Capital budgeting practices in South Africa: A review

Correia, C. Article Capital budgeting practices in South Africa: A review South African Journal of Business Management Provided in Cooperation with: University of Stellenbosch Business School (USB), Bellville, South Africa Suggested Citation: Correia, C. (2012) : Capital budgeting practices in South Africa: A review, South African Journal of Business Management, ISSN 2078-5976, African Online Scientific Information Systems (AOSIS), Cape Town, Vol. 43, Iss. 2, pp. 11-29, https://doi.org/10.4102/sajbm.v43i2.180 This Version is available at: https://hdl.handle.net/10419/218483 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may be saved and copied for your personal and scholarly purposes. You are not to copy documents for public or commercial purposes, to exhibit the documents publicly, to make them publicly available on the internet, or to distribute or otherwise use the documents in public. If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ S.Afr.J.Bus.Manage.2012,43(2) 11 Capital budgeting practices in South Africa: A review C. Correia College of Accounting, University of Cape Town, Private Bag, Rondebosch 7701, Republic of South Africa [email protected] Received May 2010 This paper reviews the capital budgeting survey literature in South Africa over the period 1972 to 2008. The survey evidence indicates a significant growth in Discounted Cash Flow (DCF) methods and a fall in the use of other methods. In particular, there has been growth in the use of Net Present Value (NPV). Yet, the Internal Rate of Return (IRR) technique remains the primary method used in practice despite some serious drawbacks. Larger companies are more likely to use DCF methods. There has been a significant growth in the use of sensitivity analysis and scenario analysis. However, there is little use of sophisticated risk analysis tools such as Monte Carlo simulation, and decision trees. Although financial theory predicates the use of risk adjusted discount rates, surveys indicate that the majority of companies use a single firm discount rate. Companies have increasingly used inflation-adjusted cash flows but the process of ranking mutually exclusive projects is not aligned with finance theory. There is limited use of the Modified Internal Rate of Return (MIRR) method and DCF dominant companies do not outperform non-DCF dominant companies. The most important phase of project evaluation is the project definition and cash flow estimation phase and yet research studies have focused mainly on the financial analysis and project selection phase. *To whom all correspondence should be addressed. Introduction In capital budgeting there has been a growing convergence between theory and practice in the USA and other countries such as the UK and Australia. Over the last three decades, there have been numerous surveys of capital budgeting practices in South Africa. The objective of this paper is to provide a review of the capital budgeting survey literature over the period 1972 to 2008, to analyse trends in capital budgeting practices, analyse the state of the art and identify areas for further research. This paper analyses the use of capital budgeting techniques in South Africa as measured by numerous published surveys and unpublished surveys, and compares the use and trends in capital budgeting practices in relation to financial theory. This study also compares results to overseas surveys. The paper focuses on such aspects as capital budgeting methods, risk analysis, discount rates and specific issues such as the performance of postaudits, the evaluation of the relative performance of DCF dominant firms, the treatment of mutually exclusive investments and the acceptance of more recent finance developments such as real options. The comparison of surveys over time is subject to limitations in terms of drawing inferences in respect to the capital budgeting practices of firms and the compliance to theory. These relate primarily to the differences in the population from which samples are drawn, response rates, sample sizes and the wording of the questions. Further, the South African surveys were evaluating particular aspects of the capital budgeting process, such as the treatment of inflation and the treatment of risk and uncertainty. However, given these limitations, it is still useful to compare results, and to understand the longer term trends in capital budgeting practices and the adoption and adaptation of firms to developments in theory and economic realities. Further, a survey of current practice is useful in terms of determining the methods in use at particular points in time. The theory and practice of capital budgeting In terms of the theory of capital budgeting, it is generally accepted that firms should employ discounted cash flow (DCF) techniques such as the internal rate of return (IRR) and net present value (NPV) to select and rank capital investment projects. These methods have been traditionally termed sophisticated capital budgeting techniques as they consider the time value of money, future cash flows and project risk. In reality, the theoretically correct method is the NPV technique, that is, project selection should be determined by the project which maximises the NPV of the project’s future cash flows. The use of the NPV method in relation to the use of the IRR method is based upon the problems arising from the evaluation of mutually exclusive alternatives, when project sizes differ, when the timing of the project cash flows differ or when the project represents a non-conventional project, that is, a project which has significant positive and negative cash flows over the life of the project. More recently, it has been argued (see, Trigeorgis, 1993; Dixit & Pindyk, 1995; Copeland & Keenan, 1998; Copeland & Antikarov, 2001) that NPV does not account for project flexibility and that the value of real 12 S.Afr.J.Bus.Manage.2012,43(2) options linked with projects should be included in the evaluation of capital projects. Surveys in South Africa up to 2006 found that the internal rate of return method is the preferred primary method used in practice. The use of NPV in terms of theoretical consistency is based upon the nature of projects, for example, whether the firm is evaluating mutually exclusive projects or whether the type of industry results in project cash flows which experience significant changes of sign over the life of the project. The continued wide use of naive methods such as the payback method and the accounting rate of return method raise some academic questions. Although there has been a growing trend in terms of the use of discounted cash flow methods, the fact is that these methods continue