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Missing Links in the Application of
Capital Budgeting in the Informal Sector
Chapter One
Introduction
1.1
Background of the Study
Capital is a very important factor in
any business. It determines the size of a business and to a large extent the
performance of such business. Capital intensity is not however all that a
business needs to make it. The investment portfolio plays a major role in the
success or failure of any business. Proper capital investment is the dream of
any investor and is the bedrock upon which the success of any business is
built. It is however evident that prudent capital investment entails prudent
capital budgeting. Proper budgeting begets well thought out investment. To the
well informed managers it implies budgeting that has been carried out from the
grassroots, involving all the persons concerned or all who should contribute
towards the realization of the budget expectations.
Capital budgeting is the process of
making long-term investment decisions that further the company’s goals. Capital
budgeting decision is concerned with efficient investment of available funds in
long term activities with anticipation of future benefits over a series of
years, so as to exert considerable influence on the overall growth of any
economy not just that of a firm (Von Horne 1980). Companies make many financial
decisions in order to grow, including selecting product lines, disposing of
business segments, choosing to lease or buy equipment and selecting
investments. To make a long- term investment decision in accordance with the
company’s goals, three basic tasks need to be addresses in the process of
evaluating capital budgeting. The tasks include estimating the expected cash
flows from the project, estimating the cost of capital, which is sorrogate for
the required rate of return, and applying a decision rule to determine whether
a project will be worthwhile for the company
Resources such as land, machine,
building, natural resources and manpower are in short supply and have
alternative uses (Von Horne1980). These resources once committed to capital
expenditure decisions of the firm have long- term implications and influence
the firm’s corporate image. In order to achieve the goal of the firm, which is
assumed to be maximization of shareholder’s wealth, it is imperative that the
impact of risk and uncertainty should as a matter of necessity, be recognized
and taken into consideration.
The term “risk’’ has different shades of
meaning. Literally, it means exposure to danger or economic adversity. In
general sense, risk is used as a surrogate for the likelihood of loss or the
potential size of such a loss. In this context we shall use the word to denote
exposure to loss arising from variations between the expected and the actual
outcome of investment decisions (Okafor,1983)
Adjusting for risk and uncertainty in
capital budgeting involves the use of both quantitative and qualitative tools.
Some of the quantitative tools include analysis of mean and variance,
accounting rate of return, payback period and the discounted cash flow (DCF)
methods such as net present value (NPV) internal rate of return (IRR) and
profitability index (PI). It is based on the above background this research
project intends to examine the impact of risk on capital budgeting decisions.
Missing Links in the Application of Capital Budgeting in the Informal Sector
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