* Investment Decision Making in an Entrepreneurial Firm: An Application

§ 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, and bankers to provide key input in the capital budgeting process.

§ discounted cash flow techniques → NPV, IRR and payback are very popular

§ CAPM → the most popular asset pricing model

§ cross-border adjustments → rarely used

§ corporations tend to disregard firm-related unsystematic risks

§ The smallness of entrepreneurial firms creates unique problems in application of traditional capital budgeting principles.

§ 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

§ Stein (2002) → found that a decentralized approach to capital budgeting often found in smaller firms works best when information about a project is "soft" → cannot be credibly transmitted within the organization.

§ 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

§ 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

§ larger firms are more likely to use the NPV method or the IRR method when evaluating foreign direct investments than smaller firms

The Investment Decision Process:

§ Total risk is more important than unsystematic risk in computation of a small business's cost of equity

§ Bailes at al. (1979) note that smaller firms are less likely to use any risk measurement techniques

§ Discounted cash flow techniques are the most preferred capital budgeting decision criteria used in the industry

§ 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.