to be widely used by firms. Yet, the use of payback may be rational in highly uncertain environments, and when firms are subject to capital rationing, and in environments of costly information. The use of the accounting rate of return may be relevant in terms of accounting returns being employed in the performance appraisal of management. The evidence indicates that although the NPV and IRR methods may be theoretically superior to the naive methods such as payback, it was found that the erroneous application of these methods, for example, in terms not making necessary adjustments for such issues as inflation, taxation, the evaluation of mutually exclusive investments and capital rationing will fundamentally impact upon the perceived usefulness of these methods in practice. In a number of surveys it was found that the vast majority of firms take into account risk in the capital budgeting process and also make adjustments for inflation. However, a number of firms did not take into account taxation in the capital budgeting analysis. The paper analyses the relative use of sophisticated methods by small firms as compared with larger firms. It found that larger firms make more use of discounted cash flow methods as compared to smaller firms. The adoption of DCF capital budgeting techniques should result in superior firm performance and the paper finds that in fact the evidence in this regard is inconsistent, with international surveys reporting no evidence of superior performance while the South African survey found evidence that firms that adopted sophisticated capital budgeting techniques did not report superior firm performance. The paper concludes that perhaps academic research has placed too much emphasis on the selection phase of capital investment in relation to the identification, and control phases of capital investment. South African surveys of capital budgeting practices This paper uses the results of published South African surveys of capital budgeting practices over the period 1972 to 2008 as well as the results of unpublished surveys undertaken by Coltman (1995) and Mokenela (2006). It is important to analyse and compare the sample of firms used in each questionnaire. Often, these are different and the results need be interpreted in terms of the samples used. First of all, almost all surveys and questionnaires are addressed to listed firms, and some surveys are further restricted to the largest firms, for example the Financial Mail top 100 firms. Therefore, these surveys represent different samples and the limitations of using these surveys have already been enumerated. However, the results of surveys which have analysed the use of techniques in relation to capital intensity and the relative size of firms means that certain conclusions as to the use of capital budgeting techniques by smaller firms may to some extent be inferred. Table 1 indicates the sample sizes, populations, and the number of companies responding to each of the ten surveys undertaken in South Africa since 1972. Table 1: South African surveys on capital budgeting and cost of capital practices Year of Survey Year Published Author(s) No. of Firms Sample Used 1972 1976 Lambrechts, I.J. 48 Largest firms, FM 100 1978 1981 Reeve, R.. 50 Largest firms, FM 100 1982 1986 Andrews, G.S. & Butler, F. 132 Largest firms, 500 firms 1986 1990 Parry, H. & Firer, C. 71 Industrial Listed Companies on the JSE, 270 firms 1987 1991 Pocock, A., Correia, C. & Wormald, M. 40 Industrial Listed Companies on the JSE, 126 firms 1995 N/A Coltman, G. 37 Listed JSE firms - industrial holding, clothing, footwear & textiles, engineering firms 1998 2000 / 2001 Hall, J. H. 65 Listed JSE firms – industrial sector, 300 firms 1998 2003 Gilbert, E. 110 SA Chamber of Business manufacturing member firms 2002 2005 Du Toit, M.J. & Pienaar, A. 67 All JSE listed companies 2006 2008 Correia, C. & Cramer, P. 32 JSE listed companies (FM 150) S.Afr.J.Bus.Manage.2012,43(2) 13 Reference is also made to three other surveys. Mokenela (2006) undertook a survey of the use of real option analysis by the top 40 firms listed on the JSE and Brijlal and Quesada (2008) investigated capital budgeting practices by undertaking interviews with businesses in the Western Cape. A further study was undertaken by Gilbert (2005), which involved a case study analysis of capital budgeting practices at two firms. The lack of consistency of questions asked by the various surveys makes comparisons problematic in relation to specific questions in respect to the application of capital budgeting techniques. Of course, the problem of nonresponse bias needs to be acknowledged, although certain surveys have found non-response bias not to be relevant. Despite these stated limitations, a study of all these surveys over time and a comparison to surveys in other countries lead to interesting conclusions in regard to the theory and practice of capital budgeting in South Africa. Techniques used in evaluating projects It is generally accepted that there has been a significant growth in the use of DCF methods over the last 30 years. Although, DCF methods may represent optimal methods in terms of taking into account the time value of money, risk and cash flows; theoretically, the NPV method should be preferred to the IRR method. In practice, the greatest increase has been in the use of the NPV method. This is particularly true in relation to the capital budgeting practices employed by large capital intensive firms. The trend in the use of Capital Budgeting techniques since 1972, taking into account the results of all the surveys, is depicted in Figure 1. The years represent the year in which each survey took place rather than the year of publication. What stands out is the significant and steady growth in the NPV method over time. In 1972, only 14% of companies surveyed used the NPV method, yet by the time of the 2006 survey, 82% of companies employed NPV to analyse projects. In comparison 64% of companies used IRR in 1972 and this had grown to 79% of companies in 2006. Therefore the growth in the use in the NPV method reflects a growing convergence of theory and practice. In the survey by Coltman (1995) it was found that the most popular method was the payback method with 91,8% of respondents making use of this method. The Internal Rate of Return was used by 78,3% of firms whilst 64,8% of firms used the NPV method. The accounting rate of return (ARR) method was used by 45,9% of firms whilst 8,1% of firms used other methods to evaluate capital investments. It is interesting to note the trend in the use of the capital budgeting methods in South Africa in relation to previous surveys undertaken by Lambrechts (1976) in 1972, Andrews and Butler (1986) in 1982, and