Ebook Capital budgeting: A case study analysis of the role of formal evaluation techniques in the decision making process
only if they add to the value of the firm. If we assume that managers act so to maximize the value of the firm, managers should then identify, and undertake, all projects that add value to the company so as to maximise shareholder value.
This theory of capital investment decision-making implies that managers should establish the expected value that a project is expected to create. This should be done through the use of value based or discounted cash flow (DCF) techniques, in particular, the net present value (NPV) approach. Capital investment decisions should then be based on these estimates of value.
Multiple surveys indicate that managers do not always use DCF techniques and that when they do, they are used in conjunction with other, theoretically deficient, techniques such as Payback Period (PP). While these surveys highlight the existence of the gap between prescribed and observed behaviour in this area, they do not suggest why this is the case. There is, thus, a need for an explicit analysis of the relative role played by formal evaluation techniques in the capital investment decision making process.
In order to address this gap, case study analysis of two capital investment decisions made by manufacturing firms in South Africa was undertaken with a particular focus on identifying the role played by formal evaluation techniques in the decisions taken. This provides new evidence that allows for an enhanced understanding of the role of these techniques in capital budgeting decisions.
The structure of this paper is as follows. A brief discussion of both the value maximising model of capital investment decision-making and the survey data concerning its descriptive accuracy is presented in the next section. Details of two investment decisions are presented, with a particular focus on the role played by DCF evaluation techniques in the decision-making process. The key differences between the traditional model of capital investment decision-making and the observed behaviour are summarised and, finally, the implications of this for further research are discussed.
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