The Capital Budgeting Decisions of Small Businesses

Introduction

• This paper try to explain why while large firms tend to rely on the discounted cash flow analysis favored by finance texts, many small firms evaluate projects using the payback period or the owner’s gut feel.
• The US Small Business Administration estimates that small businesses (they define as firms with fewer than 500 employees) produce 50 % of private GDP in the U.S., and employ 60 % of the private sector in labor force. Many small businesses were service oriented which is doesn’t need substantial capital investment.
• But, according to the 1997 Economic Census, over 50 % small businesses are in agriculture, manufacturing, construction, transportation, wholesale, and retail where all industries requiring substantial capital investment. Thus, capital investments in small businesses are important to both the individual firms and the overall company.
• Several reasons why small firms and large firms might use different criteria to evaluate projects:
• Small business owners may balance wealth maximization (the goal of a firm budgeting theory) against other objectives—such as maintaining independence of business when making investment decision.
• Small firms lack the personnel resources of larger firms and, therefore, may not have the time or the expertise to analyze projects in the same depth as larger firms.
• Some small firms face capital constraints, making project liquidity a prime concern.
• The author define small businesses as firms with fewer than 250 employees, they use the survey data collected for the National Federation of Independent Business (NFIB) Research Foundation by the Gallup Organization.
• The data includes information about the type of investments the firm makes (e.g., replacement versus expansion), the primary tools used to evaluate projects (e.g., discounted cash flow analysis, payback period), the firm’s use of other planning tools (e.g., cash flow projection, capital budgets, and tax planning activities), and the owner’s willingness to finance projects with debt. The survey also includes demographic variables that allow the author to examine the relation between capital budgeting practice and firm characteristics such as size, sales growth, industry, owner age, owner education level, and business age.
• 50 % of the small-business owners surveyed do not have a college degree. Yet, there are also specific business reasons why DCF analysis may not be the best project evaluation tool for every small firm, for example, 45 % of the sample would delay a promising investment until it could be financed internally generated funds, suggesting the firms face real capital constrains.
• And the author also found that the most important class of investment is “replacement” for almost 50 % of the firms. So the DCF calculations may not be required to justify replacement investments if the owner is committed to maintaining the firm as a going concern and if the firm has limited options about how and when to replace equipment.
• Finally, investment s in new product lines are the most important class of investments for almost one quarter of the sample firms. Because the ultimate success of this investment is uncertain.

Capital Budgeting Theory

• Barley and Myers (2003) present a simple rule managers can use to make capital budgeting decision: Invest in all positive NPV projects and reject those with a negative NPV.
• The objective of the rule is to maximize shareholder’s wealth.
• Because the PV is a complete measure of a project’s contribution to shareholder wealth, there is no need for the firm to consider alternative capital budgeting tools, such as payback period or accounting rate of return.
• There are at least three reasons question the applicability of this theory to small firms:

• Shareholder wealth maximization may not be the objective of every small firm. The objectives of small firms can be an alternative to unemployment as a way to avoid employment boredom, to invent new product, etc.
• Many small firms have limited management resources, and lack expertise in finance and accounting. Because of these, they may not evaluate projects using DCF.
• Capital market imperfections, which constrain the financing options for small firms.

Summary of the Article

• Firms with fewer than 250 employees analyze potential investments using much less sophisticated methods than those recommended by capital budgeting theory.
• In particular, survey results show these businesses use DCF less frequently than gut feel, payback period, and accounting rate of return.
• The reason why small businesses differ so dramatically from the recommendation of theory:

• Many small business owners have limited formal education, and their firms may have incomplete management teams.
• Small sizes.
• Small businesses do not operate in the perfect capital markets that capital budgeting theory assumes.
• Many investments that small firms make can not easily be evaluated using DCF techniques recommended by Capital Budgeting Theory.