Sunday, November 2, 2008

CAPITAL BUDGET TECHNIQUES AND APPLICATION IN NON CORPORATE ENVIRONMENT

TABLE OF CONTENTS
Content Page
ABSTRACT ………………………………………………………………….2
1.0 INTRODUCTION……………………………………………………….3
1.2 Objectives of the study…………………………………………………..3
1.2 Background information………………………………………………..3
2.0 LITERATURE REVIEW……………………………………………….4
2.1 Theoretical review……………………………………………………….4
2.2 Empirical review………………………………………………………...6
3.0 METHODOLOGY………………………………………………………7
3.1 Interview and Questionnaires…………………………………………..7
3.2 Quantitative and qualitative data………………………………………7
3.3 Hand books and internet review………………………………………..7
4.0 FINDINGS AND DISCUSSIONS……………………………………....8
4.1 Capital budgeting techniques case of NSSF……………………………8
4.2 Cost of capital (discount rate)…………………………………………...9
4.3 Risks……………………………………………………………………....9
4.4 Other variables…………………………………………………………..9
5.0 CONCLUSION………………………………………………………….12
6.0 REFERENCES…………………………………………………………..13
7.0 APPENDICES





ABSTRACT
The objective of the study is to find the practical use of the Capital Budgeting Techniques and their application in non-cooperative environment. Here we use NSSF as case study to find out which Capital Budgeting Technique is mostly used and why.
The National Social Security Fund was established by law in 1997. NSSF was set for the purpose of providing comprehensive social insurance services to its members. Over year’s members contributions and investments have increased. NSSF has 22,622 employees and operates all over the country (mainland). Capital for investments is financed by members’ contributions and fund generated from investments. NSSF is investing to be able to pay more benefits to members which are more than what they have contributed, to get income to finance its administrative expenses, to pay contribution to country’s economy instead of keeping money idle in the bank.
Empirical research on rate of adopting budgeting techniques, the IRR is reported to be more popular where as to use of PBP continues but as a secondary techniques.
For the case of NSSF techniques used are Present Value (NPV), Internal Rate of Return (IRR), Pay back Period (PBP), and Weighted Average Return on Investment (WAROI). During the exercise all techniques are used on each investment and compared to the operating environment and market in general. NSSF use different techniques because they normally investing in a different projects of different nature such as Real Estates, Equity shares, Loans – long term and short-term, treasurer bonds, bills and on Fixed deposits.



1.0 INTRODUCTION
1.2 Objectives of the study
The objective of the study is to find the practical use of the Capital Budgeting Techniques and their application in non-cooperate environment (public, not-for-profit organizations etc). In hereby we have taken the case of National Social Security Fund-NSSF and use its experience in using members’ contribution to invest in various areas so as to be able to pay members benefits which are obvious more than their contributions. Here we use NSSF case to find out which Capital Budgeting Technique is mostly used and why.
1.2 Background information
The National Social Security Fund was established by Act number 28 of 1997 become operation in July 1998, the Act repealed the Act number 36 of 1964 that established National Provident Fund (NPF).
NSSF was set for the purpose of providing comprehensive social insurance services to its members based on the international standards. There are four functions of the NSSF which are: Registration of employees and employers, Collection of contributions, Payments of benefits, and Investing on the viable projects.
NSSF provides seven benefits to its members which are old age pension, invalidity Pension, Funeral Grant, Survivors pension, Maternity benefit, Employment injury and social health insurance benefit.
Over year’s collection of contributions increased from Tshs. 44,414.99m. for year 2001/2002 to Tshs. 126,966.99m. for year 2005/2006 and expected to reach Tshs. 152,319.79m. by June 2007.
NSSF has employed 22,622 people, and its services covers all over the country and the members are all employees under the private sector, non-pensionable employees in the central government and public institutions who are not covered by other schemes.
NSSF capital is financed by members contributions and fund generated from investments. Under the general guidance of section 62 of NSSF Act number 28 of 1998 and the NSSF investment Policy reviewed from time to time. The policy guides NSSF where to invest and where not. It provides decision making criteria when to invest.
In 2006 NSSF had invested the members’ contribution in the government stocks, real estate properties, commercial loans, equity, treasury bills, fixed deposits, treasury bonds, corporate bonds, and commercial papers.
NSSF is investing to be able to pay more benefit to members than what they have contributed, to get income to finance its administrative expenses, to pay contribution to country’s economy instead of keeping money idle in the bank.

