.2.6 The accept/reject decision................................................................................ 23
3.2.7 Project implementation and monitoring .......................................................... 23
3.2.8 Post-implementation audit ............................................................................... 24
GEORGE E EKEHA 2 MBA –OCT. 2007
4.0 DETERMINANTS OF CAPITAL BUDGETING PRACTICES......................... 24
5.0 SURVEY DESIGN AND METHODOLOGY........................................................ 26
6.0 RESEARCH RESULTS AND ANALYSIS ............................................................ 27
6.1 COMPANY AND CFO CHARACTERISTICS.................................................................. 28
6.2 CAPITAL BUDGETING TECHNIQUES.......................................................................... 30
6.2.1 European CFOs ............................................................................................... 32
6.2.2 West African CFOs .......................................................................................... 33
6.2.3 European versus West African CFOs .............................................................. 34
6.3 COST OF CAPITAL ESTIMATION METHODS ............................................................... 35
6.3.1 European CFOs ............................................................................................... 37
6.3.2 West African CFOs .......................................................................................... 37
6.3.3 European versus West African CFOs .............................................................. 37
6.4 COST OF EQUITY ESTIMATION METHODS................................................................. 38
6.4.1 European CFOs ............................................................................................... 40
6.4.2 West African CFOs .......................................................................................... 40
6.4.3 European versus West African CFOs .............................................................. 41
6.5 CAPITAL BUDGETING TECHNIQUES, COST OF CAPITAL AND COST OF EQUITY
ESTIMATIONS: MULTIVARIATE ANALYSIS ..................................................................... 41
6.5.1 The Multivariate Analysis ................................................................................ 42
6.5.2 Capital Budgeting Techniques......................................................................... 44
6.5.3 Cost of Capital Estimation............................................................................... 46
6.5.4 Cost of Equity Estimation ................................................................................ 47
7.0 SUMMARY AND DISCUSSION ............................................................................ 49
LIST OF REFERENCES............................................................................................... 51
RESEARCH QUESTIONNAIRES ............................................................................... 54
GEORGE E EKEHA 3 MBA –OCT. 2007
LIST OF FIGURES AND TABLES
FIGURE 1: THE CAPITAL BUDGETING PROCESS ............................................. 20
TABLE 1: COMPANY CHARACTERISTICS........................................................... 29
TABLE 2: CAPITAL BUDGETING METHODS USED BY CFOS......................... 31
TABLE 3: MOST FREQUENTLY USED METHODS TO MEASURE THE COST
OF CAPITAL (% OF TOTAL)..................................................................................... 36
TABLE 4: MOST FREQUENTLY USED METHODS TO ESTIMATE THE COST
OF EQUITY (% OF TOTAL) ....................................................................................... 39
TABLE 5: DETERMINANTS OF CAPITAL BUDGETING METHODS:
MULTIVARIATE LOGIT ANALYSIS ....................................................................... 45
TABLE 6: DETERMINANTS OF THE MOST FREQUENTLY USED METHODS
TO MEASURE THE COST OF CAPITAL: MULTIVARIATE LOGIT ANALYSIS
........................................................................................................................................... 47
TABLE 7: DETERMINANTS OF COST OF EQUITY ESTIMATION METHODS:
MULTIVARIATE LOGIT ANALYSIS ....................................................................... 48
GEORGE E EKEHA 4 MBA –OCT. 2007
ABSTRACT
Over the years, efforts have been made to increase the developmental strides of African
countries. Many projects move from donor countries like the United Kingdom and the
United State into Africa to help improve the lives of the people. However, these efforts
have not been able to redeem Africa from abject poverty and indebtedness to the West.
Various projects that are targeted towards the reduction of poverty are normally
completed with no changes in the lives of the people. These projects, in my opinion, have
not been scrutinised to assess their capabilities of meeting some stated target.
Capital budgeting practices are some of the vital inputs in the decision-making process of
embarking on investment projects. A very good analysis, scrutiny, implementation and
monitoring of such projects could yield the expected results for the stakeholders (people
of the country). According to Dayananda et al (2002), the capital budgeting practices are
used to make investment decisions so as to increase shareholders value. Capital
budgeting is primarily concerned with sizable investments in long-term assets, Brealey &
Myers (2003). These assets may be tangible items such as property, plant or equipment or
intangible ones such as new technology, patents or trademarks. Investments in processes
such as research, design, development and testing – through which new technology and
new products are created – may also be viewed as investments in intangible assets (ibid).
Dayananda et al (2002), argued that irrespective of whether the investments are in
tangible or intangible assets, a capital investment project can be distinguished from
recurrent expenditures by two features. One is that such projects are significantly large.
The other is that they are generally long-lived projects with their benefits or cash flows
spreading over many years. Sizable, long-term investments in tangible or intangible
assets have long-term consequences (ibid). This implies that today’s investment will
determine the overall corporate strategic position over many years. These capital
investments also have a considerable impact on the future cash flows of the organization
and the risk associated with those cash flows. Capital budgeting decisions thus have a
long-range impact on the strategic performance of the organization and are also critical to
its success or failure.
GEORGE E EKEHA 5 MBA –OCT. 2007
This paper compares the use of capital budgeting techniques by companies in Europe and
West Africa, using data obtained from a survey between 225 European and 120 West
African companies. The main aim is to analyse the use of capital budgeting techniques by
companies in both economic blocs from a comparative perspective to see whether
economic development matters in the choice of which technique to use.
The empirical analysis provides evidence that European CFOs on average use more
sophisticated capital budgeting techniques than their counterparts in West African. At the
same time, however, the results suggest that the differences between European and West
African companies is smaller than might have been expected based upon the differences
in the level of economic development between both economic blocs. At least, this is
evident with respect to the use of methods of estimating the cost of capital and the use of
CAPM as the method of estimating the cost of equity.
GEORGE E EKEHA 6 MBA –OCT. 2007
PREFACE
The work presented in this thesis was carried out over a period between late 2006 and
early 2007 for the award of MBA (Finance) degree with University of Leicester. During
this time and all my studies period I had help from several different people that I would
like to thank.
First, I would like to thank my lecturer Jeremy French, administrators Hamza and Nikos
at Citi Banking College and Peter Alfano at Centre for Management Studies, University
of Leicester for their support and helpful advice during my period of studies. Secondly, I
would like to thank all the responding CFOs for taking the time to participate in this
study. I would also like to thank my family, my wife Mrs Beauty Ekeha, my mum Agnes
Obri, who was looking after my kids during the period of my studies and all my kids,
Norris Walter, Bright Mawusi, Urielle Jorgbenue and Suzzy Selase for their support
during my studies. Finally, I would like to thank my Administrative Director, Mr. Samuel
Boakye and all members of the Finance Department at Ghana Statistical Services,
Ministry of Finance.
Throughout the period of my studies in the United Kingdom and work with this thesis, I
have gained a lot of knowledge, experience, and insight of good business management in
the area of capital budgeting techniques, and this would also help me contribute to the
future research within this area and other managerial processes both in public and private
sectors.
March 2007
GEORGE EKEGEY EKEHA
GEORGE E EKEHA 7 MBA –OCT. 2007
1.0 INTRODUCTION
This paper reports the results of a survey with respect to the current practices of capital
budgeting techniques in two different economic blocs at two different levels of economic
development: Europe and West Africa. The main aim of this paper is to analyse the use
of capital budgeting techniques by companies in a comparative perspective to see
whether economic development matters in the choice of techniques. Whereas several
papers in the past have investigated the use of such techniques, this is one of the very few
studies that use such a comparative perspective, comparing a more developed with a
developing economy. This analysis was carried out using standard differences of mean
tests and multivariate regression analysis to see whether there is a so-called “country
effect” on the choice of capital budgeting technique. This means that the research tried to
establish whether capital budgeting practices differ significantly between companies in
the two economic blocs and whether these differences can be explained by differences in
levels of economic development.
Again, only very few papers have addressed the determinants of capital budgeting
practices using these types of analyses, let alone in a comparative economic perspective.
Notable exceptions, among others, are Brounen, et al. (2004) and Payne, et al. (1999).
Yet, both studies analyse the determinants of capital budgeting practices for a number of
developed countries (The Netherlands, Germany, France, Canada, the U.S. and the U.K.).
West Africa and Europe have been chosen for this comparison for the following reasons.
The researcher was a Finance Manager in a government department of one West African
country and considers West African countries as strongly emerging, yet still less-
developed economy in many respects, which has received a lot of attention in the
economic and financial development literature during recent years. Moreover, the
researcher also considers Europe as a typical example of a developed economic bloc and
also most companies in this bloc have various investment interests in Africa. Finally, the
researcher believes that most CFOs in African countries do not utilise the sophisticated
capital budgeting techniques to scrutinise projects very well before selection. This
resulted in various mismanagement and failure to achieve economic heights.
GEORGE E EKEHA 8 MBA –OCT. 2007
1.1 Motivation of the Study
Capital budgeting involves making investment decisions concerning the financing of
capital projects by organisations. Making a good investment decision is important since
funds are scarce and the investment is expected to add to the value of the organisation
especially in Less Developed Countries (LDCs) and Third World poor nations. Capital
investment decision is thus one of the requirements, if properly applied, that can help
accelerate economic development. All countries of the sub-Saharan Africa expend an
upward of 13.5 billion dollars per annum on foreign debt payment to rich foreign
creditors, World Bank report (2005). Many countries in the third world borrowed huge
sums of money in expectation that interest rates would remain stable. Many African
countries accepted these loans for political and economic stabilization in the post
independence era, however prominent problems such as corruption make these loans
ineffective to save the recipients countries from their economic woes.
For example in Ghana, a governance and corruption survey was commissioned by the World
Bank, which was conducted by the Centre for Democratic Development (CDD – GHANA).
Evidence from the survey showed that public concern about corruption in the country is very high
and that there is a widespread public perception that corruption has had a negative toll on
productivity and efficiency of both the public and private sectors and consequent effects on
popular welfare, CDD Ghana (2000). The Ghana Integrity Initiative (GII), a local chapter of
Transparency International, has also on various occasions undertakes some educational programs
on corruption and good governance through seminars and workshops for various interest groups
in the country. One recent study on administrative costs faced by private investors in 32
developing countries most from Africa reported that it takes up to two or three years to establish a
new business in many developing countries (Morisset and Lumenga Neso: 2002). Their study
found that the most delays occurred in securing land access and obtaining building permits. The
associated administrative costs were found to be positively correlated with estimates of the level
of corruption and negatively correlated with the quality of corporate governance, degree of
openness, and public wages, among others (Morisset and Lumenga Neso: 2002). The authors
finally argued that the level of corruption or the lack of good governance is expected to influence
administrative costs as bureaucrats and politicians are more likely to capture the extra rents (ibid).