Parry and Firer (1990) in 1986. Later surveys undertaken by Du Toit and Pienaar (2005) in 2002 and Correia and Cramer (2008) in 2006 indicate a significant fall in the use in the Payback method and the accounting rate of return and growth in the use of IRR and NPV methods. The general trend portrays an increase in the use of the NPV and the IRR methods, whilst the ARR method has shown a decline in use since 1986. The important trend is that over all the previous surveys, the NPV and IRR methods have shown increasing use and have become more popular in practice. Again, this is particularly true for the NPV method. This is line with financial theory as the NPV and IRR methods take into account the time value of money, risk and are based on cash flows. The slight variances in trends may be due to the different populations in the surveys. The survey in 1986 included many smaller firms, which means that we would expect a greater emphasis on the use of non-DCF methods as large firms tend to make greater use of DCF techniques. Also, the survey in 1986 referred to the use of return on investment rather than accounting rate of return which may have resulted in differences in interpretation. However, it is significant to note the significant increase in the use of the NPV method for all surveys over the previous 34 years. Techniques in South Africa The survey results for 1998 refer to Gilbert’s survey (2003). As Gilbert’s survey related to many smaller manufacturing companies, in order to ensure greater comparability, Figure 1 relates to the results for companies in his survey with annual sales that exceeded R100m per year. Later in this study, we will evaluate the use of DCF techniques by smaller firms. Gilbert (2003) further referred to the return on investment (ROI) as a separate method to the accounting rate of return (ARR). It was found that only 23% of the large companies in his survey used ARR but 77% of firms used ROI. Again, there may be interpretative and definitional issues regarding the use of ROI. Further, if we include Discounted Payback, with straight Payback, then the combined use rises to 64% in 2002 and 78% in 2006. The results for South Africa are consistent with the increasing use of DCF methods as indicated by surveys in other countries. (See Blazouske, Carlin & Kim (1988), Shao & Shao (1996), Kim & Ulferts (1996), and Ryan and Ryan (2002).) Pike (1996) undertook a longitudinal survey on capital budgeting practices in the United Kingdom for different years consisting of surveys of the same firms in 1975, 1982, 1986 and 1992. In order to bring Pike’s research up to date for the UK, this paper has included the results of a survey undertaken in 1997 by Arnold and Hatzopoulos (2000) and a survey undertaken in 2003 by Alkaraan and Northcott (2006). The results are depicted graphically in Figure 2 to indicate trends in capital budgeting practices over the intervening period for the UK. 14 S.Afr.J.Bus.Manage.2012,43(2) Figure 1: Trends in the use of capital budgeting techniques in South Africa Figure 2: Trends in the use of capital budgeting techniques in the United Kingdom The results are generally consistent with the findings for South Africa to the extent that there has been a significant growth in the use of the NPV method in the UK, from 32% in 1975 to 99% in 2003 whilst the use of IRR has grown from 44% to 89% over the same period. Yet, the use of DCF methods is greater in the UK than in South Africa. It is also interesting to note that UK firms make much greater use of the payback method with 96% of firms making use of this method. The use of the accounting rate of return (ARR) method has remained more constant and significantly exceeds the use of ARR by South African firms. Initially, the growth in the use of DCF methods internationally was driven by the increase in inflation rates, but particularly by the increase in interest rates during the 1970s (and perhaps due to academic recommendations). Further, in the last 20 years, the growth in use of computer spread-sheets has had a significant effect on the use of DCF and sophisticated capital budgeting techniques. This means that the determination of NPVs and IRRs has become straightforward. This may of course mean that the calculation of NPV is a click away whilst understanding the correct application of NPV may be more elusive. This is a potential problem resulting in erroneous applications of DCF methods. This is implied in the questionnaire by Lambrechts (1976) and the conclusions reached by Pike (1996) for the UK. Lambrechts (1976) found in undertaking in-depth interviews S.Afr.J.Bus.Manage.2012,43(2) 15 with responding South African firms that the application of all the methods was subject to serious deficiencies. Although the payback method was found to be traditionally one of the most popular methods used in practice, studies have indicated that it is used as a supplementary method rather than as a primary method in project evaluation. In the survey by Coltman (1995) it was found that by analysing the frequency of usage of various techniques, the payback method was the most popular, but not the most important method. In Australia, Truong, Partington and Peat (2008) found that firms had generally increased their use of DCF methods since 1981, with 94% of Australian firms making use of NPV and 81% of firms using IRR whose use had fallen from 96% in a previous survey in 1999. The use of the payback method remains high at 90% whilst 57% of firms retain the use of the accounting rate of return. The trends in capital budgeting practices for Australia are depicted in Figure 3. It is interesting to note that there is widespread use of NPV and IRR as well as the Payback method in developing countries such as Malaysia, Indonesia and the Philippines as well in the more developed economies such as the USA, Canada, UK and Australia. However, these survey results relate to large companies in those countries, particularly for the developing countries in South-east Asia. European countries such as the Netherlands, Germany and France indicate a lower use of DCF methods but this may be due to the fact that the survey by Brounen, De Jong & Koedijk (2004) was sent to 2500 companies thereby including perhaps smaller companies than the other surveys. The overall conclusion is that for larger companies – the use of the NPV and IRR are now dominant whilst payback remains a popular method used in practice. Table 2 sets out the use of capital budgeting techniques in South Africa in the most recent survey, the USA, UK and the Asia-Pacific region. Figure 3: Trends in the use of capital budgeting techniques in Australia Table 2: Capital budgeting in SA, USA, UK and the Asia-Pacific region Method South