The Capital Budgeting Decisions of Small Business

1. Introduction
§ Capital investments in the small business sector → important to both the individual firms and the overall economy
§ Small and large firms → use different criteria to evaluate the project
o Small business owners → balance wealth maximization against other objectives (e.g. independency of business)
o Small firms lack of personal resources → have no time or expertise as deep as the large firm
o Some small firms are capital constraints
§ Result of research:
o Types of investment the firm makes
o Tools to evaluate the project
o Firm’s use of other planning tools
o Owner’s willingness to finance project with debts
o Relation between capital budgeting practice and firm’s characteristics


2. Capital Budgeting Theory and Small Firms
§ Simple rule managers can use to make capital budgeting decisions
o Invest in all positive net present value projects and rejects those which have negative net present value
© Firms will make set of investment decision that will maximize the shareholder’s value
© No need to consider alternative capital budgeting tools → payback period or ARR
§ Problem → small firms often operated in environment that do not satisfy the basic capital budgeting model

A. Capital Budgeting Assumptions and the Small Firm
§ Capital budgeting theory → The primary goals of a firm’s shareholders is to maximize firm value
o Firm is assumed to have access to perfect financial markets
o Allowing it to finance all value enhancing projects
§ Reasons why it cannot be implemented to small firm
o Shareholder wealth maximization may not be the objectives of all small firms
o Many small firm have limited management resources → lack expertise in finance and accounting
o Capital market imperfections → constraint the financing options for small firm (wrong information)

B. Cash Flow Estimation Issues
§ Estimation issues managers must confront when implementing discounted cash flow analysis
§ Discounted cash flow is less valuable when the level of future cash flows is more uncertain
o Discounted cash flow analysis can be applied most directly to projects with cash flow profiles similar to the firm’s current operations
§ Small firms is considering investment in new product lines → future cash flow cannot be estimated directly from the past performance of the firm’s current operations
§ Small firms may not rely exclusively on discounted cash flow analysis when evaluating investments in new product lines
§ Small firms may not use discounted cash flow analysis to evaluate replacement decisions
o Small firm may have limited replacement options and differences in future maintenance costs of the various option can be difficult to forecast


3. Description of Data
§ Survey provide information that cannot be readily gleaned from financial statements
§ Survey can shed light on how firms make investment and financing decisions and why they use these approach
§ 72% of samples → construction, manufacturing, retail, all industries requiring substantial capital investment
o 20% is services industries


4. Survey Results
§ Three questions concerning the capital budgeting activities of small firms
o We consider whether the investment and financing activities of small firms conform to the assumptions underlying capital budgeting theory
o We look at the overall planning → identify firm’s characteristics
o We provide evidence about the specific project evaluation techniques small firms use

A. Investment Activity
§ The most important type of investment is replacement for 46% of the sample firms
o Firms in service industry are more likely select this response → firms in manufacturing industry were less likely
o Firms with highest growth rates and those who in business less than six years were less likely than the firm which report replacement activities as the primary investment type
o The importance of replacement activity increases with the age of the business owner
§ Project to extend existing product lines are shown as the primary investment activity for 21 % of the sample firms
o Construction and manufacturing firms, firms with highest growth, young firms → more likely to expand the existing project
o Low growth rates firms, oldest firms → less likely to expand the existing project
§ Many small firms face real capital constraints → wait for cash
o Youngest firms, the smallest firms, firms with older owners, and those whose owners does not have a college degree → wait for cash
§ Reasons why small firms might not follow the prescriptions of capital budgeting theory
o Replacement is not the most important type of activities
i. Maintaining the viability of the firm is going concern might be the owner’s objectives
o Many small firms place internal limits on the amount they will borrow
o Personal financial planning considerations of business owners may effect the investment and financing decisions of small firms

B. Planning Activity
§ 31 % of the sample firms have written business plan
§ Over 30 % of the sample firm do not estimate future cash flows
§ 26 % of the firms do not consider the tax implications of investment decisions
o Firms with highest growth rates, firms that extend business project, newer firms and younger owners, firms which the owners have college degree → more likely to have formal and complete business plan

C. Project Evaluation Methods
§ Primary tools firm use to assess a project’s financial viability → payback period, accounting rate of return, discounted cash flow analysis, “gut feel”, or combination
§ Use of Gut Feel → related to owner’s background → inverse with firm’s planning tools
o It is widely used by firms that make primarily replacement investments
o Small business owners use relatively unsophisticated methods of analysis to evaluate replacement options
o Gut Feel → Service industry
i. Firm’s primary considerations when evaluating the purchasing decision → cost, reliability, product features → structuring discounted cash flow is difficult
§ Payback period → used by firms that will use wait for cash
o Use of payback period → increase → related to educational level of owners
o Payback period can be a rational project evaluation tool for small firms facing capital constraints
§ Accounting Rate of Return → the use increase → with firm’s growth rates
o ARR → important → if firm must provide with periodic financial statements or is required to comply with loan covenants based on financial statement ratios
§ Discounted cash flow → primary evaluation method of only 12 % of the firms
o Firms with written business plan, those who consider taxes of investment, less than six years firms, and also firms extending existing product lines → more likely use this method

D. Multivariate Analysis
§ Using multinomial logit → jointly identify factors influencing the choice of a project evaluation tools
§ This technique → appropriate → when unordered response has more than two outcomes
§ Result
o Firms using any formal investment evaluation tools → more likely to make cash flow projection
o Firms using ARR, DCF, or a combination → more likely consider tax implications
o Capital constraints and the type of investment can influence how firms evaluate projects
o Wait for cash coefficient → positive and significant to both payback period and DCF
o Firms committed to funding projects internally are not necessarily irrational or unsophisticated
o ARR → the choice of firms pursuing either growth strategy, expand product lines or new product line
o The importance of DCF analysis → depend on the type of growth the firm is pursuing