Investment Decision Making in an Entrepreneurial Firm: An Application

Abstract (Summary)

This paper is a case study of a capital budgeting decision made in a small manufacturing plant in Torrance, California. The firm manufactures generic type of laser cartridges for use in monochromatic laser printers and has a distribution network all over the United States. The firm is considering the purchase of automation equipment which will increase its production three-fold, and will use the excess production to serve the Latin American markets, including Mexico. It has been in operation for over 4 years and has experienced substantial growth since prices of laser printers have fallen. The data represented in this case study is from the 2006-2007 fiscal year and is used to show the benefits of implementing good capital budgeting techniques in a small, rapidly growing entrepreneurial firm. This paper will discuss the current capital budgeting process, problems, and proposed solutions in the framework of entrepreneurial finance. [PUBLICATION ABSTRACT]

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Copyright Journal of American Academy of Business Mar 2008

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ABSTRACT

This paper is a case study of a capital budgeting decision made in a small manufacturing plant in Torrance, California. The firm manufactures generic type of laser cartridges for use in monochromatic laser printers and has a distribution network all over the United States. The firm is considering the purchase of automation equipment which will increase its production three-fold, and will use the excess production to serve the Latin American markets, including Mexico. It has been in operation for over 4 years and has experienced substantial growth since prices of laser printers have fallen. The data represented in this case study is from the 2006-2007 fiscal year and is used to show the benefits of implementing good capital budgeting techniques in a small, rapidly growing entrepreneurial firm. This paper will discuss the current capital budgeting process, problems, and proposed solutions in the framework of entrepreneurial finance.

INTRODUCTION

Small entrepreneurial firms are typically run by single owners who may lack financial expertise to evaluate investment proposals. They may rely on their personal accountants, tax advisors, bankers to provide key input in the capital budgeting process. Many studies have been undertaken to evaluate methods used in capital budgeting in small firms.

Pereiro (2002) looked at Argentinian firms and found that (a) discounted cash flow techniques like NPV, IRR and payback are very popular among corporations and financial advisors; (b) the CAPM is the most popular asset pricing model (c) cross-border adjustments to U.S. multiples and betas are rarely used by corporations; and (d) corporations tend to disregard firm-related unsystematic risks, like small size and illiquidity.

Results of mainstream capital budgeting research typically apply to large firms. The smallness of entrepreneurial firms creates unique problems in application of traditional capital budgeting principles. For instance, Banz (1981), Chan, Chen & Hsieh (1985) & Fama & French, 1992 have documented firm related unsystematic risk to be a key issue for very small firms.

Small firms are also prone to violent changes in profitability when faced with economic downturns than large firms which tend to be diversified as well as have access to financial resources. This 'small size' effect culminates in a higher discount rate when evaluating capital investment proposals. Studies have found this effect to be substantial (for e.g. Pratt (2001)) whereas others have not found it to be significant (Amihud, Christensen and Mendelson, and Black, cited in Jagannathan & McGrattan, 1995). Pereiro (2002) finds that none of the firms in his sample made any adjustments for their small size in the discount rate used in capital budgeting. Hall & Weiss (1967) noted that large firms have all the options of a small firm, and can also undertake large scale projects which the small firms are excluded from.

In a study of firms using sophisticated capital budgeting practices, Verbeteen (2006) found that large firms have a tendency to use them as opposed to small firms. Earlier research by Williams and Seaman, 2001 and Rogers (1995) had also confirmed their findings. Large firms seem to have more at stake and are more likely to have the available resources to use sophisticated capital budgeting practices (Chenhall and Langfield-Smith, 1998; Ho and Pike, 1998). Other empirical research has also indicated that size has an impact on capital budgeting practices (Farragher et al., 2001; Ho and Pike, 1996; Klammer et al., 1991). Stein (2002) found that a decentralized approach to capital budgeting often found in smaller firms works best when information about a project is "soft" and cannot be credibly transmitted within the organization.

In a behavioral study by Boot et al (2005), a junior analyst's behavior towards capital budgeting is more a reflection of his assessment of how his boss views him rather than an analysis of the project itself. In other words, the analyst tends to agree with his boss' prior beliefs about acceptability or not of a project rather than come up with a totally objective analysis. This problem is particularly crucial in small, entrepreneurial firms where the chain of command between the decision making authority and the analyst is very small. In another study, found that smaller firms tend to have less complex, more interpersonal evaluation system. Marino and Matsusaka (2002) state that the choice of a particular decision making process in a firm is a function of the agency problem, quality of information and project risk.

Holmen & Pramborg (2006) found that larger firms are more likely to use the NPV method or the IRR method when evaluating foreign direct investments than smaller firms. They also found that larger firms and public firms are also more likely to use real option methods when evaluating FDIs. They defined a firm to be small if its sales were less than $ 100 m.

This paper is organized as follows. The following section discusses prior research in the investment decision process. This is followed by a case study of an entrepreneurial firm involved in making a capital equipment decision. Results of numerical analysis are provided thereafter and the paper concludes with general comments.