Africa Correia & Cramer USA Ryan & Ryan UK Alkaraan & Northcott Australia Kester et al Hong Kong Kester et al Singapore Kester et al Indonesia Kester et al Malaysia Kester et al Philippines Kester et al Year of survey 2006 2002 2003 2004 1997 1996 1997 1996 1996 Year of publication 2008 2002 2006 2008 1999 1999 1999 1999 1999 IRR 79% 77% 89% 96% 86% 88% 94% 89% 94% NPV 82% 85% 99% 96% 88% 86% 94% 91% 81% ARR 14% 15% 60% 73% 80% 80% 56% 69% 78% Payback 54% 53% 96% 93% 100% 98% 81% 94% 100% 16 S.Afr.J.Bus.Manage.2012,43(2) The results for South Africa are similar to the results of the Ryan and Ryan (2002) survey for the USA, yet in other countries greater use is made of DCF methods as well as ARR and the Payback methods. In relation to the use of discounted payback, Correia and Cramer (2008) found that 25% of South African companies use this method whilst Ryan and Ryan (2002) reported that 38% of US companies used discounted payback. There is limited use of methods such as Profitability Index and Economic Value Added (EVA). Correia and Cramer (2008) found that only 7% of South African companies determine a project’s Profitability Index. The increasing focus on economic profit or EVA means that one would expect to see a growth in the use of this method over time. Yet Correia and Cramer (2008) found that only 14% of South African companies use EVA to evaluate projects. This is in contrast to the USA, where Ryan and Ryan (2002) reported that 31% of the firms used EVA to assess capital projects. Primary methods used in capital budgeting Coltman (1995) found that although the payback method was the most popular method with 92% of firms using this method, it was found that only 48% of firms used the payback method more than 75% of the time. It was found that 49% of firms use the NPV method more that 75% of the time as compared to 46% of firms that use the IRR method more than 75% of the time. Only 27% of companies employed the ARR method more than 75% of the time. The usefulness of the payback method may be to evaluate small projects which may not justify a detailed evaluation employing “sophisticated” techniques such as the IRR and NPV methods. Further, the payback method may be used as an indicator of risk and therefore acts as a supplementary measure rather than as a primary evaluation method. This conclusion is consistent with the findings of other South African surveys which analysed the primary techniques employed by South African firms. Andrews and Butler (1986) found that 45% of responding firms reported the IRR as the primary method in evaluating capital projects. In the survey, Andrews and Butler requested companies to report their capital budgeting techniques for 5 years and 10 years previously. The results are depicted in Figure 4. Although this method of determining historical trends in the use of capital budgeting techniques is subject to certain limitations, it may useful to indicate general trends of how companies have modulated reliance on the various methods over the intervening periods. The use of the NPV method which is supported by theory had shown little growth in the usage by firms as a primary method in the survey undertaken by Andrews and Butler (1986), which asked firms to set out primary methods used in 1971, 1976 and 1982. This conclusion is subject to the proviso that this method has in fact shown the greatest increase in general use and is particularly relevant for large capital intensive firms. Yet the survey by Du Toit and Pienaar (2005) in 2002 indicated a significant growth in the use of NPV as the primary method used to evaluate capital projects. Yet, the IRR remained as the most important primary method used by South African firms. The trends in the primary technique used for capital budgeting is depicted in Figure 4. The survey by Hall (2001) in 1998 generally reflected the trends in place, except for the results for ARR. In his survey, Hall specified this as the Return on Investment (ROI) rather than ARR. Consistent with Gilbert (2003) it was found that a high percentage of firms use ROI but this may be due to differences in the definition and interpretation of this term. Figure 4 depicts a significant and steady increase in the use of NPV as a primary method. Yet IRR remains the most popular primary method used in South Africa. This practice is not aligned with financial theory as IRR is subject to significant disadvantages relative to the NPV method. This relates to possible problems with the IRR arising from the reinvestment assumption, multiple IRRs when the signs of cash flows change and potential incorrect rankings of mutually exclusive projects. Du Toit and Pienaar (2005) specifically requested respondents to select whether IRR or NPV should be used to rank mutually exclusive projects and find in conflict with finance theory that IRR is the preferred method to rank mutually exclusive projects. Yet, in line with financial theory, there has been a steady decline in the use of Payback as a primary method and the ARR has also fallen in use as a primary indicator for all surveys except for the survey by Hall (2000). Project risk analysis Risk analysis is a critical aspect of the capital budgeting process. Risk analysis involves the assessment of risk and the adjustment for risk. The assessment of risk may involve the use of sensitivity analysis, scenario analysis, probability analysis, decision trees and Monte Carlo simulation. These techniques measure the variability of returns, the probability of not meeting a required return or the potential downside risk of the project resulting in significant losses for the firm. Adjusting for project risk may involve altering a firm’s WACC, shortening the required payback or reducing project cash flows. Surveys by Correia and Cramer (2008) find that there is a low utilisation of sophisticated risk methods to assess project risk. Firms in South Africa do not use methods such as Probabilities, Decision trees and Monte Carlo Simulation to any great extent and there has been little growth in the use of such methods in practice. Firms have traditionally made greatest use of Sensitivity Analysis and surveys (see Parry & Firer (1990); Pocock, Correia & Wormald (1991); Coltman, (1995)) found this to be the most important single method for determining project risk. Although, Sensitivity Analysis evaluates each variable in isolation, it is considered that firms undertake scenario type analysis using the same technique and there has been a significant growth in the use of Scenario Analysis over time. Recently, Scenario Analysis has become the most popular risk assessment method in South Africa as indicated by the Correia & Cramer (2008) survey. S.Afr.J.Bus.Manage.2012,43(2) 17 Figure 