In fact, the corrupt practices of most executives in both public and the private sectors of these
developing West African countries have led to increases in debts to their borrower countries with
GEORGE E EKEHA 9 MBA –OCT. 2007
the intended targets of the loans not met. On the side of the creditors as well, many of these
loans were given in order to gain and or retain the loyalty of those corrupt regimes, which
is the characteristic of African governments.
1.2 The Debt Servicing Cycle of Less Developed Countries
These debt-trapped nations were under-developed and their debt crisis further plunge
them into deeper economic crisis and abject poverty due to excessive borrowing. Most
executives of these developing countries have the selfish tendency of mismanaging the
various project assigned to them. Some managers of the projects are eager to satisfy their
personal needs before thinking of the implementation of whatever projects has been
assigned to them. This leads to poor budgeting, poor monitoring and hence poor
implementation of the project. Governments of the nations have to then borrow more
funds in order to complete and maintain the existing projects. Due to the fact that these
loans were thoughtlessly accepted, and collected by most African governments, they had
neither little implications for development nor benefit for the masses.
Finally the unreliable market prices in the world’s market for agricultural products and
low-technologically manufactured goods, which make it particularly difficult for African
countries to diversify and increase exports to hard currency markets. Thus making it
difficult for them to earn their way out of the debt trap. In my opinion, the developed
countries, like the USA and UK who have been prophesising their lengthy plans to
alleviate Africa from its economic woes must endeavour to ensure some monitoring
system such that the aids will go a long way to improve the investment capacity of the
continent. International markets should also be opened to the African manufacturers in
the said developed countries. Finally, loans must be channelled towards the
transformation of the primary products into products worthy for the international market.
Notwithstanding, however, the researcher believes that these debt-ridden nations in the
Sub-Saharan Africa are expected to make attempts at improving their economic status
themselves through huge research and development leading into economic productivity.
The concerns of the developed nations may be to no avail if these less developed nations
GEORGE E EKEHA 10 MBA –OCT. 2007
do not take steps that will help relief their situation. The capital investment decision is
thus one of the most critical and crucial decisions that any country or organisation can
take to achieve economic development-thus by adding economic value. Since economic
development depends on the multiplicity of viable corporate organisations and enterprises
in the country, the approach adopted here is to demonstrate how capital budgeting, as an
investment decision can help African countries promote corporate organisational growth
by using acceptable techniques to identify viable projects. In other words, capital
budgeting is an integral part of the corporate plan of an organisation, which reflects the
basic objectives of an organization. The capital investment decision involves large sums
of money and may introduce a drastic change in companies as well as the whole
economy, when it is well scrutinised. For instance, acceptance of a project may
significantly change a company’s operation, profitability and create more jobs within the
country. These changes might also affect investors’ evaluation of a company (Osaze,
1996:40-44).
1.3 The Problems and Research Hypothesis
Most third world countries depend excessively on importation. They do not develop an
enduring technological base that can support the growth of their economies. Their capital
investment decisions are not usually well articulated. This may be due to the fact that
their governments do embark on white elephant projects that gulp huge sums of money
and are useless in terms of utility to the people. The projects often are abandoned halfway
and in some cases, are only executed on papers. The current efforts of some African
governments like those of Ghana and Nigeria, towards privatisation of hitherto
government-owned firms and corporations is an indirect concession to the fact that the
former investment decision pattern of the national government is not wise enough to
alleviate their countries from poverty. In fact, most of the diversified companies have
improved productivity and quality with enormous benefits to their countries. Considering
the matter from the corporate perspective therefore, the researcher believes that capital
budgeting decision is one of the decision-making areas of a financial manager that
involves the commitment of large funds in long-term projects or activities. And these
projects have a huge impact on the county’s economic development.
GEORGE E EKEHA 11 MBA –OCT. 2007
This 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. It is also expected to show that the use of sophisticated
techniques by both corporate and governmental CFOs will help in the development
efforts of Africans and other poor nations. The researcher believes that most developed
countries in Europe have achieved highs in today’s competitive international market
because they put money where it adds value. Investments are well scrutinised using
various sophisticated techniques, both qualitative and quantitative, before final decision is
arrived and such projects are well monitored until fully completed. It is my believe also
that most African Countries remain in the low economic growth and poverty zone
because CFOs don’t make use of technical tools to analyse various investment projects,
which have significant impact on the economic development. These differences might be
due to the level of education, technology and economic development between the two
economic blocs. Therefore, the researcher hypothesizes that CFOs of European
companies will use net present value (NPV) and internal rate of returns (IRR) methods
more often than their counterparts in West Africa, whereas the opposite will be true for
the pay back (PB) and accounting rate of returns (ARR) methods.
An additional contribution of this paper to the existing empirical literature on capital
budgeting practices is in terms of the countries for which the researcher had gathered
data. Most previous studies focus on the United States and the United Kingdom and there
are some few studies available for the Netherlands (Herst, Poirters and Spekreijse, 1997;
Brounen, De Jong and Koedijk, 2004). The researcher is also aware of study on “Capital
Budgeting and Economic Development in the Third World Countries” (Elumilade, et al
2006) but there were no comparisons with any developed economy.
1.4 Organisation of the study
The paper is organised in seven different sections, with section one dealing with
introduction, hypothesis and motivations of the study. Section two discusses literature
GEORGE E EKEHA 12 MBA –OCT. 2007
review on capital budgeting practices and further discussed the capital budgeting process,
classification of investment projects and alternative determinants of capital budgeting
practices in sections three and four. This was followed by a discussion of the design of
the survey in section five. Section six then provides the results of the survey and a
discussion of the empirical analysis of determinants of capital budgeting practices. The
paper ends with a summary and discussion of the results in the final section.
2.0 LITERATURE REVIEW
In this section the researcher tries to outline previous studies relevant to this study. The
section discussed various studies on economic development, capital budgeting among
CFOs from various countries and if there is any comparative study between developed
and developing countries.
2.1 Economic Development in Africa
Economic development in Africa has not been steady. In fact, when compared to the
situation in the Western countries like Europe, the conclusion is that countries of the third
world are either qualified as undeveloped or mildly put underdeveloped. African scholars
have tended to heap the blame on the Europeans; saying that colonialism or neo-
colonialism is the bane of Africa’s economic woes. This notion is referred to by
Onigbinde (2003:21-25), as the “Original Sin Fallacy”. The present economic woe of
underdeveloped countries (UDCs) according to this fallacy is that UDCs’ condition is
original “in relation to a so-called non-achievement, the present condition of the
underdeveloped world is a historical product of capitalist expansion (ibid).
The crisis of underdevelopment in Africa is also captured in the “Africa at the Doorstep
of Twenty-First Century” by Adebayo Adedeji as sited by Onigbinde, 2003. According to
him, African within the world is, …poverty increased in both the rural and urban areas:
real 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, there is a mess vengeance (Onigbinde, 2003: 78-79) .
GEORGE E EKEHA 13 MBA –OCT. 2007
The United States Assistance for International Development (USAID), 1988-1992 (cited
from Onigbinde, 2003:79-80), stated among other things that, … approximately 180
million of sub-Saharan Africa’s 500 million people could be classified as poor, of whom
66.7 percent, or 120 million, are desperately poor. By every international measure, be it
per capital income ($330), life expectancy (51 years), or the United Nation’s Index of
Human Development (0.255 compared to 0.317 for South Asia, the next poorest region),
Africa is the poorest region in the world, Onigbinde 2003. The solution to all these
problems lies in the fact that firms are to embark on projects that would give rise to
company’s value which will by extension enhancing the desired economic development
for the country. In the course of achieving these development efforts, the company’s
activities become more complex and corporate management assumes a sound financial
position in the handling of problems and decisions therein.
In his study of “The obstacles to investment in Africa…”, Professor Peter Montiel of the
World Bank concluded among other things that “One set of explanations is based on the
view that investment projects with high economic rates of return are not as plentiful in
Africa as the simple neoclassical growth paradigm would seem to imply. One argument is
that for a variety of reasons, aggregate production functions may be characterized by
lower levels of productivity in Africa than in creditor countries. An alternative or
complementary story is based on generalizing the aggregate production function to
include roles for human capital, public capital, and institutional capital” Montiel (2006).
He continued to say “These effects raise questions about the abundance of investment
opportunities yielding high economic rates of returns in Africa at the present time”,
(ibid). This conclusion suggests that, though not abundant, investment opportunities with
high returns exist in African countries and when applied properly, it could bring
economic growth to Africa. One of the best ways to scrutinise these opportunities is by
using various techniques like the capital budgeting techniques, to access the profit
potentials.
GEORGE E EKEHA 14 MBA –OCT. 2007
2.2 The Capital Budgeting Decision
Capital budgeting decisions are among the most important decisions the financial
manager of a company has to deal with. Capital budgeting refers to the process of
determining which investment projects result in maximisation of shareholder value,
Dayananda et al, 2002. Generally speaking, there are four main capital budgeting
techniques the manager may use when evaluating an investment project. In fact, there are
other techniques that could have been considered, such as sensitivity analysis, real
options, book rate of return, simulation analysis, etc. (Graham and Harvey, 2001, pp.196-
197). However, the researcher has chosen to focus on the most well known techniques to
keep the study simple. The net present value (NPV) and internal rate of return (IRR)
methods are considered to be discounted cash flow (DCF) methods. The payback period
(PB) and average accounting rate of return (ARR) methods are so-called non-DCF
methods, Brealey and Myers, 2003. From a pure theoretical point of view the NPV is
considered to be the most accurate technique to evaluate projects. Yet, it is also the most
sophisticated of the four, followed by the IRR method. Both non-DCF methods are
considered to be less accurate, of which the PB method is the least sophisticated (ibid).
In the past, several studies of capital budgeting practices have been carried out. Most
studies focus on companies in the U.S. Comparing survey results of capital budgeting
practices in the U.S. over time generally seems to show that the analytical techniques
used by executives have increased in terms of sophistication. For example, in one of the
earliest studies reporting the results of questionnaires on capital budgeting practices,
Klammer (1972) shows that in 1959, based on a sample of 184 large U.S. companies, 19
per cent indicated that they used DCF methods as their primary method to evaluate
projects. The majority of companies used either PB (34 per cent of the total sample) or
ARR methods (34 per cent) as their primary method of evaluation. In 1970, the picture
had changed drastically: DCF methods were used by 57 per cent of the companies; 26 per
cent used ARR and only 12 per cent used PB as their primary method of project
evaluation (ibid). In a later study, Hendricks (1983) reports that in 1981 76 per cent of the
companies in his sample studied used DCF methods as their primary tool. Only 11 per
cent stated they used the PB method as their primary tool. Trahan and Gitman (1995)
GEORGE E EKEHA 15 MBA –OCT. 2007
show that, based on a 1992 survey of 58 of the Fortune 500 large companies and 26 of
the Forbes 200 best small companies, most companies used DCF methods as their
primary evaluation tool, although these methods were more important for the large
companies (88 per cent for NPV and 91 per cent for IRR) than for the small companies
(65 and 54 per cent for NPV and IRR respectively).
