Capital Budgeting Practices: A Survey in the Firms in Cyprus

Article excerpt

Introduction

Cyprus is a small country with some special characteristics: first, its geographic position as it stands between east and west; and second, its eventual joining to the European Community. According to the Union of Industrial and Employers' Confederations of Europe (UNICE), Cyprus is expected to be ready to confront competition and pressures in the common market, since it is an important place of economic activities among Europe, North Africa, and the Middle East.

To meet this competition and pressures successfully, Cyprus's businesses need imperatively today more than ever an increase in the volume of their investments and a readjustment of their investment policy. The need for a readjustment of their investment policy is the result of important differences that exist between the capital budgeting practices in Cyprus and those used in the United States (Cooper and Petry 1994; Gitman and Mercurio 1982; Kim and Farragher 1981; Schall 1978; Fama 1977; Fregren 1973; Klammer 1972) and other European countries. Specifically, most American and European firms use scientific evaluation methods (Vogt 1994; Pinches 1982; Perty 1975), whereas Cypriot firms use empirical ones. This may be explained by the fact that Cypriot entrepreneurs are reluctant to use new evaluation methods since they rely basically on the past and their experience.

The purpose of this paper is to investigate (1) the methods used by the Cyprus companies to evaluate investments (the ones that are materialized); and (2) the approach adopted to handle important estimation problems inherent to the use of these methods, such as the definition and estimation of the cost of capital and the incorporation of risk analysis in the evaluation methods used (Woods and Randall 1989). More specifically, the second section of the paper focuses on the review of the literature associated with the use of capital budgeting techniques in practice. The third section explains the methodology used in the implementation of the survey. The fourth section gives a short summary of the profile of the sample companies. The fifth section presents and analyzes the results of the survey, and the last section of the paper presents conclusions and provides suggestions for further research.

Review of Literature

Gitman and Forrester (1977)'s research, based on a survey of 268 U.S. firms, found that the internal rate of return was the most popular technique at that time. This finding was supported by a similar survey conducted by Scott and Petty (1984) for large U.S. firms. The findings of this research were that the companies prefer the IRR method, with the payback period being a supplementary tool. As far as the discount rate used, they found that the primary one is a management-determined target rate of return followed by the weighted cost of capital.

Academicians, as we all know, prefer the net present value (NPV) method for capital budgeting decisions. Practitioners, on the other hand, prefer the internal rate of return (IRR) method, as several other studies have revealed. For example, the study of Pan, Nichols, and Joy (1977) presented some evidence regarding the current state of the art of business sales forecasting practices.

McDaniel, McCarty, and Jessell (1988), developed an alternative yield-based capital budgeting technique, the marginal return on invested capital (MRIC). This technique, the authors proved, can be applied more generally than other yield-based methods used as substitutes for the NPV technique. Porter (1992) stated that U.S. companies use hurdle rates that are higher than their estimated cost of capital for the evaluation of investment projects. Harris and Raviv (1996) studied the capital allocation process within firms. They constructed a model that incorporated managerial incentive problems and asymmetric information and showed that in an optimal capital budgeting process, the top manager specifies an initial limit for capital spending that can be upgraded after further examinations and audits. …