4: Primary techniques used by South African companies The use of sensitivity analysis by UK companies over time is indicated by Pike (1996), Arnold and Hatzopoulos (2000) and a survey undertaken in 2003 by Alkaraan and Northcott (2006). The use of sensitivity analysis as indicated by South African and UK surveys is depicted in Figure 5. The UK study combined the use of sensitivity analysis and scenario analysis and therefore due to the increased use of scenario analysis in South Africa, the combined total for sensitivity/scenario analysis is expected to be greater than indicated in Figure 5. There has also been a growth in the use of various methods to assess and adjust for risk. Parry and Firer (1990) in 1986 found that 61% of firms employed sensitivity analysis in assessing risk and this had grown to 68% of firms in the Correia and Cramer (2008) survey undertaken in 2006. The quantitative methods used by firms, as determined by Parry and Firer (1990) in their 1986 study was compared to the use of the same quantitative methods in 2006 and the results are presented in Figure 6. Correia and Cramer (2008) in their 2006 survey found that 50% of firms also use break-even analysis to evaluate risk. As this is linked with sensitivity and scenario analysis, this reinforces the dominance of these methods in practice. In another study Pocock, Correia and Wormald (1991) found that 58% of firms employed Sensitivity Analysis whilst only 15% of firms used simulation. These results support the conclusions of Parry and Firer (1990) and Correia and Cramer (2008) that there is a low usage of Monte Carlo (computer) simulation but a much higher use of sensitivity analysis. Pocock, Correia and Wormald (1991) also found that 15% of firms surveyed employed Beta Analysis in risk appraisal and the rand size of the project and its payback period were important in assessing risk. Therefore, Figure 6 indicates limited growth in the use of such sophisticated methods as decision trees and Monte Carlo simulation over the 20 years from 1986 to 2006. Hall (2001) in 1998 investigated the risk analysis techniques employed by South African firms. The results add up to 100% and it is assumed that firms have responded by indicating the most important method employed rather than which methods were used (which would add up to more than 100%). Interestingly, Hall reported that 37% of South African firms do not employ risk analysis in project evaluation. Sensitivity analysis was the most important method used by 31% of firms. It is relevant to distinguish between risk assessment and risk adjustment. Risk assessment refers to the process of measuring project risk while risk adjustment refers to the method used to include risk in the process of project evaluation, such as increasing the required hurdle rate by a risk premium or shortening the required pay-back period. Risk assessment is used to determine the required risk premium whilst risk adjustment is the inclusion of the risk premium in the method of project evaluation. In the United Kingdom, Pike (1996) recorded the increases in the use of risk appraisal techniques for capital budgeting, however, Pike (1996) does not appear to differentiate between risk assessment and risk adjustment. Pike indicated that the most popular risk appraisal method was found to be the use of Sensitivity Analysis. This is followed by the use of shortened payback and the adjustment to the required return. Probabilities and Beta analysis have shown increases in usage off low bases. 18 S.Afr.J.Bus.Manage.2012,43(2) Figure 5: The use of sensitivity analysis in SA and the UK Figure 6: Quantitative methods used to assess risk S.Afr.J.Bus.Manage.2012,43(2) 25 available to encourage investment in plant and machinery and factory buildings. The cost of capital is also based on the after tax cost of financing. Therefore, it is surprising that some surveys found that there are a sizable number of firms which are not adjusting cash flows for income tax. Lambrechts (1976) found that 50% of the firms which employed the ARR method did not take tax into account. Unfortunately, he does not indicate the percentages for firms employing DCF techniques which do not adjust cash flows for taxation. Reeve (1981) does not indicate whether firms have adjusted cash flows for income tax and Andrews and Butler (1986), as well as Parry and Firer (1990) do not address this issue. The survey by Coltman (1995) found that 70,8% of companies evaluate projects on an after tax basis. This means that a sizable number of firms (29,2%) do not take tax into account in evaluating capital projects. Kester et al. (1999) reported in his survey of capital budgeting practices within the Asia-Pacific region that although the majority of respondents indicated that cash flows are determined after tax, a sizable minority of firms in Hong Kong (41%), the Philippines (40%) and Singapore (42%) evaluated future cash flows before tax. In Australia, 27% of firms and 29% of firms in Malaysia evaluate cash flows before tax whilst in Indonesia only 7% of firms evaluate future project cash flows before tax. Whilst firms may decide to employ a before tax discount rate to discount before tax cash flows, further research is required to determine the motivations of firms. Otherwise, there are a minority of firms who are not including tax in the evaluation of capital projects. This is further accentuated if firms are subject to depreciation tax shields. The use of APV is limited as this may have pointed to the separate valuation of tax shields. Danielson and Scott (2006) in their survey of the capital budgeting practices of small firms in the USA found that 26% of firms did not assess or evaluate the tax consequences of investment decisions. The performance of companies who have adopted DCF methods The adoption of sophisticated capital budgeting techniques should result in superior firm performance and a number of empirical studies have tested the relationship between capital budgeting practices and firm performance. Klammer (1973) tested the relationship between the rate of return on investment and the use of sophisticated capital budgeting techniques, but found no significant relationship between these two variables. Haka, Gordon and Pinches (1985) used market returns as the measure of performance and tested the adoption of sophisticated techniques in relation to firm performance as measured by changes in share prices. Sample companies were divided into an experimental group, which adopted sophisticated techniques and a control group which employed naive methods to evaluate projects. The study found that the adoption of sophisticated techniques did not, per se, result in superior firm performance. However, firms that