A recent study by Graham and Harvey (2001), a comprehensive survey published on
capital budgeting practices (using answers from a 1999 survey among 392 Chief
Financial Officers (CFOs) of companies in the U.S. and Canada) showed that the NPV
and IRR techniques are the most frequently used capital budgeting techniques. Their
survey reported that 75 per cent of the CFOs always use NPV and 76 per cent always or
almost always use the IRR method. Their survey results also show, however, that even
though over time the use of the PB method has declined as a primary tool for project
evaluation, it remains to be an important secondary instrument CFOs normally use.
According to Hendricks (1983), in his 1981 survey 65 per cent of the companies in his
sample used PB as a secondary measure. Trahan and Gitman (1995) show that in 1992,
72 per cent of the large and 54 per cent of the small companies used PB as one of the
evaluation tools. In the 1999 survey of Graham and Harvey (2001) 57 per cent indicated
they use the PB method as one of their evaluation tools.
The general picture that emerges from the previous short discussion also emerges from
survey studies based on other U.S. as well as U.K., European and Australian companies
(Gitman and Forrester (1977); Schall, et al. (1978); Kim and Farragher (1981); Shao and
Shao (1996); Pike (1996) and Brounen, et al. (2004) ; Freeman and Hobbes (1991) and
Truong, et al. (2005); Herst, et al. (1997) and Brounen, et al. (2004). A comparison of the
results of these survey studies also showed an increasing sophistication with respect to
the use of evaluation techniques over time. At the same time, however, it seems that
companies in European countries report lower rates of the use of DCF techniques as
compared to U.S. companies.
GEORGE E EKEHA 16 MBA –OCT. 2007
Brounen et al (2004) replicate the Graham and Harvey (2001) survey in four European
countries (U.K., France, Germany and the Netherlands; total sample was 313 companies)
in 2002-2003 and find that for the U.K. companies in their sample 47 per cent states that
NPV is (almost) always used as a tool of evaluating projects, whereas 69 per cent
(almost) always use the PB. For the Netherlands these figures are comparable (70 and 65
per cent, respectively); for France and Germany the figures are even lower (42-50 per
cent and 44-51 per cent, respectively).
2.3 Studies on Capital Budgeting Practices in Developing Countries
A few studies have reported survey evidence on capital budgeting practices in the Asia-
Pacific region. These studies show a somewhat different picture. Wong, et al (1987) used
information from a survey among a large number of companies in Malaysia, Hong Kong,
and Singapore in 1985 and found that in these countries the PB method was the most
popular primary measure for evaluating and ranking projects. For Malaysia this picture
was confirmed in Han (1986). In a recent paper by Kester, et al. (1999), based on
information from surveys of 226 companies in Australia, Hong Kong, Indonesia,
Malaysia, The Philippines and Singapore in 1996- 1997, it was reported that the PB
method was still an important method. Yet, DCF methods seem to have increased in
importance as well. Excluding Australia from the sample of the countries studied, 95 per
cent of the companies in the five Asian countries indicated that they use the PB method
and 88 per cent of them said they use the NPV method when evaluating projects. In terms
of importance (on a scale from 1 to 5, where 1 = unimportant and 5 = very important)
both methods are rated almost equally important (3.5 versus 3.4) (ibid). When comparing
these results to the results of studies for companies in Western economies, these figures
seem to be very high. Comparing the results of the study by Wong, et al. (1987) with
those of Kester, et al. (1999) does seem to suggest that the level of sophistication of
capital budgeting techniques has increased quite rapidly during a period of just one
decade within the developing countries in Asia.
GEORGE E EKEHA 17 MBA –OCT. 2007
3.0 CAPITAL BUDGETING PROCESS AND PROJECT CLASSIFICATIONS
3.1 Classification of Investment Projects
Investment projects can be classified into three categories on the basis of how they
influence the investment decision process: independent projects, mutually exclusive
projects and contingent projects, Dayananda et al (2002).
3.1.1Independent Projects
An independent project is the one which the acceptance or rejection of does not directly
eliminate other projects from consideration or affect the likelihood of their selection. For
example, management may want to introduce a new product line and at the same time
may want to replace a machine, which is currently producing a different product. These
two projects can be considered independently of each other if there are sufficient
resources to adopt both, provided they meet the firm’s investment criteria (ibid). This
implies that the projects can be evaluated independently and a decision made to accept or
reject them depending upon whether they add value to the firm.
3.1.2 Mutually Exclusive Projects
According to Dayananda et al (2002), two or more projects that cannot be pursued
simultaneously are called mutually exclusive projects – the acceptance of one prevents
the acceptance of the alternative proposal. Therefore, mutually exclusive projects involve
‘either-or’ decisions – alternative proposals cannot be pursued simultaneously. The early
identification of mutually exclusive alternatives is crucial for a logical screening of
investments. Otherwise, a lot of hard work and resources can be wasted if two divisions
independently investigate, develop and initiate projects, which are later recognized to be
mutually exclusive (ibid).
3.1.3 Contingent Projects
Finally, a contingent project is the one which the acceptance or rejection is dependent on
the decision to accept or reject one or more other projects. Contingent projects may be
complementary or substitutes (ibid). For example, the decision to start an agricultural
GEORGE E EKEHA 18 MBA –OCT. 2007
project in a West African village may be contingent upon a decision to build roads
leading to the project sites. In this case the projects are complementary to each other. The
cash flows of the farming project will be enhanced by the existence of good roads to
transport inputs and outputs to and from the farm and conversely the cash flows
necessary for the road maintenance will be enhanced by the existence of high road taxes
paid by the trucks using the road. In contrast, substitute projects are ones where the
degree of success (or even the success or failure) of one project is increased by the
decision to reject the other project. For example, market research indicates demand
sufficient to justify two restaurants in a shopping complex and the firm is considering one
Chinese and one Thai restaurant. Customers visiting this shopping complex seem to treat
Chinese and Thai food as close substitutes and have a slight preference for Thai food
over Chinese (ibid). Consequently, if the firm establishes both restaurants, the Chinese
restaurant’s cash flows are likely to be adversely affected. This may result in negative net
present value for the Chinese restaurant. In this situation, the success of the Chinese
restaurant project will depend on the decision to reject the Thai restaurant proposal. Since
they are close substitutes, the rejection of one will definitely boost the cash flows of the
other. Contingent projects should be analysed by taking into account the cash flow
interactions of all the projects (ibid).
3.2 The capital budgeting process
This section was adopted from Dayananda et al (2002), they stated that there are several
sequential stages in the process. For typical investment proposals of a large corporation,
the distinctive stages in the capital budgeting process are depicted, in the figure 1 below:
GEORGE E EKEHA 19 MBA –OCT. 2007
Figure 1: The Capital Budgeting Process
Corporate Goal
Strategic Planning
Investment Opportunities
Preliminary Screening
Financial appraisal, quantitative analysis, project evaluation/analysis
Qualitative factors, judgement & gut
feeling
Accept/reject decision on the projects
Implementation
Facilitation, monitoring, control & review
Continue, expand or abandon project
Post-implementation audit
Source: Capital Budgeting: Financial Appraisal of Investment Projects (Dayananda et al 2002) 3.2.1 Strategic planning
A strategic plan is the grand design of the firm and clearly identifies the business the firm
is in and where it intends to position itself in the future. Strategic planning translates the
firm’s corporate goal into specific policies and directions, sets priorities, specifies the
structural, strategic and tactical areas of business development, and guides the planning
process in the pursuit of solid objectives, Daft (2003). A firm’s vision and mission is
encapsulated in its strategic planning framework. There are feedback loops at different
stages, and the feedback to ‘strategic planning’ at the project evaluation and decision
Accept Reject
GEORGE E EKEHA 20 MBA –OCT. 2007
stages – indicated by upward arrows in Figure 1 – is critically important. This feedback
may suggest changes to the future direction of the firm, which may in effect, cause
changes to the firm’s strategic plan Dayananda et al (2002).
3.2.2 Identification of investment opportunities
According to Dayananda et al (2002), the identification of investment opportunities and
generation of investment project proposals is an important step in the capital budgeting
process. They proposed that the projects have to fit in with a firm’s corporate goals, its
vision, mission and long-term strategic plan. Of course, if an excellent investment
opportunity presents itself the corporate vision and strategy may be changed to
accommodate it. Thus, there is a two-way traffic between strategic planning and
investment opportunities. Deyananda et al (2002) went on to argue that this is very
tactical level of the capital budgeting process because, some investments are mandatory –
for instance, those investments required to satisfy particular regulatory, health and safety
requirements – and they are essential for the firm to remain in business. Other
investments are discretionary and generated by growth opportunities, competition, cost
reduction opportunities and so on (ibid). Some firms have research and development
(R&D) divisions constantly searching for and researching into new products, services and
processes and identifying attractive investment opportunities. Sometimes, excellent
investment suggestions come through informal processes such as employee chats in a
staff room or corridor (ibid).
3.2.3 Preliminary screening of projects
The next stage after identifying various investment opportunities is to do initial
screening. It is obvious that all the identified opportunities cannot go through the rigorous
project analysis process. Therefore, the identified investment opportunities have to be
subjected to a preliminary screening process by management to isolate the marginal and
unsound proposals, because it is not worth spending resources to thoroughly evaluate
such proposals. Dayananda et al (2002) suggested that the preliminary screening may
involve some preliminary quantitative analysis and judgements based on intuitive
feelings and experience.
GEORGE E EKEHA 21 MBA –OCT. 2007
3.2.4 Financial appraisal of projects
The next stage after the initial screening of identified projects is to go through rigorous
financial appraisal to ascertain if they would add value to the firm. According to
Dayananda et al (2002), this stage is also called quantitative analysis, economic and
financial appraisal, project evaluation, or simply project analysis. This project analysis
may predict the expected future cash flows of the project, analyse the risk associated with
those cash flows, develop alternative cash flow forecasts, examine the sensitivity of the
results to possible changes in the predicted cash flows, subject the cash flows to
simulation and prepare alternative estimates of the project’s net present value. Thus, the
project analysis can involve the application of forecasting techniques, project evaluation
techniques, risk analysis and mathematical programming techniques such as linear
programming. The financial appraisal stage will provide the estimated contribution that
the project would make towards the increase of the firm’s value in terms of the projects’
net present values. “If the projects identified within the current strategic framework of the
firm repeatedly produce negative NPVs in the analysis stage, these results send a message
to the management to review its strategic plan” (ibid). It is noteworthy therefore that the
feedback from project analysis to strategic planning plays an important role in the overall
capital budgeting process. The results of the quantitative project analyses will therefore
influence the project selection or investment decisions.