The Investment Decision Process:

Palliam (2005) and Reeb et al. (1998) argues that total risk is more important than unsystematic risk in computation of a small business's cost of equity. In a survey of small and large firms in the U.S. forest products industry, Bailes at al. (1979) note that smaller firms are less likely to use any risk measurement techniques. In a later study of the same industry, Hogaboom and Shook (2004) find that discounted cash flow techniques are the most preferred capital budgeting decision criteria used in the industry. Some larger firms have started using more sophisticated evaluation methods, such as economic value analysis. These results have been corroborated by , Keasey and Watson (1993) and McMahon et al. (1993). It has been established widely in academic literature that small firms are often remiss in using the appropriate technique while evaluating projects. This evidence comes from domestic and international studies. For example, North American evidence can be found in by Soldofsky (1964), Luoma (1967), Scott et al. (1972), Walker (1975), Grablowsky and Burns (1980), Pattillo (1981), Runyon (1983) and Pope (1986). United Kingdom evidence is provided by Corner (1967), Murphy (1979), Pattillo (1981), Hankinson (1984), Arnold-McCulloch and Lewis (1986) and Peel and Wilson (1996). Evidence for Australia, is provided by Holmes (1986, 1987).

In a recent study by Danielson & Scott (2005), small business owners are most likely to use relatively unsophisticated project evaluation tools due to their limited educational background, small staff sizes, and liquidity concerns.

Example of Investment Decision Making By an Entrepreneurial Firm:

Decision making on a project of a small firm can be best described by an example. Typical features of a small firm project are incorporated, though the details may vary from firm to firm.

Mr John Smith is the owner of a small manufacturing company in Torrance, California. The firm is a limited liability company which manufactures generic type of laser cartridges for use in monochromatic laser printers and has a distribution network all over the United States. The company is considering the purchase of automation equipment which will increase its production three-fold, and will use the excess production to serve the Latin American markets, including Mexico. The firm has been in operation for over 4 years and has experienced substantial growth since prices of laser printers have fallen in recent years. John has considered other options of increasing his production. There are competing firms located in Arizona and Missouri with which he can collaborate to increase his production. This option is not palatable to him as it would mean giving up control, as well as profits to a competitor. He considered outsourcing production in Taiwan and China but he quickly gave up that option for quality control issues, as well as his lack of experience in international business. After consulting his vendors he decided to increase his own production by buying state-of-the art equipment. A salesman from the equipment manufacturing company visited him last month and provided the following details:

The delivered cost of the equipment would be $ 2.5 million. The manufacturer recommends that set-up be done by certified installers or they can do that for an extra $ 300,000. In addition, training will need to be provided on the proper use of the equipment. Training costs were separate and the manufacturer will charge $ 1000 per employee. Currently, John has 11 employees working in his plant, and he plans on training all of them.

The equipment will replace the existing machinery which was occupying 2/3rd of the current factory space. The new equipment will require 3/4th of the current factory space, with the additional coming from unused factory space. The existing machinery has a book value of $ 670,000 but it can no longer be used in another facility or sold to another manufacturer. Consequently, it will be scrapped and the costs of hauling it away will amount to $ 100,000. The vendor of the new equipment is willing to haul it away for free.

Once the new equipment is installed and running, the cost per unit of making a laser cartridge will drop from $ 33 to $ 17. The maximum production capacity of the new equipment will be 300,000 units a year, but John believes it is likely to operate at 60 % capacity. The equipment will be written off using the 3-year MACRS depreciation schedule, though John plans on using it for at least 5 years. He expects the capacity to increase by 10 % every year until it reaches full capacity in the 5 year. The new equipment is likely to become obsolete in the 3r year, but John plans on using it for 2 more years.

John plans on buying an extended warranty from the manufacturer for $ 100,000 a year for 5 years. This warranty will take care of any break downs, or mechanical problems should they occur during the normal operation of the equipment. John will need to spend an additional $ 1000 per month on utility costs, as well as $ 2000 per year for special tools to keep it running in peak condition.

John pays state and federal taxes on his income at 40 % and expects the tax rate to continue for the next 5 years. In the current business, John earns a net return of 19 % after paying taxes. Since he is taking a chance of tripling his production without having assurance of increased sales, he expects this equipment should earn at least 25 % to compensate him for the extra risk. He would also like to get his money back within 3 years. John would like to know if it is feasible to produce at 100 % from day 1 and use the excess production (assuming 60 % capacity to be normal production capacity) to cater to foreign markets. Since overseas markets are more competitive, John anticipates spending $ 200,000 per year more on marketing efforts in those countries.

John wants to know if he should buy the new equipment, and if so, if he should produce and sell locally or produce and sell globally.

ANALYSIS

John performs the following analysis in evaluating his investment decision: [insert table i here]

According to his analysis, John should go ahead and buy the equipment as it yields a positive net present value. John can expect to get the cost of his equipment back within 15 months. This investment will end up increasing his personal wealth, if he were to go ahead with the purchase decision.

Summary and concluding comments

We have described one of the investment decision process made by an entrepreneur. Our literature survey shows that discounted cashflow techniques like NPV, IRR and payback are very popular among corporations and advisors. When used correctly, these techniques can help entrepreneurs allocate scarce resources wisely.