adopted DCF techniques were on average experiencing declining returns in relation to the returns achieved by the control group, prior to the adoption of such sophisticated techniques and were able to show positive short run effects after these firms adopted DCF techniques. The adoption of sophisticated techniques may therefore simply reflect a response to economic stress and the adoption of these methods enabled the firms to at least match the performance of the companies in the control group. Kim and Farragher (1982) found a significant relationship between earnings performance and capital budgeting practices. Earnings performance was measured by after-tax operating cash flows in relation to operating assets. The variable, “sophisticated techniques” was defined more comprehensively than in other studies by requiring adherence to nine criteria and therefore measured the level of sophistication of capital budgeting practices by additional factors than the simple adoption by firms of sophisticated techniques. For South Africa, Andrews and Butler (1986) state that firms that are sophisticated in their approach to capital investment, as measured by specified criteria, were found to be more profitable and experienced faster growth rates. The adherence to the concept of the maximisation of shareholder wealth is more closely met by the use of DCF techniques and this represented the primary indicator of the level of sophistication of firms in undertaking project evaluations. Coltman (1995) employs Cumulative Abnormal Returns to compare the results of DCF dominant firms relative to the performance of Non-DCF dominant firms. Responding firms which employed DCF methods for more than 75% of the time were classified as DCF dominant firms and firms which did not employ DCF methods for more than 75% of the time were classified as Non-DCF dominant firms. Market returns for each firm were compared to their respective sector returns to calculate annual abnormal returns. These annual abnormal returns were then accumulated to obtain the cumulative abnormal return (CAR) for each period. Data on share returns and sector returns were obtained from the Bureau of Financial Analysis (BFA) network. The CARs of DCF-dominant firms and Non-DCF dominant firms is plotted in Figure 12. Coltman (1995) states that based on the respective CARs of the DCF dominant firms relative to the CARs of the Non- DCF dominant firms, the adoption of sophisticated techniques did not result in superior firm performance. In fact, the CAR plots indicate that the Non-DCF firms outperformed the firms which employed DCF methods to evaluate projects. However, Coltman found that in the last two years of his study, DCF firms strongly outperformed non-DCF firms. The evidence in this regard is inconsistent. International surveys have reported no evidence of superior firm performance, yet the adoption of DCF methods may reflect a response to firms experiencing economic stress. For South Africa, Coltman found evidence that the adoption of sophisticated capital budgeting techniques over the whole period under review did not result in superior firm 26 S.Afr.J.Bus.Manage.2012,43(2) performance, although in the latter years, DCF firms did outperform non-DCF firms. Further research is required in this area in respect to the methodology employed, the selection of sector indices and firm selection as well as defining what represents the use of sophisticated capital budgeting techniques. Capital budgeting decisions and shareholder wealth Is capital budgeting consistent with the maximisation of shareholder wealth in South Africa? Bhana (2008) analysed 378 capital expenditure decisions in the period 1995 to 2004 and found significant positive excess returns for shareholders in the period around such capital expenditure announcements, particularly for focused firms. This may indicate that capital budgeting decisions add value to shareholders. Real options A major development in finance theory is to include embedded real options and project flexibility in the valuation of capital projects. NPV analysis may be enhanced by the inclusion and analysis of real options in the evaluation of capital projects. Yet, in the USA, Block (2007) surveyed the Fortune 1000 firms and found that only 14% of responding companies used real option analysis to enhance the results arising from the traditional NPV and IRR analysis of capital projects. However, the survey also found that 44% of non-users in the USA indicated they would consider the use of real option analysis in the future. Kester et al. (1999), found for the USA, UK, Netherlands, Germany and particularly France, that from 26% to 53% of firms incorporate real options when evaluating projects. This may indicate a qualitative analysis of project flexibility rather than applying a formal real option valuation methodology. Ryan and Ryan (2002) found very limited use of real option analysis by Fortune 1000 companies with 89% of companies never or rarely ever using real option analysis. In the UK, Alkaraan and Northcott (2006) reported that only 3.6% of respondents regarded the application of the real options approach as important and only another 16.9% of companies regarded this approach to be of average importance. The limited use of formal real option analysis in the UK is confirmed by MacDougall and Pike (2003). Correia and Cramer (2008) found that only 10,7% of companies in South Africa used real option analysis. In the section on risk analysis, Correia and Cramer (2008) found that 14% of South African companies evaluated abandonment and expansion options. Further, the survey also found that South African companies made limited use of Monte Carlo simulation, decision trees and APV, techniques which may be linked to real option analysis. Mokenela (2006) surveyed the top 40 listed firms on the JSE Securities Exchange and found that only 9% of responding firms used real options in project evaluation. This result is in line with the results of Correia and Cramer (2008). However, Mokenela (2006) also reported that managers recognise the value of project flexibility even if they may not quantify the value of project flexibility in a real option valuation model setting. The reasons given for the non-use of real options in the USA relates to the lack of top management support, the level of complexity and the view that the use of real options encouraged excessive risk taking. Management may view the use of real option analysis to ensure project acceptance when NPV or IRR analysis may indicate that projects should not be accepted. Yet the use of IRR may have a similar impact if the implied reinvestment rate assumption is not likely to be attained in the future. The existence of real operating options means that the use of the NPV technique may be questionable unless specific provision is made for the value of real operating options available to firms undertaking capital projects. Therefore, in a broader context, we cannot simply praise the ascendancy of NPV but need to take into account the value of real options. The existence of real options would impact on all the methods used to evaluate capital investments but will more closely align the concepts of strategic planning and capital budgeting. Further issues included in South African capital budgeting surveys Hall (2000) in his survey found that the most important (66%) and most difficult stage (46%) in the capital budgeting process was project definition and cash flow estimation. This is set out in Figure 13. In contrast, only 29% of companies found the financial analysis and project selection stage to be the most difficult and 26% found it to be the most important stage. The project implementation and project review stages were viewed by most companies to be relatively unimportant and not difficult although companies did regard project implementation to involve some risk. Project definition and cash flow estimation was also regarded as the most risky stage of the capital budgeting process. The reason why Hall’s results are relevant is that it clearly indicates that the most important and most difficult stage, project definition and cash flow estimation, is not reflected in many of the research surveys to date. Almost all the surveys have researched the financial analysis and project selection stage. These results are confirmed by Brijlal and Quesada (2008) for businesses in the Western Cape, who found that 56% of firms identified project definition to be the most important stage in capital budgeting, whilst only 26% of firms identified the analysis and selection phase to be the most important stage in capital budgeting. Only Gilbert (2005) investigates the capital budgeting process in greater detail in relation to the project identification and cash flow estimation phase, as well as the other phases, in a case study analysis of two firms. S.Afr.J.Bus.Manage.2012,43(2) 27 Figure 12: Cumulative abnormal returns - DCF vs Non-DCF firms Figure 13: Most important and most difficult stages in capital budgeting Future research needs to increasingly explore issues that arise in the project definition and cash flow estimation stage. Burns and Walker (2009) in their survey of capital budgeting surveys in the USA confirm that there has been too much focus in the survey literature on the selection stage and too little research has been undertaken on the other stages of the capital budgeting process. Conclusion Despite the limitations of comparing surveys in South Africa over time, it is clear that there has been significant growth in the use of DCF capital budgeting techniques, a trend which is consistent with financial theory. Practice is moving closer to theory and the gap between theory and practice in relation to the adoption of DCF capital budgeting methods by firms is no longer a major consideration for academic study. In particular, there has been a dramatic increase in the use of NPV over the last thirty years and there has been a fall in the use of Payback and the Accounting rate of return methods. Yet, IRR remains the primary method used in project evaluation despite the fact that finance theory states that there are major disadvantages in the use of IRR as compared to NPV. In relation to project risk analysis, the most popular methods are sensitivity analysis and there has been a significant growth in the use of scenario analysis. There has been very little growth in the use of such methods as Monte Carlo simulation and decision tree analysis over the last 20 years. Although firms undertake risk analysis of projects, most firms do not use risk adjusted discount rates and may use the discount rate for the firm to discount expected future cash 28 S.Afr.J.Bus.Manage.2012,43(2) flows. Most firms tend to use a combination of capital budgeting methods to evaluate projects. The survey literature indicates that larger firms tend to use DCF methods such as IRR and NPV and small firms make greater use of Payback and ROI (ARR). Most surveys indicate a preference for NPV by larger firms but there is also survey evidence that large companies prefer IRR. In the mining sector most companies use NPV. In South Africa close to nine out of ten companies undertake post completion audits. However, further research is required to understand the nature and impact of such post completion audits and the forecasting accuracy in relation to revenues and costs. In South Africa, unlike the USA, most firms discount inflation-adjusted cash flows at the cost of capital. The discounting of inflation-adjusted cash flows at a nominal discount rate is in line with finance theory. There is limited use by South African companies of such methods as MIRR, EVA, APV and real option analysis. Further, the ranking of mutually exclusive projects by South African companies is not aligned with finance theory. However, firms seem to recognise, if not quantifiably value, project flexibility. In line with finance theory, most South African firms evaluate projects on the basis of after-tax cash flows. The evidence presented is inconclusive in respect to the relative performance of DCF firms and non-DCF firms, yet DCF dominant firms do not appear to outperform non-DCF firms. Further research needs to be undertaken to measure the relative performance of companies that have adopted DCF methods as compared to companies which use naive methods to evaluate capital projects. Although a number of capital budgeting practices are increasingly in line with finance theory, there remain unexplained differences between practice and theory relation to such issues as the continuing importance of IRR, the low use of advanced methods such as Monte Carlo simulation, MIRR and risk adjusted discount rates. Further, the survey literature has placed too much emphasis on the selection phase of the capital investment and future research should increasingly focus on the identification and control phases of capital investment. References Alkraan, F. & Northcott, D. 2006. ‘Strategic capital investment decision-making: A role for emergent analysis tools? A study of practice in large UK manufacturing companies’, British Accounting Review, 38:149-173. Andrews, G.S. & Butler, F. 1986. ‘Criteria for major investment decisions’, The Investment Analysts Journal, 27:31-37. Arnold, G.C. & Hatzopoulos, P.D. 2000. ‘The theorypractice gap in capital budgeting: evidence from the United Kingdom’, Journal of Business Finance and Accounting, 27(5&6):603–626. Bhana, N. 2008. ‘The market reaction to capital expenditure announcements’, The Investment Analysts Journal, 68: 53- 64. Blazouske, J.D., Carlin, I. & Kim, S.H. 1988. ‘Current capital budgeting practices in Canada’, CMA Magazine, 62(2): 51-54. Block, S. 2007. ‘Are 'real options' actually used in the real world?’, The Engineering Economist, 52(3): 255-268. Brijlal, P. & Quesada, L. 2008. ‘The use of capital budgeting techniques in businesses: A perspective from the Western Cape’. Conference Proceedings. 21st Australasian Finance and Banking Conference, Australian School of Business, The University of New South Wales, December, Sydney, pp.2136-2152. Burns, R.M. & Walker, J. 2009. ‘Capital budgeting surveys - the future is now’, Journal of Applied Finance, 1&2: 78- 90. Brounen, D., De Jong, A. & Koedijk, K. 2004. ‘Corporate finance in Europe: Confronting theory with practice’, Financial Management, 33(4): 71-101. Coltman, G. 1995. ‘An analysis of capital budgeting techniques and their impact on shareholder wealth’ B.Com (Hons) unpublished technical report, University of Cape Town. Copeland, T. & Antikarov, V. 2001. Real options: A practitioner’s guide. New York: Texere LLC. Copeland, T. & Keenan, P. 1998. ‘Making real options real’, The McKinsey Quarterly, 3: 128-141. Correia, C. & Cramer, P. 2008. ‘An analysis of cost of capital, capital structure and capital budgeting practices: A survey of South African listed companies’, Meditari Accountancy Research, 16(2): 31-52. Correia, C., Flynn, D., Uliana. E. & Wormald, M. 2007. Financial management. 6th Edition. Cape Town: Juta. Correia, C. & Uliana, E. 2004. ‘Market segmentation and the cost of equity of companies listed on the Johannesburg Stock Exchange’, South African Journal of Accounting Research, 18(1): 65-86. Danielson, M.G. & Scott, J.A. 2006. ‘The capital budgeting decisions of small businesses’, Journal of Applied Finance, Fall/Winter: 45-56. Dixit, A.K. & Pindyk, R.S. 1995. ‘The options approach to capital investment’, Harvard Business Review, May/June: 105-115. Du Toit, M.J. & Pienaar, A. 2005. ‘A review of the capital budgeting behaviour of large South African firms’, Meditari Accountancy Research, 13(1): 19-27. S.Afr.J.Bus.Manage.2012,43(2) 29 Freeman, M. & Hobbes, G. 1991. ‘Capital budgeting: Theory versus practice’, Australian Accountant, 61: 36-41. Gilbert, E. 2003. ‘Do managers of South African manufacturing firms make optimal capital investment decisions?’ South African Journal of Business Management, 34(2): 11-17. Gilbert, E. 2005. ‘Capital budgeting: A case study analysis of the role of formal evaluation techniques in the decision making process’, South African Journal of Accounting Research, 19(1): 19-36. Gitman, L. J. & Forrester, J. R. 1977. ‘A survey of capital budgeting techniques used by major U.S. firms’, Financial Management, 6: 66-71. Graham, J.R. & Harvey, C.R. 2001. ‘The theory and practice of corporate finance: Evidence from the field’, Journal of Financial Economics, 60: 187-243. Haka, S. G. L. & Pinches, G. 1985. ‘Sophisticated capital budgeting selection techniques and firm performance’, Accounting Review, 60(4): 651-669. Hall, J.H. 2000. ‘Investigating aspects of the capital budgeting process used in the evaluation of investment projects’, South African Journal of Economic & Management Sciences, 3(3): 353-368. Hall, J.H. 2001. ‘Risk analysis and evaluation of capital investment projects’, South African Journal of Economic & Management Sciences, 4(2): 398-368. Hogaboam, L.S. & Shook, S.R. 2004. ‘Capital budgeting practices in the U.S. forest products industry: A reappraisal’, Forest Products Journal, 54(12): 149-158. Kellerher, J.C. & MacCormack, J.J. 2004. ‘Internal rate of return: a cautionary tale’, McKinsey on Finance, Summer: 16–19. Kester, G., Chang, R., Echanis, E., Haikal, S., Isa, M., Skully, M., Kai-Chong, T. & Chi-Jeng, W. 1999. ‘Capital budgeting practices in the Asia-Pacific Region: Australia, Hong Kong, Indonesia, Malaysia, Philippines, and Singapore’, Financial Practice and Education, 9(1): 25-33. Kim, S.H. & Farragher, E.J. 1982. ‘An empirical study on the relationship between capital budgeting practices and earnings performance’, Engineering Economist, Spring: 185-196. Kim, S.H. & Ulferts, G. 1996. ‘A summary of multinational capital budgeting studies’, Managerial Finance, 22(1): 75- 85. Klammer, T. 1973. ‘The association of capital budgeting techniques with firm performance’, The Accounting Review, 48(2):353-364. Lambrechts, I.J. 1976. ‘The practice of capital investment decision-making in South Africa’, The Investment Analysts Journal, 8:27-31. MacDougall, S.L. & Pike, R.H. 2003. ‘Consider your options: Changes to strategic value during implementation of advanced manufacturing technology’, Omega, 31(1):1– 15. McKinsey & Co. 2007. ‘How companies spend their money: A McKinsey Global Survey’, McKinsey Quarterly, June. McMahon, R. 1981. ‘The determination and use of investment hurdle rates in capital budgeting: A survey of Australian practice’, Accounting and Finance, 21(1): 15-25. Mokenela, L. 2006. ‘Managerial flexibility using ROV: A survey of top 40 JSE listed companies’. Unpublished M.Com thesis, University of Stellenbosch. Parry, H.M.A. & Firer, C. 1990. ‘Capital budgeting under uncertainty: An empirical study’, Investment Analysts Journal, 21(3): 52-58. Pike, R. 1996. ‘A longitudinal survey on capital budgeting practices’, Journal of Business Finance & Accounting, 23(1):79-92. Pocock, A.S., Correia, C. & Wormald, M. 1991. ‘An analysis of the approaches used by industrial companies listed on the JSE to identify their cost of capital’, South African Journal of Accounting Research (De Ratione), 5(1): 27-40. Reeve, R. 1981. ‘Business investment decisions under inflation: Some South African evidence’, The Investment Analysts Journal, 18: 9-17. Ryan, P.A. & Ryan, G.P. 2002. ‘Capital budgeting practices of the Fortune 1000: How have things changed?’ Journal of Business and Management, 8(4): 355-364. Shao, L.P., & Shao, A.T. 1996. ‘Risk analysis and capital budgeting techniques of U.S. multinational enterprises,’ Managerial Finance, 22(1):41-57. Soares, J.O., Countinho, M.C. & Martins, C.V. 2007. ‘Forecasting errors in capital budgeting: A multi-firm postaudit study’, The Engineering Economist, 52:21-39. Trigeorgis, L. 1993. ‘Topics in real options and applications’, Financial Management, 22(3):202–223. Truong, G., Partington, G. & Peat, M. 2008. ‘Cost-of-capital estimation and capital-budgeting practice in Australia’, Australian Journal of Management, 33(1):95-121. Waweru, N.M., Hoque, Z. & Uliana, E. 2005. ‘A survey of management accounting practices in South Africa’, International Journal of Accounting, Auditing and Performance Evaluation, 2(3): 226–263.