3.2.5 Qualitative factors in project evaluation
Dayananda et al (2002), continued that when a project passes through the quantitative
analysis test, it has to be further evaluated taking into consideration some qualitative
factors. Qualitative factors are those which will have an impact on the project, but are
virtually impossible to be evaluated accurately in monetary terms. They suggested the
following factors for consideration:
• the societal impact of an increase or decrease in employee numbers
• the environmental impact of the project
• possible positive or negative governmental political attitudes towards the project
• the strategic consequences of consumption of scarce raw materials
GEORGE E EKEHA 22 MBA –OCT. 2007
• positive or negative relationships with labour unions about the project
• possible legal difficulties with respect to the use of patents, copyrights and trade
or brand names
• impact on the firm’s image if the project is socially questionable.
They argued that some of the items in the above list affect the value of the firm, and some
not. The firm can address these issues during project analysis, by means of discussion and
consultation with the various parties, but these processes will be lengthy, and their
outcomes often unpredictable. This stage will require considerable management
experience and judgemental skill together with high level of think-tack to incorporate the
outcomes of these processes into the project analysis. In some cases, however, those
qualitative factors which affect the project benefits may have such a negative bearing on
the project that an otherwise viable project will have to be abandoned.
3.2.6 The accept/reject decision
Having done the critical quantitative and qualitative analysis, the NPV results from the
quantitative analysis combined with those qualitative factors will form the basis of the
decision support information. The analyst relays this information to management with
appropriate recommendations. Management considers this information and other relevant
prior knowledge using their routine information sources, experience, expertise, ‘gut
feeling’ and, of course, judgement to make a major decision – to accept or reject the
proposed investment project (ibid).
3.2.7 Project implementation and monitoring
Once investment projects have passed through the decision stage they must be
implemented by management without any further delay. During this implementation
phase various divisions of the firm like sales and marketing, production and technical are
likely to be involved. An integral part of project implementation is the constant
monitoring of project progress. This would enable management to identifying potential
bottlenecks thus allowing early intervention. Deviations from the estimated cash flows
GEORGE E EKEHA 23 MBA –OCT. 2007
need to be monitored on a regular basis so that corrective actions will be taken when
needed.
3.2.8 Post-implementation audit
Dayananda et al suggest that, post-implementation audit does not relate to the current
decision support process of the project; it deals with a post-mortem of the performance of
already implemented projects. They said that, “An evaluation of the performance of past
decisions, however, can contribute greatly to the improvement of current investment
decision-making by analysing the past ‘rights’ and ‘wrongs’. The post-implementation
audit can provide useful feedback to project appraisal or strategy formulation. For
example, ex post assessment of the strengths (or accuracies) and weaknesses (or
inaccuracies) of cash flow forecasting of past projects can indicate the level of confidence
(or otherwise) that can be attached to cash flow forecasting of current investment
projects” (ibid). This might also be important because if projects are undertaken within
the framework of the firm’s current strategic plan and they do not prove to be as lucrative
as predicted, the audit information can prompt management to consider a thorough
review of the firm’s current strategic plan.
4.0 DETERMINANTS OF CAPITAL BUDGETING PRACTICES
As was shown in the previous section, over time, financial managers have applied various
methods and procedures to determine which investments are beneficial to the firm. The
choice of the evaluation method may therefore be determined by individual preferences
of the manager and/or by the environment in which decisions have to be made.
While in the literature several factors have been mentioned as determinants of the choice
of capital budgeting practices, in this paper the researcher wants to focus on the role that
is played by the level of economic development in this respect. The review of studies of
capital budgeting practices in the previous section showed that over time, the use of more
sophisticated DCF methods has become more popular. This may be explained by various
factors. First, financial markets have developed over time, making the use of DCF
methods more applicable, convenient and necessary. Due to the development of financial
GEORGE E EKEHA 24 MBA –OCT. 2007
markets (and especially stock markets) shareholder’s value maximization has gained high
importance, which has pressured CFOs of companies to use DCF methods over other
simpler and less accurate alternatives. Second, training of CFOs has improved over time,
which may have enabled them to better understand and thus use more sophisticated
techniques. Third, financial tools and programmes that help the CFO to determine which
investments are beneficial to the firm have become increasingly sophisticated, which may
also have stimulated the use of more sophisticated techniques. Finally, the increased use
of computer technology and the related reduction in the cost of this technology may have
stimulated the use of more sophisticated techniques.
This researcher believes that these factors are all related to increasing levels of
development. More developed countries generally tend to have more sophisticated
financial markets, Levine (1997) higher levels of human capital, Schultz (1988), Boozer
et al (2003), and higher levels of technology, Evenson (1988). This would also mean that
the level of economic development of a country and the sophistication of the capital
budgeting techniques implemented by CFOs in that country are positively related. In
general terms, therefore, it could be expected that CFOs of companies in more developed
countries use DCF methods significantly more often than do their counterparts in less
developed countries. The opposite may hold for the use of non-DCF methods. It is this
hypothesis that will be investigated in this study, using information from Europe and
West African CFOs with respect to their capital budgeting practices.
Although since the late 1980s some West African countries have seen some impressive
economic growth, over the period, the researcher believes that at the beginning of the
new millennium there was still a wide gap in levels of economic, human and
technological development between West African countries and the developed countries
such as Europe. Whiles the investment in high returns projects will facilitate the
development efforts of these poor nations, the researcher also believes that the use of
sophisticated capital budgeting techniques will help the West African CFOs to identify
the most profitable projects and thereby helping their governments to achieve economic
heights. The high level of economic and technological developments in the developed
GEORGE E EKEHA 25 MBA –OCT. 2007
countries have facilitated the ability to make use of very sophisticated techniques, which
are more likely to produce more reliable results. Therefore, the researcher hypothesizes
that CFOs of European companies will use NPV and IRR methods more often than do
West African CFOs, whereas the opposite will be true for the PB and ARR methods.
To test the hypothesis the researcher will also take into account other variables that
according to the literature may also explain the use of capital budgeting practices,
Brounen, et al. (2004) and Graham and Harvey (2001). These variables will be included
in the multivariate analysis as control variables. In particular, the researcher included
measures of the size of the firm, the industry to which the firm belongs, and the
educational level and age of the CFO of the firm. Firm size is included because some
papers have argued and indeed found evidence for the fact that larger companies are more
inclined to use more sophisticated capital budgeting techniques (Payne, et al., 1999; Ryan
and Ryan, 2002; Brounen, et al., 2004). One important reason for this may be that larger
companies generally deal with larger projects, which makes the investment in the use of
more sophisticated techniques less costly (Payne, et al., 1999). Based on this argument,
the researcher expects to find a positive relationship between firm size and the use of
DCF methods.
The measure of the educational level of the CFO is included, since it may be expected
that CFOs with higher levels of education will have less problems in understanding and
using more sophisticated capital budgeting techniques. Again, therefore, the researcher
expects a positive relationship between the level of the educational background of the
CFOs of the companies and the use of DCF methods. With respect to measures of the
industry and age of the CFO, there are no specific and priori expectations about the
nature of the relationship.
5.0 SURVEY DESIGN AND METHODOLOGY
The data for the analysis have been obtained by using the results of structured
questionnaires. The questionnaires were sent to 225 Europe and 120 West African listed
and non-listed companies in the period between August 2006 and January 2007. The
GEORGE E EKEHA 26 MBA –OCT. 2007
questionnaires consisted of a number of multiple choice questions related to capital
budgeting practices of companies, questions specifying firm characteristics, such as size,
foreign sales and industry, as well as questions asking for the age and educational
background of the respondent.
With respect to the questions related to capital budgeting practices the researcher asked
companies to indicate the frequency of the use of different project evaluation techniques
(running from 0 to 4, where 0 = never and 4 = always), the cost of capital estimation
method used most frequently, the use of methods to estimate the cost of equity. To
increase the chances of getting responses from the companies, the researcher decided to
keep the survey as short as possible. In total, I included only fifteen questions. The same
set of questions was sent to European and West African companies. The questions were
all structured in English and were sent by post. To increase the level of response, two
reminders were sent to the companies: the first one was two weeks and the second three
weeks after the original questionnaires were sent, all by email. The questionnaire was to
be completed by the CFO of the company or any person in financial authority. The
researcher received 36 responses, 28 from Europe and 8 from West African companies,
resulting in a response rate of 12 per cent for the European and 6 per cent for the West
African companies sampled. These response rates are somewhat on average to those
found in other studies. For example, Graham and Harvey (2001) report a response rate of
9 per cent; Trahan and Gitman (1995) have a rate of 12 per cent and Brounen, et al.
(2004) reports a rate of 5 per cent. Kester, et al. (1999) shows an average response rate
for the five Asian countries of 15.5 per cent.
6.0 RESEARCH RESULTS AND ANALYSIS
This section first describes and compares the characteristics of European and West
African companies in the sample that was considered to be relevant as determinants of
their capital budgeting practices. Next, it discusses the outcomes related to the answers to
the questions on capital budgeting practices, focusing on the use of different capital
budgeting techniques and methods used to estimate cost of capital and equity. Finally, the
researcher present a univariate and multivariate analysis of the relationship between firm
GEORGE E EKEHA 27 MBA –OCT. 2007
characteristics and capital budgeting practices for the European and West African
companies in the sample.
6.1 Company and CFO Characteristics
Table 1 shows the information on the characteristics of both the European and West
African companies in the sample. With respect to total sales the table shows that the
European companies on average report higher sales than the West African companies.
While 36 per cent of the European companies have sales of more than 1 billion dollars,
none of the West African companies reports sales in this category. About 55 per cent of
the West African companies have sales of 100 million dollars or above, while the
remainder have sales less than 100 millions dollars. If small companies are classified as
having sales of less than 100 million dollars, medium-sized companies having sales of
between 100-499 million dollars, and large companies having sales of 500 million dollars
or more, then the figures indicate that majority of the European companies responding to
this study fall within the large companies category, whereas the West African companies
responding to the study mainly consist of medium-sized and small-sized companies.
