Introduction:
§ The paper analyzes the capital budgeting practices of small firms
§ Small firms → Employed less than 500 employees
§ In 1997 → Small Business include → agriculture, manufacturing, constructions, transportations, wholesale → industries that require substantial capital investment.
§ Several reasons
o First, small business owners may balance wealth maximization → in making decisions
o Second, Small firms lack personnel resources → may not have the time or expertise to analyze projects
o Finally, some small firms face capital constrains → making project liquidity a prime concerns
§ To document the capital budgeting practice in the small firms → Survey from NFIB → Primary tools used to evaluate project & planning tools & also the owners’ willingness to finance the projects with debt.
§ Result Small firms & Large Firms → different
§ Large firms tend to rely on discounted cash flow
§ Less than 15% small firms use discounted cash flow
§ But Over 30% small firms do NOT estimate cash flows AT ALL
§ Reason → Small business owners surveyed → do not have a college degree
I. Capital Budgeting Theory:
§ Brealey and Myers (2003) → simple capital budgeting decisions → invest in all positive net present value projects and reject those with a negative net present value
§ This decisions → maximizing shareholders wealth → therefore do not need to consider alternative capital budgeting tools, such as payback period or accounting rate of return → Small firms cannot be able to make reliable estimates of future cash flows.
- Capital Budgeting Assumptions and the Small Firms
o First, shareholders wealth maximization may NOT be the objective of small firms → in each case primary goal of entrepreneur → to maintain the viability of the firm
o Second, small firms have limited management resources → lack expertise in finance and accounting → so may not evaluate projects using discounted cash flows.
o Finally, capital market imperfections → constrains the financing options for small firms. → Ang (1991) notes → access to public capital markets can be expensive for certain small firms and impossible for others.
o Small firms more concern → How quickly a project will generate cash flows? → payback period.
- Cash Flow Estimation Issues
o Booth (1996) concludes → discounted cash flow analysis is less valuable → when the level of future cash flows is more uncertain
o Discounted cash flow analysis will be less valuable to evaluate venture that are not directly related to current activities
o Discounted cash flows → could be used in the small firms → but because of firm’s size → Cash flow analysis will not be cost effective
o That’s why small firms may not rely exclusively on discounted cash flow analysis
II. Description of data
§ Demographic characteristics of the sample → industry, sales growth, business age, employment, owner education, and owner age
§ 72% of the sample firms are → service 20%, construction / manufacturing 24%, retail / wholesale 48%.
§ High growth category define as → a cumulative increase of 20% or more over the pas 2 years → includes 24% of the sample firms.
§ 24% of the firms also report two year sales declines of 10% or more
§ Therefore → approximately 75% of the sample firms have experienced an average annualized growth rate of 10% or less over the pas two years.
§ Thus many → capital budgeting of small business focused on → maintaining the current level of service and quality → rather than expansion.
§ The mean number of total employees is 4 → only 16% that have only 1 employee and → only 18% have 10 employees or more
§ Over 50% business owners do not have a four year college degree
§ Only 13% have
§ Therefore → many small-business owners may have incomplete or even incorrect understanding of how capital budgeting alternatives should be evaluated
III. Survey Results
- Investment and Financing Activities
o Identify the firms’ most important type of investment over the previous 12 months → reports the percentage of firms that will delay a potentially profitable investment
o Replacement:
· Firms in service are more likely to this response → but firms in constructions and manufacturing are less likely.
· Firms with high growth rate but age less then 6 years → less likely than the average sample firm
· Finally the replacement activities increases with the business owner over 44 than the business owner is younger than 44
o New product line:
· Firms in service industry → Less likely
· Firms with higher growth rate → More likely than the lower growth rate firms’.
· Oldest firms were → less likely than the average firm to be considering expansion a new product lines
o Wait for Cash:
· Wait for cash → Youngest firms, smallest firms, and owners that have not a college degree
· Almeida, Campello, and Weisbach → Capital constrains will make a firm more likely to save cash.
o Three reasons small firms not follow Capital Budgeting Theory:
· First, it is Not Worthy replacement activities is the most important type of investment for almost half of the sample firms. Maintaining viability of the firms is becoming more concern of the owner rather than maximizing its value.
· Second, the result suggest that many small firms place internal limits on the amount they will borrow → Cannot separate investment and financing decisions → contrary with capital budgeting theory
· Finally, personal financial planning considerations of business owners may affect the investment and financing decisions of small firms.
· These result conflicts with the capital budgeting theory → The transferability of ownership interest allows managers to separate the planning horizon of a business from the planning horizon of its owners.
- Planning Activity
o How frequently forms estimate cash flows in making capital budgeting decisions
§ 30% do not estimate the future cash flows
§ Smallest firms → (Three or less employees) → are less likely to make cash floe projections
§ Larger firms → (ten or more employees) → more likely to make and use their estimations
o Whether they have written business plans
§ Only 31% have written their business plan
§ Newer firms → (less than 6 years old) and younger owners → (less than 45 years old) → more likely to use or build the business plan before they run the firm
o Whether they consider tax implications in making capital budgeting decisions
§ 26% do not consider tax implications
- Project Evaluation Methods
o Gut feel:
§ → Owners without a college degree resort to it most frequently use this rather than → Owners with advance degree
§ Firms with cash flow projections are significantly less likely to rely on guts feel.
§ Difficulties that occur because of the other side of the firms → (Transportations in service industry) → gut feel play there
o Payback Period:
§ Used more often by the wait for the cash firms
§ Firms using the payback period → significantly more likely than other firms to estimate future cash flows
§ Finally → use of the payback period appears to increase with the formal education of the business owner
o Accounting rate of return:
§ → Increases with the firms growth rates significantly higher → than the sample mean for firms entering new lines of business
o Discounted Cash Flows:
§ Primary investment evaluations method of only 12% of the firms
§ Firms use discounted cash flows → use business plans and consider the tax implications of investment
§ Discounted cash flow analysis is useful when evaluating projects with the similar project profiles to current operations
- Multivariate Analysis
o This techniques appropriate when an unordered response, such as a set of project evaluation tools, ahs more than two outcomes
o Firms using any of the formal investment evaluation tools are more likely to make cash flow projections than firms using gut feel
o Firms using accounting rate of return, discounted cash flow or both → more likely to consider tax implications
o Gut feel → Have less structured planning
IV. Summary
§ Firms with fewer than 250 employees analyze potential investment using much less sophisticated methods
§ Discounted cash flow analysis used → Less frequent than gut feel, payback period, and accounting rate of return
§ Most of the firms in sample are very small → Fewer than 10 employees → Have short operating histories → almost 50% Under 10 years → The owner also not college educated → may have limitations in their bank credit, posing credit constrains.
§ Many investment that small business make → cannot easily evaluated using the discounted cash flow techniques that recommended by capital budgeting theory
§ For these reasons, small firms face capital budgeting challenges that differ from the larger firms. Make it possible → optimal budgeting methods in small and large firm → may differ.
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