It is vital for firms to get capital budgeting right as their ability to survive, grow and stay ahead of the competition depends on it

Capital is an important area in financial management, as is evident by the huge amount of research this field has attracted over the last eight decades. This has given the academic world many doctrines like the Markowitz Portfolio Theory and the Modigliani and Miller Code of Capital Structure, to name a few. Then there is the Fama French Capital Asset Pricing Model, the Sharpe Index Model, the Black Scholes Option Pricing Model and so on. However, things have changed drastically in the business world due to the advent of globalisation, rapid developments in technology and environmental degradation.

Hence, the applicability of the theories and models of the last century in today’s fluid environment is questionable. Even Nobel Prize-winning models and theories, taught as a mandatory part of the curriculum, may not be practical to use in the real business scenarios created by the ongoing pandemic. Capital budgeting decisions, such as acquiring existing assets and investing in new ones, product and technology development and adoption of new business processes hold importance to finance managers as these decisions always involve huge investments for a long-term and are irreversible in nature.

So it is important for organisations to get capital budgeting decisions right as their ability to survive, sustain, grow and stay ahead of the competition, even in a crisis, depends on them. Capital budgeting choices are strategic in nature as they can have a role in long-term corporate performance. Overall, there are 12 capital budgeting techniques that are used in organisations based on their suitability: Net Present Value (NPV), Internal Rate of Return (IRR), Payback (PB), Discounted Payback (DPB), Accounting Rate of Return (ARR), Profitability Index (PI), Annuity, Price-Earnings Ratio (P/E), Sensitivity Analysis, Adjusted Present Value (APV), Value at Risk and Real Options.

However, the traditional capital budgeting techniques have  come under criticism for not including the use of advance technology in the manufacturing process overlooking the competitiveness of organisations. Several researchers have pointed out the gaps in the Capital Budgeting Theory and its relevance. The current health emergency has further shown that uncertainty is something that will stay with us and for survival and long-term growth, this, along with other factors, has to be taken into account.

There are several sources of uncertainties ranging from routine issues like cash flow estimations, to more obscure ones like opportunity cost of capital. One of the most difficult issues facing researchers and businesses is the question of identifying and capturing uncertainties related to long-term projects. Therefore, over the years, the traditional capital budgeting decision techniques are being supported by risk analysis and management science techniques, like the Monte Carlo simulations, Game Theory, Decision Trees, Capital Asset Pricing Model, scenario analysis and so on.

The inclusion of managers in a capital budgeting decision is imperative. Therefore, they are taken at a higher level such as president, controller, finance director or treasurer. In addition, several psychological characteristics like age, gender, schooling, technical expertise, experience and manager personality play an important role in decision-making.

So which capital techniques do Indian companies use? Since liberalisation, the country’s economic environment has become integrated with the world economy and Indian organisations are subject to business turbulences, like a slowdown, competition and risks such as interest rate, inflation risk, business exposure, exchange rate hazard and so on. In such conditions, only firms with effective decision-making and sound financial management practices can survive and grow. Therefore, corporate investment decision-making is important for any organisation.

Batra and Verma in their research paper published in the IIMB Management Review have found that in 85 per cent organisations, capital budgeting decisions are taken by the senior management and the mid-level management is involved in just nine per cent of the firms. Indian businesses have become sophisticated in the use of capital budgeting decisions. A majority of companies adopt superior Discounted Cash Flow (DCF) techniques like NPV, IRR with advanced techniques like Real Options and simulations. However, the easier and non-DCF technique of Payback is still regarded as the second best option. Some firms also use both, DCF and non-DCF techniques, to evaluate their projects.

Companies have to change their decision-making tools to face the growing ambiguities in today’s world. They must do this in order to meet the challenges that will be thrown up by a post-Covid world too, as economies around the world strive to recover from the bashing that they have taken due to the pandemic. Use of sophisticated capital budgeting tools and factoring in uncertainty will help Indian companies tide through volatility and thrive in the long run.

(The writer is Associate Professor, Amity University, Noida. The views expressed are personal)