GEORGE E EKEHA 28 MBA –OCT. 2007
Table 1: Company Characteristics Europe (%) West African (%)
Sales (US$ million): Less than 25 million 18 12 25 – 99 million 12 36 100 – 499 million 25 50 500 – 999 million 12 12 More than 1 billion 36 0 Foreign sales (% of total sales: No foreign sales 4 37 1 – 24% 18 38 25 – 49% 25 25 50 – 99% 53 0 100% 0 0 Industry Manufacturing 53 62 Technology 21 0 Retail and Wholesale 12 12 Transport and Energy 20 26 Financial 4 0 CFO’s Level of Education: Professional (Undergraduate) 12 38 MBA 20 25 Non-MBA Master 42 25 PhD 26 12 Age of CFOs: Less than 40 years 7 0 40 – 49 years 48 62 50 – 59 years 45 37 More than 60 0 0 Source: survey results
Additionally, with respect to the share of foreign sales both samples differ quite
substantially. Whereas 75 per cent of the West African companies report that their
foreign sales are zero or are less than 25 per cent of total sales, about 65 per cent of the
European companies state they have 50 per cent or more foreign sales. Table 1 also
shows that more than 50 per cent of the European and about two thirds of the West
African companies are classified as manufacturing companies. It also provides
information on CFO characteristics. In general, European CFOs seem to have a higher
level of education. Whereas almost 70 per cent of the European CFOs have a non-MBA
master or PhD, this is only 37 per cent for the West Africa CFOs. At the same time, 38
per cent of the West Africa CFOs have an undergraduate degree or professional
qualification as their highest level of education; for the European CFOs this is only 12
per cent. With respect to the age structure CFOs in both countries are rather similar.
GEORGE E EKEHA 29 MBA –OCT. 2007
6.2 Capital Budgeting Techniques
The first question in the questionnaire relates to the capital budgeting practices of
companies. Similar to Graham and Harvey (2001) and Brounen, et al. (2004), the
researcher asked companies to rate different capital budgeting methods on a 4-point scale
in terms of the frequency with which they are used (where 0 = never and 4 = always).
This provides information with respect to the methods that are being used, and also with
respect to the relative importance of the different methods. The following capital
budgeting techniques are used: two DCF methods (NPV and IRR), two non-DCF
methods (PB and ARR) and other techniques. As was already discussed above, from a
pure theoretical point of view the NPV is the most accurate technique. Yet, it is also the
most sophisticated of the four, followed by the IRR method. Both non-DCF methods are
considered to be less accurate, of which the PB method is the least sophisticated method,
Dayananda et al, 2002.
Table 2 shows the results of the responses from European and West African companies.
First of all, the table shows the percentage of CFOs who indicate that they always or
almost always use a certain capital budgeting method (scores 3 and 4). Next, the table
shows the mean scores for the different methods in both continental blocs. Finally, the
table shows the mean scores for different methods of different categories of companies,
using the characteristics of companies and CFOs discussed in table 1 to categorize
companies in sub-samples.
Before going into the analysis of the differences between the European and West African
CFOs, let me shortly discuss this results and compare them to those of other studies
relevant for this analysis. The row labelled “% 3 and 4 scores” presents the percentage of
companies that indicate they use a certain capital budgeting method always (score = 4) or
almost always (score = 3). The row labelled “mean” gives the mean score of all
companies, using a 0 (never) to 4 (always) scale. The other rows show mean scores of
different categories of companies, based on firm characteristics discussed in table 1. The
figures in italics are t-test statistics based on standard differences of mean test, showing
whether the averages for the different categories of companies are significantly different
GEORGE E EKEHA 30 MBA –OCT. 2007
from each other. The t-test statistics shown for the mean scores of West Africa report
whether they are significantly different from the mean scores reported for the Europe. (a),
(b), (c) are significance levels of 10, 5 or 1 per cent respectively. Table 2: Capital Budgeting Methods Used by CFOs NPV IRR PB ARR Other
Europe (N = 42) % responding 3 & 4 scores 89 75 79 7 7 Mean Score 3.50 2.98 3.10 0.24 0.17 Total Sales <$500 million
3.27
2.73
3.36
0.09
0.05
≥$500 million 3.75 3.25 2.80 0.40 0.30 2.30(b) 1.32 2.10(b) 1.33 1.56 CFOs Edu. (Master/PhD) Yes
3.55
3.00
3.10
0.10
0.14
No 3.38 0.70
2.92 0.18
3.08 0.09
0.54 1.76(a)
0.23 0.51
Age of CFOs < 50 yrs
3.52
2.78
3.17
0.22
0.09
50 yrs or older 3.47 0.22
3.21 1.07
3.00 0.61
0.26 0,19
0.26 1.06
Industry: Manufacturing
3.52
3.14
3.00
0.05
0.24
Others 3.48 0.22
2.81 0.83
3.19 0.68
0.43 1.66(b)
0.10 0.86
Foreign Sales: < 50% of sales
3.55
3.15
3.40
0.20
0.00
≥50% of sales 3.45 0.43
2.82 0.82
2.82 2.17(b)
0.27 0.31
0.32 1.98(a)
West Africa (N = 8) % responding 3 & 4 scores 50 87 75 12 0 Mean Score 2.51
4.43(c) 3.38
1.82(a) 3.16 0.35
1.00 3.92(c)
0.02 1.73(a)
Total Sales <$100 million
2.12
3.29
3.00
0.82
0.00
≥$100 million 2.75 1.65(a)
3.43 0.64
3.25 1.22
1.11 0.90
0.04 0.78
CFOs Edu. (Master/PhD) Yes
2.95
3.45
3.00
0.70
0.00
No 2.16 2.15(b)
3.32 0.63
3.28 1.40
1.24 1.81(a)
0.04 0.89
Age of CFOs < 50 yrs
3.13
3.48
3.00
1.00
0.04
50 yrs or older 1.86 3.82(c)
3.27 1.01
3.32 1.61
1.00 0.00
0.00 0.86
Industry: Manufacturing
2.43
3.43
3.10
1.03
0.03
Others 2.67 0.58
3.27 0.77
3.27 0.78
0.93 0.31
0.00 0.70
Foreign Sales: Yes
2.97
3.42
3.03
1.03
0.00
No 1.50 4.21(c)
3.29 0.60
3.43 1.88(a)
0.93 0.31
0.07 1.51
GEORGE E EKEHA 31 MBA –OCT. 2007
6.2.1 European CFOs
Table 2 shows that the NPV method is the most popular method among the European
CFOs. 89 per cent of the respondents indicated they use this method (almost) always, and
its mean score is 3.50, which is 0.40 above the second most popular method (the PB
method). The IRR and PB method are quite comparable in terms of their mean scores and
percentage of CFOs who say they use these methods (almost) always. The ARR method
is clearly the least popular: its mean score is 0.24 and only 7 per cent of the CFOs in the
sample stated that they use this method (almost) always.
If these results for the European CFOs are compared with those found in Brounen, et al.
(2004), it seems that this finding has significantly higher percentages and mean scores for
most of the methods reported in the survey. Brounen, et al. show that 70, 56 and 65 per
cent of companies (almost) always use the NPV, IRR or PB method respectively, and
they report mean scores of 2.76, 2.36 and 2.53, respectively. The differences between
their findings and this study may be due to the fact that in their sample there are more
smaller companies: almost 40 per cent of their companies have total sales between 25 and
102 million dollars, whereas in this study I have no respondent of the companies in this
size category. In contrast, in this study 36 per cent of the companies have sales of more
than 1 billion dollars, whereas in the sample of the study by Brounen, et al. only 20 per
cent of the companies is in this size category.
Table 2 also shows the results of a standard difference of mean test of the mean scores of
the NPV, IRR, PB and ARR method for the five different categories of companies listed
in table 1 (size, educational level of the CFO, age of the CFO, industrial sector and
percentage foreign sales of total sales). The results of these tests show that for larger
companies the mean score for the NPV method is significantly higher (at the 5 per cent
level) than for smaller companies. The opposite is true for the PB method. With respect
to the PB method, the table also shows that companies with lower foreign sales have
significantly higher mean score than companies with higher foreign sales. The other
GEORGE E EKEHA 32 MBA –OCT. 2007
mean tests report either insignificant t-values or values that are only significant at the 10
per cent level. These results are comparable to similar tests results presented in Brounen,
et al., who also find that larger companies have significantly higher mean scores for the
NPV method. They, however, do not find significant differences for any of the other
methods for any of the categories of companies they use in their study.
6.2.2 West African CFOs
Table 2 shows that the IRR and the PB method are the most frequently used methods.
87 and 75 per cent of the CFOs in the sample stated that they use these methods (almost)
always. The NPV method is used much less: only 50 per cent of the CFOs report they use
this method (almost) always. Looking at the mean scores the IRR and PB method are
comparable with 3.38 and 3.16 mean score respectively, whereas the NPV method’s
score falls behind with only 2.51. In the researcher’s opinion, the use of IRR scored very
high in these countries because of the unstable nature of inflation and interest rates in
those countries. As was true for the European companies sampled, the ARR method is the
least popular. The mean score for this method is 1.00 and only 12 per cent of the West
African CFOs in this sample say they use this method (almost) always. The researcher is
unable to compare the results for West Africa with those found in other studies, simply
because the researcher couldn’t find any literature on capital budgeting practices in West
Africa. Probably the best comparison to make here is by looking at the outcomes of a
survey of capital budgeting practices for five Asian countries carried out by Kester, et al.
(1999). This is based on the assumption that one can look at most of these countries as
developing countries as compare to their fellow West African counterpart.
As already mentioned in section 2, Kester et al (1999) found that 95 per cent of the Asian
companies in their sample indicate they use the PB method, whereas 88 per cent report
they use the NPV method. The mean scores for both methods are 3.5 and 3.4 (on a scale
of 5), respectively. Although it is difficult to make a simple comparison between the
outcomes of the survey by Kester, et al and this study results, since the questions in their
survey were slightly different from the ones used here, these figures nevertheless seem to
suggest that CFOs in West Africa use the NPV method on a much less regular basis than
GEORGE E EKEHA 33 MBA –OCT. 2007
their colleagues in other developing countries like those in Asia. The results of the
standard differences of mean test of the mean scores of the NPV, IRR, PB and ARR
method for the five different categories of companies and CFOs show that, for the higher
educated and younger CFOs the mean score for the NPV method is significantly higher
than for the lower educated and older CFOs. Also, companies with foreign sales have a
significantly higher mean score for the NPV method than companies with no foreign
sales. The mean score of the NPV method of the larger companies is higher than for the
smaller companies, yet the t-value is only just significant at the 10 per cent level. The
other mean tests report either insignificant t-values or values that are only significant at
the 10 per cent level. Kester, et al. do not report mean scores of different categories of
companies, so it is very impossible to make any comparisons.
