CAPITAL BUDGETING DECISSIONS OF SMALL BUSINESS

CAPITAL BUDGETING DECISSIONS OF SMALL BUSINESS
(Morris G. Danielson and Jonathan A. Scoot)

INTRODUCTION

“This paper analyze the capital budgeting practices of small firm”
· Small firm (≤500 employees)à produces 50% private US GDPà employ 60% of private sector labor force.
· All industries requiring substantial capital investmentàcapital investment in small business also important.
· Several reason (different criteria to evaluate project):
may balance wealth maximization
lack of personnel resources
face capital constrainà making project liquidity a prime concern
· methodology:
ü data collected from NFIB (secondary data)
ü Result include the information about types of investment firm makes (replacement versus expansion)
ü Tools: DCF analysis, payback period (evaluate project), Cash flow projection, Capital budgeting, and tax planning activities (planning), and the last one is use the owner willingness.
· Survey: small and large firm evaluate project differently, lack of sophistication contributes to these result, most class investment is “replacement”, and investment in new product are the most important classes.
· The result in this research, suggest that optimal method of capital budgeting analysis can differ between large and small firm.

I. CAPITAL BUDGETING THEORY and SMALL FIRM
· “Basic theory” Brealey and Myers (2003): “invest in all positive NPV project and reject those with negative NPV” à concern with maximize shareholder wealth à yet small firm often operate in environment that do not satisfy the assumption underlying the basic capital budgeting model.
· Discuss the potential problem in detail and explain why discounted cash flow analysis is not necessarily the one best capital budgeting decision tool for every small firm.

A. Capital budgeting Assumption and the small firm
· Capital Budgeting theoryà primary goalà maximize firm value
· Three :
1. Shareholder wealth maximization may not be the objective of every small firm
2. Many small firms have limited management resources and lack expertise in finance and accounting.
3. Capital market imperfection, which constrain the financing option for small firms.
B. Cash Flow Estimation Issue
“DCF analysis is less valuable when the level of future cash flows is more uncertain”
There are also reasons why a small firm may not use DCF analysisi to evaluate replacement decision.
Small firm do not satisfy the theoryà natural for small firm to evaluate profect using different technique than a larger one.
II. DESCRIPTION of DATA
· Using the survey data
+ Long history in finance literature
- measure mangers belief not their auction
Not be representative the defined population
May misunderstood by some participant
· Data from NFIB in April and May 2003
III. SURVEY RESULT
· Using NFIB survey à address 3 question:
whether the investment and financing activity of small firm conform to the assumption underlying capital budgeting theory
look at the overall planning activities of small firm
provide evidence
· Identify significant differences between average responses.
· Using a multinomial logit to evaluate how the choice of investment evaluation tools is related to a set of firm characteristics.
A. Investment Activity
These results suggest three reasons for a small firm might not to follow the prescription of capital budgeting theory:
1. It is noteworthy that replacement activity is the most important type of investment for almost sample firm.
2. The result suggests that many small firms place internal limits on the amount they will borrow. Thus, many firm cannot separate investment and financing decisions, contrary to capital budgeting theory
3. The results suggest that the personal financial planning considerations of business owners may affect the investment and financial decisions of small firm.
B. Planning Activity
· Many small firm don’t have a formal planning system
· Firm with the highest growth rate are more likely to use each these planning tools
· Newer firm likely to use business plan
· The smallest firm are less likely to make cash flow projections
· Planning activities strongly related to the educational background of the business owners.
C. Project Evaluation Method
· Using gut feel, payback period, the accounting rate of return, DCF (the most theoretically correct method).
· The result is different with (Graham and Harvey (2001)), approximately 75% of their firm evaluate projects using estimates of projects NPV or IRR
· “It is therefore not surprising that their firm use more sophisticated method of project analysis.
D. Multivariate Analysis
· Use the multinomial logit (are represented that affect the decision tools most frequently used to assess the financial viability of a project) to jointly identify factors influencing the choice of a project evaluation tools.
· The result *** see on the paper***
IV. SUMMARY
· Firm with fewer than 250 employees analyze potential investment using much less sophisticated methods than those recommended by capital budgeting theory
· Many small-business owners have limited formal education, and their firm may have incomplete management teams
· Reason: àMany small business do not operate in the perfect capital market that capital budgeting theory assumes
àMany of investment that small firms make cannot easily be evaluated using the DCF techniques recommended by capital budgeting theory

MANY SMALL FIRM FACE CAPITAL BUDGETIGN CHALLENGES THAT DIFFER FROM THOSE FACED BY LARGER FIRMS.