2.0 LITERATURE REVIEW
2.1 Theoretical review
Firm’s success requires strategic decisions. A strategic investment decision is a forward-looking process through which the future of the firm and that of the wealth of its shareholder is determined. Consequently, such decisions must be properly appraised and evaluated before being implemented. Hence the need to review: the investment process, the investment analysis techniques commonly used by managers to evaluate such alternatives (Dixon, 1994).
Investment means (Dixon, 1994) forgoing present consumption of resources in order to increase the total amount of resources which can be consumed in the future. Involves making an outlay of cash now in the expectation of extra cash inflow in the future. Its objective is to acquire an asset (real or financial) for less than its value in order to add value.
2.1.1 Why investment appraisal?
From their characteristics, we appraisal before investment because we commit resources into the future, involve substantial amounts of cash, are difficult and costly to reverse once taken, usually include intangible costs and benefits which are difficult to evaluate, require approval by higher organs within the organisation.
2.1.2 Appraisal techniques used in decision-making
Traditional or non-discounted cash flow (NDCF):
Payback Period (PBP); The PBP of a project is the number of years it takes before the cumulative forecasted cash flow equals the initial outlay. The PBP rule says - only accept projects that “payback” in the desired time frame. This method is very flawed, primarily because it ignores cash flows after the PBP, ignores the timing of cash flows and treats cash flows the same across the years (i.e. ignores TVM)
Despite the problems above, PBP is very useful because it: deals with cash flows rather than accounting profits, is used as a risk screening device, the longer it takes to recover the initial cash flow the greater the chances of something going wrong, is frequently used to supplement more sophisticated investment appraisal techniques, and is useful in circumstances where the company is facing liquidity difficulties.
Accounting Rate of Return (ARR) or Return on Investment (ROI); is the ratio of accounting profit to investment in the project expressed as percentage.
ARR limitations are: It ignores cash flows and uses accounting profits instead, It ignores the timing of return by taking a simple average, which gives equal weighting to each year’s returns, and ignores the time value of money.

Discounted cash flow (DCF) techniques:
Net Present Value is the difference between the PV of future CFs and the PV of the initial outlay, discounted at the firm’s cost of capital. Decision rule:“Accept the project if the actual PV of the expected benefits exceeds costs (NPV>=0),otherwise reject”
Internal Rate of Return (IRR), the rate of return, which equates the Present Value of future Cash Flows to the initial outlay, the rate of return such that the outlay equals future Cash Flows discounted at rate r. Decision Rule: “Accept the project if its IRR>investor’s required rate of return, otherwise reject”.
Problems with IRR are different cash flow profiles, differing size and scale of projects, and multiple rates of returns.
Profitability Index (PI); the ratio of Present Value of benefits to initial outlay. Decision rule: “accept the project if PI>1.00, otherwise reject”
2.2 Empirical review
Existence of empirical evidence on the application in both developed and developing world, corporate and non-corporate world
According to survey done by Graham and Harvey (2002) indicates that firm size significantly affects the practice of corporate finance. For example, large firms are significantly more likely to use net present value techniques, while small firms are more likely to use the payback criterion. A majority of large firms have a tight or somewhat tight target debt ratio, in contrast to only one-third of small firms. Empirical research (Kaijage:1994) done in the 1960 showed that conventional techniques especially PBP were very much relied upon decision making. Research findings by Istvan (1961); Pfolmn (1963) all bears to this testimony. Beginning in the early 1970s, more firms gradually changed from using conversional techniques in favour of Discount Cash Flow Technique. This include the work done by Klammer (1972); Gitman and Forrester (1977); Schell Sundem and Geijsbeck Jr (1978); Oblack and Helm (1980); Kim and Farrcher (1981) Pike (1988) in all above research confirmed that there has been an increase overtime in the rate of adopting budgeting techniques. The IRR is reported to be more popular where as te use of PBP continues but as a secondary techniques. According to the research of Kaijage himself still the DCFT considered valuable budgeting technique singing out the IRR to be the most popular technique.
With regard to the above findings this assessment has found a need how capital budgeting techniques used at non-corporate environment while most of the above research relied on business oriented sectors. Aim on looking for frequent used techniques and why are they important to be done before starting a project.

3.0 METHODOLOGY
During assessment, we used different methods and techniques.
3.1 Interview and Questionnaires
Interview was conducted to NSSF Officials, A list of attached questions were used as a special tool to guide discussion and interviews.Questionnaires distributed to respondents were in Kiswahili language purposely prepared to allow the respondents to understand and be able to offer appropriate answers in comfortable manner.
3.2 Quantitative and qualitative data
Information collected during the assessment were qualitative where descriptions of information collected were in form of explanations and quantitative data obtained in forms of numerical. Most of the quantitative data obtained from documents given by NSSF officials.
3.3 Hand books and internet review
Some books concern with capital budget techniques were reviewed during the assessment and internet assists to find out some theoretical reviews and empirical reviews on applications of capital budgeting techniques to assess proper projects for investment.