6.2.3 European versus West African CFOs
First, European CFOs seem to use the NPV method more often than their colleagues in
West Africa. Whereas 89 per cent of the European CFOs indicate they (almost) always
use this method, this is only true for 50 per cent of the West African CFOs. Instead, the
IRR method is used more by West African CFOs than by European CFOs (87 versus 75
per cent). The differences with respect to the use of the NPV and IRR method in the
Europe and West Africa are confirmed when looking at the mean scores. In Europe the
mean score for the NPV method is 3.50 whereas in West Africa it is 2.51. For the IRR
method, mean scores are 2.98 and 3.38, respectively. The differences of the mean scores
with respect to the use of the NPV and IRR method between European and West African
CFOs are statistically significant, as shown in table 2 (see the t-values in italics presented
in the row below the mean scores for West Africa). Note, however, that for the IRR
method the difference is only significant at the 10 per cent level. Although the PB method
seems to be more popular among European CFOs responding to this study (79 per cent of
the European CFOs indicate they (almost) always use this method, against 75 per cent for
the West African CFOs), the difference between the mean scores of West Africa versus
the Europe is not statistically significant. Finally, the ARR method is not used very much
in both West Africa and the Europe; yet the analysis shows that the mean score for the
West African CFOs is significantly higher than the score for their European counterparts
GEORGE E EKEHA 34 MBA –OCT. 2007
(1.00 versus 0.24). The above discussion seems to suggest that the European CFOs are
using the most sophisticated capital budgeting method (i.e. NPV) on a significantly more
regular basis than their West African colleagues do. Instead, West African CFOs use the
less sophisticated ARR method significantly more than the European CFOs. This result
seems to partly confirm the research hypothesis that, based on the fact that there is quite
some difference in the level of economic development of the two continental blocs, on
average European CFOs will use more sophisticated capital budgeting methods than their
West African colleagues.
6.3 Cost of Capital Estimation Methods
The next important question in the questionnaire focuses on the methods that are used to
estimate the cost of capital. Estimating the cost of capital is necessary when a firm
applies discounting techniques like the NPV or IRR method. The researcher asked
companies to indicate which method they use most frequently when estimating the cost
of capital. In particular, CFOs are asked to make a choice out of the following set of
possible methods, i.e. the project dependent (risk-adjusted) cost of capital (PDCC), the
weighted average cost of capital (WACC), the cost of debt and other methods. Whereas
the PDCC and WACC are the more sophisticated methods, the cost of debt is clearly the
least sophisticated of the three methods. In fact, using the cost of debt for capital
budgeting purposes is in most cases not appropriate. Yet, since in many cases projects are
financed by newly issued debt, using the cost of debt is tempting, and also because of the
ease with which it can be calculated.
Table 3 presents the results of the responses from European and West African companies.
In particular, it presents the percentage of companies that indicates that a certain method
of cost of capital estimation is the one they use most frequently. The researcher again
used the characteristics of companies and CFOs discussed in table 1 to categorize
companies in sub-samples. The percentages given in this table refer to the share of CFOs
in each of the categories, using DCFs methods, who indicated that certain discount rate is
the one they use most frequently. Total percentages for different categories of companies
may add up to more or less than 100 per cent due to rounding errors.
GEORGE E EKEHA 35 MBA –OCT. 2007
Table 3: Most Frequently Used Methods to Measure the Cost of Capital (% of total) Project dependent
(risk-adjusted) cost of capital
(PDCC)
Weighted Average Cost of Capital
(WACC)
Cost of debt (CD)
Other Methods
Europe (N = 28) % of total companies
10.7 67.9 14.3 7.1
Total Sales <$500 million
14.3
64.3
21.4
0.0
≥$500 million 5.0 70.0 5.0 20.0
CFOs Edu. (Master/PhD) Yes
13.8
62.1
10.3
13.8
No 0.0 76.9 23.1 0.0
Age of CFOs < 50 yrs
13.0
56.5
21.7
8.7
50 yrs or older 5.3 78.9 5.3 10.5
Industry: Manufacturing
14.3
71.4
14.3
0.0
Others 4.8 61.9 14.3 19.0 Foreign Sales: < 50% of sales
10.0
65.0
20.0
5.0
≥50% of sales 9.1 68.2 9.1 13.6
West Africa (N = 8) % of total companies 12.5 50 25 12.5 Total Sales <$100 million
5.9
47.1
47.1
0.0
≥$100 million 21.4 57.1 17.9 3.6
CFOs Edu. (Master/PhD) Yes
15.0
70.0
15.0
0.00
No 16.0 40.0 40.0 4.0
Age of CFOs < 50 yrs
21.7
69.6
4.3
4.3
50 yrs or older 9.1 36.4 54.5 0
Industry: Manufacturing
13.3
43.3
40.0
3.3
Others 20.0 73.3 6.7 0.0
Foreign Sales: Yes
19.4
54.8
25.8
0.0
No 7.1 50.0 35.7 7.1
GEORGE E EKEHA 36 MBA –OCT. 2007
6.3.1 European CFOs
The results in table 3 show that 67.9 per cent of the European companies state that they
use the WACC for discounting purposes. Only 10.7 per cent of the companies use a
project dependent (risk-adjusted) cost of capital. In addition, table 3 shows that a
relatively large number of European companies (14.3 per cent) use the simple cost of
debt as the discount rate. When looking at the results for different sub-samples of
companies, a couple of points are noteworthy. Small companies use the cost of debt more
often than large companies do: 21.4 versus 5.0 per cent. In addition, CFOs with higher
levels of education make less use of the cost of debt than less educated CFOs. Less
educated European CFOs do not use a project dependent (risk-adjusted) cost of capital at
all, while 13.8 per cent of the higher educated CFOs indicate that they use this one the
most frequently.
6.3.2 West African CFOs
Of the West African companies, 50 per cent indicate that they use the WACC most
frequently, 25 per cent mention the cost of debt, while 12.5 per cent state that they use the
project dependent cost of capital most often. Compared to the European companies, West
African companies appear to use the cost of debt more often. In addition, like European
CFOs, West African CFOs with higher levels of education use the cost of debt less often
than their less educated colleagues. Moreover, small West African companies use the cost
of debt more often than larger companies. This result is consistent with those for the
European companies in this sample. In contrast to their European counterparts, however,
older West African CFOs are more inclined to use the cost of debt. The level of CFO
education does not seem to influence the use of the project dependent (risk-adjusted) cost
of capital.
6.3.3 European versus West African CFOs
In all, when looking at the methods used to measure the cost of capital, the outcomes
presented in table 3 suggest that the main differences between West Africa and Europe
are with respect to the use of the cost of debt. In West Africa, the cost of debt is used
more often than in Europe. Based upon the difference in the level of economic
GEORGE E EKEHA 37 MBA –OCT. 2007
development between the two continental blocs, this may be expected, since the cost of
debt is a relatively simple method of calculating the cost of capital. Moreover, most
companies in West Africa are significantly small in size as compare to those in the
European countries, hence the use of the simpler methods.
6.4 Cost of Equity Estimation Methods
The researcher finally asked companies to indicate which methods they use to estimate
the cost of equity. Estimating the cost of equity is necessary when a firm applies
discounting techniques like the NPV or IRR method. The cost of equity is an input for
calculating the project dependent (risk-adjusted) cost of capital and the WACC. The
researcher asked companies to indicate which methods they use most frequently when
estimating the cost of equity. In particular, companies were asked to indicate whether
they make cost of equity estimations, and if they do, what type of method they use most.
Although there are several possible methods available, the survey results showed that
companies basically use two (in the Europe) or three (in West Africa) different methods
on a regular basis. The following methods were mentioned by the respondents: average
historical returns on common stock, Capital Pricing Asset Model (CAPM), no estimation
done, and other methods (e.g. dividend discount type of models). Of these methods, the
CAPM can be seen as the most sophisticated model.
Table 4 presents the results of the responses from European and West African companies.
In particular, it presents the percentage of companies that indicates that a certain method
of cost of equity estimation is the one they use most frequently. The researcher again
used the characteristics of companies and CFOs discussed in table 1 to categorize
companies in sub-samples. The percentages between brackets in columns 3, 4 and 5 refer
to the share of companies that indicate they do estimate the cost of equity. So, for
instance if all the European companies in this sample stated they do estimate the cost of
equity, 52 per cent uses the CAPM.
GEORGE E EKEHA 38 MBA –OCT. 2007
Table 4: Most Frequently Used Methods to Estimate the Cost of Equity (% of total) No
Estimation done
Average historical returns on common
stock
Capital Asset Pricing Model
(CAPM)
Other Methods
Europe (N = 28) % of total companies
35.7 0.0 33.3 (52.0) 31.0 (48.0)
Total Sales <$500 million
31.8
0.0
27.3(40.0)
40.9(60.0)
≥$500 million 40.0 0.0 40.0 (66.7) 20.0 (33.3)
CFOs Edu. (Master/PhD) Yes
34.5
0.0
24.1 (36.8)
41.4
No 38.5 0.0 53.8 (87.5) 7.7 (12.5)
Age of CFOs < 50 yrs
43.5
0.0
30.4 (53.8)
26.1 (46.2)
50 yrs or older 26.3 0.0 36.8 (50.0) 36.8 (50.0)
Industry: Manufacturing
19.1
0.0
42.9 (53.0)
38.1 (47.0)
Others 52.4 0.0 42.9 (50.0) 23.8 (50.0) Foreign Sales: < 50% of sales
30.0
0.0
35.0 (50.0)
35.0 (50.0)
≥50% of sales 40.9 0.0 31.8 (53.8) 27.3 (46.2)
West Africa (N = 8)
% of total companies 64.4 4.4 (12.7) 24.4 (68.5) 6.7 (18.8) Total Sales <$100 million
76.5
0.0
17.6 (74.9)
5.9 (25.1)
≥$100 million 57.1 7.1 (16.7) 28.6 (66.7) 7.1 (16.7)
CFOs Edu. (Master/PhD) Yes
55.0
5.0 (11.1)
35.0 (77.8)
5.0 (11.1)
No 72.0 4.0 (14.3) 16.0 (57.1) 8.0 (28.6)
Age of CFOs < 50 yrs
43.5
4.4 (7.8)
39.1 (69.2)
13.0 (23.0)
50 yrs or older 86.4 4.6 (33.8) 9.1 (66.2) 0.0
Industry: Manufacturing
66.7
3.3 (9.9)
20.0 (60.1)
10.0 (30.0)
Others 60.0 6.7 (16.7) 33.3 (83.3) 0.0
Foreign Sales: Yes
51.6
6.5 (13.3)
32.3 (66.7)
9.7 (20.0)
No 92.9 0.0 7.1 (100.0) 0.0
GEORGE E EKEHA 39 MBA –OCT. 2007
6.4.1 European CFOs
The results in table 4 show that almost 36 per cent of the European companies in this
study stated that in most cases they do not estimate the cost of equity. Of the companies
that do regularly estimate the cost of equity, roughly half of them stated that they use the
CAPM in most cases. When looking at the results for different sub-samples of
companies, the table shows that 80 per cent of the manufacturing companies stated they
do regularly estimate the cost of equity, a percentage that is much higher than that of the
total sample of European companies. When splitting up the companies into two groups
based on the age of the CFO, the table shows that companies with younger CFOs seem to
be much less regularly making cost of equity estimations than companies with older
CFOs (26 versus 44 per cent).
If we turn to the outcomes for those companies that do make frequent estimations of the
cost of equity, the table shows that CFOs of smaller companies less frequently use
CAPM as compared to their colleagues of larger companies. Moreover, CFOs with lower
levels of education use the CAPM more often than highly educated CFOs do. Given the
fact that CAPM is the most sophisticated method, the results with respect to the
educational level of the CFO may be somewhat surprising and cannot easily be
explained. For this, one might have to know more about what the respondents will
include in the category “other methods”, since it turns out to be about 41 and 8 per cent
for higher and lower level of educated CFOs respectively, but unfortunately this
information is lacking in this questionnaire. One plausible explanation may be that other
methods used by European companies consist of methods such as dividend discount
models, which belong to the more sophisticated DCF-methods. For the other sub-
samples, there is no big difference in the use of methods between different types of
companies or CFOs.
6.4.2 West African CFOs
With respect to the West African companies in the sample, table 4 shows that the
percentage of companies stating that they do not regularly make cost of equity
estimations is much higher than for Europe: almost 65 per cent for West Africa versus 36
GEORGE E EKEHA 40 MBA –OCT. 2007
per cent for Europe. The table also shows that there are quite some differences for several
of the sub-samples on the issue of whether or not estimations of the cost of equity are
made on a regular basis. In particular, smaller companies, companies with no foreign
sales, and companies with CFOs who are older or have lower levels of education make
cost of equity estimations (much) less frequently. Of the companies that do regularly
estimate the cost of equity, almost 70 per cent stated that they use CAPM in most cases,
whereas 13 per cent say that they use average historical returns on common stock as their
estimation method. Looking at different sub-samples, the table suggests that higher
educated CFOs use the CAPM much more frequently than CFOs with lower levels of
education (78 percent versus 57 per cent). Moreover, older CFOs seem to use average
historical returns quite often as their method of estimating cost of equity (34 per cent).
These outcomes for sub-samples are more or less in line with what has been hypothesized
above.
6.4.3 European versus West African CFOs
To conclude the analysis in this sub-section, the outcomes presented in table 4 show that
there seems to be quite some difference with respect to the use of techniques between
Europe and West Africa. In particular, the results from the questionnaire seem to
establish that the European CFOs are more inclined to use more sophisticated methods to
estimate cost of equity. This outcome is in line with what may be expected based on the
differences in the level of economic development between the two economies. It also
seems to confirm what was already found before in table 2, that European CFOs use
discounting techniques, and in particularly the NPV method, significantly more often
than West African CFOs do. This probably explains the higher percentage of European
CFOs reporting they make use of cost of equity estimations as compared to their West
African colleagues.
6.5 Capital Budgeting Techniques, Cost of Capital and Cost of Equity Estimations:
Multivariate Analysis
The discussion in the previous sub-sections was based on comparing averages. Although
the discussion provided some interesting results on the differences in the use of capital
GEORGE E EKEHA 41 MBA –OCT. 2007
budgeting methods between Europe and West Africa, in this section, the researcher wants
to go one step further by performing multivariate regression analysis. In particular, the
researcher wants to investigate whether the use of different capital budgeting techniques
and different methods of estimating the cost of capital is determined by a so-called
country effect, i.e. to ask ourselves whether it matters if the company is European or
West African when it decides on using a capital budgeting, cost of capital, and/or cost of
equity estimation method. When investigating this country effect, the researcher made a
consideration for other factors, such as market size, cultural and political environment,
that may influence the choice of capital budgeting, cost of capital, and/or cost of equity
estimation methods.
6.5.1 The Multivariate Analysis
The multivariate analysis is set up as follows. The researcher estimated two different
versions of three different models. The first version of the first model establishes to what
extent the choice of a specific type of capital budgeting method is determined by the
country effect. In the second version of this model, a number of control variables are
added to see if the country effect still holds when adding other possible determinants of
the choice of the capital budgeting method. The first version of the second model
investigates whether the choice of a specific cost of capital estimation method is
determined by the country effect, whereas in the second version of this model I again
introduce a number of control variables to see if the country effect still holds even after
controlling for other possible determinants of the choice of the cost of capital estimation
method. The first version of the third model investigates whether the choice of a specific
cost of equity estimation method is determined by the country effect, whereas in the
second version of this third model I again introduce a number of control variables to see
if the country effect still holds even after controlling for other possible determinants of
the choice of the cost of equity estimation method.
With respect to the first model I tried to investigate the determinants of three different
capital budgeting methods, i.e. the NPV, IRR and ARR method. The PB method has been
left out, since the results in table 2 showed that for this method there was no significant
GEORGE E EKEHA 42 MBA –OCT. 2007
difference in the mean scores between European and West African companies. The
category of “other methods” has been left out due to the fact that only a very few number
of companies in both Europe and West Africa indicated they used other capital budgeting
methods. With respect to the second model I analyse the determinants of the decision to
make estimations of the project dependent (risk-adjusted) cost of capital, the WACC, as
well as of the cost of debt. The category ‘other methods’ is left out, since the results in
table 3 show that the percentage of both European and West African companies that
using other methods is very low. With respect to the third model I analyse the
determinants of the decision not to make estimations of the cost of equity, as well as of
the CAPM and ‘other methods’. The control variables included are the same for all model
specifications. Thus measures of size, level of education of the CFO, age of the CFO and
type of Industry.
The dependent variables are binary dummy variables. In table 5, the dependent variables
are created as follows: NPV = 1 if the score for a company for the NPV method is 3 or 4,
it is 0 if the score of a company is less than 3; IRR = 1 if the score for a company for the
IRR method is 3 or 4, it is 0 if the score of a company is less than 3; ARR = 1 if the score
for a company for the ARR method is 1 or higher, it is 0 if the score of a company is 0.
The dependent variables used in table 6 are defined as follows: PDCC = 1 if a company
indicates that in most cases it uses a project dependent (risk-adjusted) cost of capital, it is
0 if this is not the case; WACC = 1 if a company indicates it uses the weighted average
cost of capital on a regular basis to estimate the cost of capital, it is 0 if this is not the
case; CD = 1 if a company indicates it uses the cost of debt as an estimate for the cost of
capital on regular basis, it is 0 if this is not the case. Finally, the dependent variables used
in table 7 are defined as follows: NOCC = 1 if a company indicates that in most cases it
does not make estimates of the cost of equity, it is 0 if it does make estimations of the
cost of equity on a regular basis; CAPM = 1 if a company indicates it uses the CAPM on
regular basis to estimate the cost of equity, it is 0 if this is not the case; Other = 1 if a
company indicates it uses another, not explicitly identified model to estimate the cost of
equity, it is 0 if this is not the case. The researcher have excluded the share of foreign
sales to total sales as one of the control variables, since with respect to this variable the
GEORGE E EKEHA 43 MBA –OCT. 2007
West African and European companies cannot really be compared in the context of a
multivariate analysis. For the West African companies in the sample 30 per cent does not
have foreign sales and another 40 per cent has foreign sales less than 25 per cent. Instead,
half of European companies in the sample have foreign sales of more than 50 per cent of
their total sales.
The independent variables are also binary variables. I used the following variable
specifications: West Africa = 1 if the company is a West African company, it is 0 if the
company is European, this variable is used to measure the country effect; Size = 1 if an
European company has total sales of less than 500 million dollars or if a West African
company has total sales of less than 100 million dollars, it is 0 if a European (West
African) company has total sales of 500 (100) million dollars or more; Education = 1 if
the CFO of the company has a PhD or Master degree, it is 0 if (s)he has an undergraduate
degree; AGE = 1 if the CFO of the company is 50 years or older, it is 0 if (s)he is
younger; Industry = 1 if the company is manufacturing company, it is 0 if it is not. The
figures in brackets are t-test statistics and (a), (b), (c) are significant levels of 10, 5 and 1
respectively. All estimations are carried out using the logit estimation method, Hosmer,
D.W. and Lemeshow, S (1989) and Long S J (1997). The results of the multivariate logit
analysis are presented in tables 5, 6 and 7.
6.5.2 Capital Budgeting Techniques
Table 5 shows the results for the determinants of the use of the different capital budgeting
techniques. The results provide the following picture. First, for the NPV method the
country effect is negative and statistically significant (see column [1]). This result can be
interpreted as supportive evidence for the fact that West African companies use the NPV
method significantly less often than European companies do. This finding supports the
hypothesis on the relationship between the level of development and the choice of the
capital budgeting technique as discussed in section 1.3 of this paper. This result holds
even if I include control variables for size, CFO education and age, and type of industry
(column [2]). Moreover, the results show that the choice for the NPV method is also
determined by the size of the company and the age of the CFO; both variables have a
GEORGE E EKEHA 44 MBA –OCT. 2007
negative and statistically significant coefficient. This means that smaller companies and
companies with older CFOs use the NPV method less often than larger companies and
companies with younger CFOs do. Based on the discussion in section 4 of this paper, the
outcomes with respect to the size variable are as expected.
Table 5: Determinants of Capital Budgeting Methods: Multivariate Logit Analysis NPV NPV IRR IRR ARR ARR [1]
[2] [3] [4] [5] [6]
Constant 2.001(c) (4.20)
2.957(c) (3.35)
1.036(c) (2.95)
1.585(b) (1.88)
-2.001(c) (-4.20)
0.028 (0.04)
West Africa -2.046(c) (-3.64)
-2.324(c) (-3.61)
1.043(a) (1.77)
0.807 (1.32)
2.315(c) (4.10)
2.350(c) (3.68)
Size -1.172(b) (-2.010)
-0.593 (-1.00)
-0.883 (-1.55)
Education 0.525 (0.93)
-0.523 (-0.83)
-1.626(c) (-2.61)
Age -1.212(b) (-2.15)
-0.293 (-0.50)
-0674 (-1.15)
Industry 0.155 (0.27)
0.595 (1.02)
-0.948 (1.53)
Number of Observations
36 36 36 36 36 36
Secondly, table 5 shows that the country effect for the IRR method is positive and
significant, which indicates that the IRR method is used more often by West African
companies than by European companies (column [3]). Note, however, that the coefficient
is only significant at the 10 per cent confidence level. If the control variables are
introduced in the model, the country effect is still positive, yet it becomes insignificant
(column [4]). This suggests that the choice for the IRR method may not really be
different between European and West African companies. This finding is perhaps
somewhat surprising in the light of the hypothesis on the relationship between the level of
development and the choice of the capital budgeting technique as discussed in section 4,
based on which it might have been expected that European companies are more regular
users of DCF methods than West African companies. On the other hand, combined with
the findings with respect to the use of the NPV method, these findings may make sense. It
might be the case that in recent years European companies have been substituting the IRR
GEORGE E EKEHA 45 MBA –OCT. 2007
method for the NPV method. Consequently the use of the IRR method by European
companies has decreased.
Finally, table 5 shows that the country effect is positive for the ARR method, indicating
that West African companies are using this method significantly more often than
European companies do (column [5]), a result that still holds after introducing the control
variables (column [6]). This result seems to be in line with the hypothesis that has been
formulated on the relationship between the level of economic development and the use of
capital budgeting techniques. Of the control variables, only the education variable is
statistically significant and it has the expected negative sign, meaning that higher
educated CFOs will use the ARR method significantly less, which is consistent with what
is expected.
6.5.3 Cost of Capital Estimation
Table 6 presents the results for the determinants of the use of the different methods of
estimating the cost of capital. For the PDCC and WACC there were no statistically
significant coefficients for the country effect variable, indicating that for these two
methods of estimating cost of capital there is no difference in use between European and
West African CFOs. Although the country effect is positive and statistically significant at
the 10 per cent level in the bivariate model for the cost of debt estimation method
(column [9]), this effect becomes statistically insignificant after the control variables
were added (column [10]). In the extended, multivariate model, the size variable is
positive and statistically significant at the 1 per cent level. Moreover the age variable is
also positive and statistically significant at the 5 per cent level. The result for the size
variable is in line with what may be expected based on the discussion in section 4.
GEORGE E EKEHA 46 MBA –OCT. 2007
Table 6: Determinants of the Most Frequently Used Methods to Measure the Cost of Capital: Multivariate Logit Analysis
Project dependent
(risk-adjusted) Cost of Capital (PDCC)
Weighted Average Cost of Capita
(WACC)
Cost of Debt (CD)
Cost of Debt (CD)
[7] [8] [9] [10] Constant -2.251(c)
(-4.28) 0.693(a) (2.12)
-1.172(b) (-4.06)
-3.766(c) (-3.61)
West Africa 0.560 (0.84)
-0.560 (-1.26)
0.891(a) (1.62)
0.746 (1.13)
Size 1.886(c) (2.75)
Education -0.974 (-1.52)
Age 1.298(b) (2.02)
Industry 1.213(a) (1.72)
Number of Observations
36 36 36 36
6.5.4 Cost of Equity Estimation
Table 7 presents the results for the determinants of the use of the different methods of
estimating the cost of equity. The results can be summarized as follows. First, the country
effect is positive and statistically significant in the model explaining when companies do
not regularly make cost of capital estimations (column [11]), which means that West
African companies do make such estimations on a less regular basis than their European
counterparts. This result holds even after the control variables were added (column [12]).
This outcome seems to be in line with the results presented in table 5, showing that
European companies do use the NPV method significantly more often than West African
companies do.
GEORGE E EKEHA 47 MBA –OCT. 2007
Table 7: Determinants of Cost of Equity Estimation Methods: Multivariate Logit Analysis
No Cost of
Capital Estimation (NOCC)
No Cost of Capital
Estimation (NOCC
Capital Asset Pricing Mode
(CAPM)
Capital Asset Pricing Mode
(CAPM)
Others Others
[11]
[12] [13] [14] [15] [16]
Constant -0.588(a) (-1.83)
-0.386 (-0.57)
-0.693(b) (-2.12)
0.203 (0.28)
-0.802(b) (-2.40)
-2.90(c) (-2.87)
West Africa 1.182(c) (2.64)
1.283(c) (2.60)
-0.435 (-0.91)
-0.664 (-1.26)
-1837(c) (-2.68)
-1.662(b) (-2.30)
Size 0.308 (0.64)
-0.765 (-1.45)
0.900 (1.40)
Education -0.464 (-0.95)
-0.348 (-0.66)
1.325(a) (1.80)
Age 0.581 (1.23)
-0.798 (-1.55)
0.290 (0.46)
Industry -0.700 (-1.43)
0.135 (0.267)
0.897 (1.36)
Number of Observations
36 36 36 36 36 36
Secondly, the country effect is negative but not statistically significant in the models
explaining the use of the CAPM (columns [13] and [14]). Thus, there seems to be no
difference between European and West African companies with respect to the frequency
with which they use the CAPM to estimate cost of capital. Third, table 7 shows that the
country effect is negative and significant for the ‘other methods’, suggesting that West
African companies use other methods less regularly than European companies do
(column [15]). This result remains after adding the control variables (column [16]). If
‘other methods’ can be interpreted as being dividend discount models – which belong to
the sophisticated DCF-methods – then this finding supports the hypothesis on the
relationship between the level of development and the choice of the cost of equity
estimation methods presented in section 4. Since detailed information about the contents
of the other methods category is lacking, this conclusion remains to be only tentative. The
table also shows that the education variable is positive and statistically significant,
confirming the idea that more developed countries make use of estimation methods that
are positively related to the level of education of the CFO.
GEORGE E EKEHA 48 MBA –OCT. 2007
7.0 SUMMARY AND DISCUSSION
In this paper, it was argued that the use of capital budgeting practices might be related to
the level of economic development. The researcher has given a number of arguments to
support this argument. First, financial markets have developed over time, making the use
of DCF methods more applicable, convenient and necessary. Due to the development of
financial markets (and especially stock markets) shareholder maximization has gained its
importance, which has pressured CFOs of companies to use DCF methods over other,
more simple and less accurate alternatives. Secondly, training of CFOs has improved
over time, which may have enabled them to better understand and therefore use more
sophisticated techniques. Thirdly, tools and packages that help the CFO to determine
which investments are beneficial to the company have become increasingly sophisticated,
which may also have stimulated the use of more sophisticated techniques. Finally, the
increased use of computer technology and the related reduction in the cost of technology
may have stimulated the use of more sophisticated techniques.
This paper has investigated this hypothesis using information on the use of capital
budgeting techniques by companies in the Europe and West Africa. This information was
obtained from a survey among 28 European and 8 West African companies, who
responded to the questionnaires sent to 345 companies. This minimum response was, in
my opinion, due to the limited time allowed for the return of the questionnaires and some
financial constrains. With this information, the researcher carried out the analysis using
standard differences of mean tests and multivariate regression analysis to see whether the
level of economic development matters for the use of capital budgeting practices. I
focused on whether there was a so-called “country effect”, i.e. whether capital budgeting
practices differed significantly between European and West African companies and
whether these differences can be explained by differences in levels of economic
development. The researcher was not aware of any other study in the literature that has
looked at this issue.
The main findings of the analysis can be summarized as follows. First, European CFOs
use the NPV method significantly more often than their West African colleagues do.
GEORGE E EKEHA 49 MBA –OCT. 2007
Second, West African CFOs use the ARR method significantly more than European
CFOs do. Third, CFOs of West African companies less often make cost of equity
estimations as compared to European CFOs. These results may be explained by the fact
that there is still a gap with respect to the level of economic, financial, human and
technological development between the two continental blocs. At the same time,
however, the study also found that the use of the IRR method does not seem to differ
significantly between European and West African companies. The same is true for the
estimation of the cost of capital and the use of CAPM as a method of estimating the cost
of equity. The latter three results do not lend support to the central hypothesis of this
paper.
Therefore, the researcher will restrain himself from drawing too strong conclusions with
respect to the importance of the “country effect” as an explanation for differences in
capital budgeting practices between the European and West African companies.
However, the researcher still believes that there are some levels of economic factors
among the determinants of the choice of capital budgeting practices.
It is therefore proposed that further research into this issue is required and that more and
larger data sets should be created, in terms of the number of companies and individual
company observations, as well as in terms of the selected countries included in the
research.
GEORGE E EKEHA 50 MBA –OCT. 2007
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RESEARCH QUESTIONNAIRES
These questionnaires are for the purpose of academic attainment in Masters of Business
Administration (MBA) in Finance. The researcher intends to find out the use of capital
budgeting methods among the developed and developing countries. It is also intended to
establish if there be any relationship between level of economic, financial, human and
technological development and the choice of capital budgeting methods. No part of any
information provided in these questionnaires will be shared or used for any purpose other
than as stated above. The researcher will therefore be very glad if the person answering
these questionnaires is the Chief Finance Officer (CFO) or in authority of financial
matters within the organisation. Thank you for your participation towards this study.
1. What is your position in the company? CFO Financial Manager
Financial Director Others (Please state) ………………………
2. Which of the following does your age fall? Less than 40 40 – 49
50 – 59 60 or above
3. What is your highest level of education? PhD MBA
Non-MBA Masters Undergraduate/Professional
4. What industry does your company belong? Manufacturing Financial
Technology Transport & Energy Retail & Wholesale
5. What is the total volume of annual turnover in dollars? Less than 25 million
25 – 99 million 100 – 499 million 500 – 999 million
More than 1 billion
6. What percentage of the total sales is made outside the home country of your
company? 100% 50 – 99% 25 – 49% 1 – 25%
No foreign sales
7. Do you use any capital budgeting method to assess projects when making
investment decisions? Yes No
GEORGE E EKEHA 54 MBA –OCT. 2007
8. If yes, which method(s) do you use? (Please select all that apply) Net Present
Value (NPV) Internal Rate of Return (IRR) Pay Back (PB)
Accounting Rate of Return (ARR) Others
9. On the scale of 0 – 4 , with 4 being the method(s) used always and 0 being never,
how would you rate the frequency of use for the selected methods above? NPV 0
1 2 3 4 ; IRR 0 1 2 3 4 ; PB 0 1 2
3 4 ; ARR 0 1 2 3 4 ; Others 0 1 2 3
4
10. Do you use any technical method to measure the cost of capital of projects when
making investment decisions? Yes No
11. If yes, which method(s) do you use? (Please select all that apply) Project
dependent cost of capital (PDCC) Weighted average cost of capital
(WACC) Cost of debt (CD) Others
12. On the scale of 0 – 4, with 4 being the method(s) used always and 0 being never,
how would you rate the frequency of use for the selected methods above? PDCC
0 1 2 3 4 ; WACC 0 1 2 3 4 ; CD 0 1
2 3 4 ; Others 0 1 2 3 4
13. Do you use any technical method to estimate the cost of equity of projects when
making investment decisions? Yes No
14. If yes, which method(s) do you use? (Please select all that apply) Capital asset
pricing methods (CAPM) Average historical returns on common stock No
estimate done Others
15. On the scale of 0 – 4, with 4 being the method(s) used always and 0 being never,
how would you rate the frequency of use for the selected methods above? CAPM
0 1 2 3 4 ; Average historical returns on common stock 0 1
2 3 4 ; Others 0 1 2 3 4
Thank you for your time and invaluable contribution to this study.
GEORGE E EKEHA 55 MBA –OCT. 2007