4.0 FINDINGS AND DISCUSSIONS
4.1 Capital budgeting techniques case of NSSF
Capital Budget techniques which are used to evaluate investments in the fund are Net Present Value (NPV), Internal Rate of Return (IRR), Pay back Period (PBP), and Weighted Average Return on Investment (WAROI). During the exercise all techniques are used on each investment and compared to the operating environment and market in general.
There is no most superior technique used at the fund even though through various documents show that Return on Investment (ROI) techniques used to evaluate investments performance annually and Pay Back Period (PBP) technique, but the assessment lack the evidence to show which one is used mostly. However it insisted that in order to make investment decision the NSSF uses all techniques according to the operating environment and market situation.
NPV-Net Present Value and IRR-Internal Rate of Return are found to be most difficult techniques to apply because they involve too much sophisticated formulas and calculations to use is not easy to learn than using ARR and PBP.
These techniques are not applied equally across different sizes of investments/projects for instance PBP may be used to invest in treasury bills and bonds and loans, while the large investments such as real estate all methods are used to find the viability of the anticipated investments. Meanwhile the NPV, IRR and Payback Period are used most to appraise the projects while the Return on Investment is mostly used to evaluate projects after a certain period of implementation to see the impact of the investment.


4.2 Cost of capital (discount rate)
There are several costs of capital used in the capital budgeting in the NSSF which include the ongoing interest rate, cost of equity, and internal rate of return.
4.3 Risks
In the project undertaken by the NSSF there are some risks involved such as low occupancy rates in some buildings, low uneconomical rental, high maintenance costs defaulters who do not pay rent on time delays to cover initial outlay and current value fluctuations.
However there are several techniques used to care off the potential risks such as investing more in less risks projects such as government securities, now NSSF is planning to build houses and sell them instead of holding them to avoid maintenance costs, difficult in rent collections and depreciation costs. Also NSSF has some principles of investment which are also there to escape risks, which are safety, to invest in areas which guarantee security of fund, Yield; to invest in areas which pay high yielding, Liquidity; to invest where there is guarantee of availability of liquidity to meet shot term obligations, maintenance of assets value, to direct fund in areas which will ensure positive real returns so as to maintain the value of assets of the fund and diversification for the purpose of minimizing risks.
4.4 Other variables
Cash flow in NSSF is determined by considering the effect of taxation, inflation, depreciation and interest expense.
Effect of tax is determined on the profit and not cash flow therefore to take into account the tax effects calculated from profit.
Inflation adjustment is also considered in the cash flow even though for the current years due to the country’s economy stability doesn’t take into account due to its minor effect since the rate is below 10 percent.
Depreciation is not applied in counting cash flow since it doesn’t involve typical cash but is just accounting adjustment to realize real accounting profit since in cash flow we are dealing with cash in and cash out therefore the effects of non cash flow do take into account.
In the economy stability, it is expected that inflation and interest rate continue to fall the NSSF Return on Investment falls too to reflect macro economic stability.
Issues of anticipating tax effect when making investment decision is the one of the big problem involved in making investment decision. Also the decision of not involving inflation rate by considering the existing economic stability may cause problems in counting real return on investment.

5.0 CONCLUSION
The NSSF is investing not for profit purposely but for the aim making sure earns something to pay as benefits to members, to pay for administrative costs and offer some economic contribution to the country’s economy
All NSSF’s investments have been selected after performing investment appraisal to see if they are viable or not. According to the findings all methods such as NPV, IRR, and Pay Back methods and ROI are used to determine the viability of the projects to invest, they use all methods in order to avoid risks that may incur incase of using one or some methods. During the evaluation of the investment each year of implementation, the ROI method is normally used to measure the impact and the extent of achievement of the project.
Despite of the weaknesses of each technique there are some advantages in appraising projects. As almost all projects of NSSF are doing so fine due to the proper selection done after using all mentioned capital budgeting techniques. In the way forward, further research is required to be done to see the frequency of each technique used, while for the shortage of time and resources these assessment failed to find how much each technique is used to appraise and evaluate the project.




















6.0 REFERENCES
1.0 Ngatuni (2008); Lecture notes
2.0 Mcmenamin J.(1999): Investment appraisal
3.0 Kaijage(1994) Paper on business management Review Journal
4.0 Graham and Harvey (2002); How do CFOs make capital budgeting and capital structure decision.

No comments: