UTILIZATION OF CAPITAL BUDGETING AS AN OPTIMAL TOOL FOR INVESTMENT ANALYSIS IN MANUFACTURING COMPANIES IN ENUGU AND ANAMBRA STATES
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INTRODUCTION
Background of the Study
A company is a form of business organization, a corporate body or a corporation, generally registered under the company‟s Act or similar legislations. It is a legal entity, created under an enabling law of the government, having unlimited life span and limited liability. Igben (2007) defines a company as a body corporate, having a distinct legal personality created by or under an enabling statute of the government. A company is a form of business organization, whose characteristics include; limited liability, corporate body, right to sue or be sued, enter into contracts, owe debts, pay debts, pay taxes, pay dividend from earnings, and neither the death nor the bankruptcy of any of its members can force it to liquidate (Chartered Institute of Management Accountants (CIMA), 2004).
Manufacturing companies are companies that convert raw materials and component parts into consumer, and or industrial goods (Garner, 2001). Manufacturing companies are companies that engage in production (i.e. business organizations which creates utility). The manufacturing sub-sector can be classified based on two major sub-division; either in accordance with area of coverage, or in relation to its capital base. Based on area of coverage, four distinct groups are identified, namely: the multi-nationals, the nationals, the regional and the local manufacturing companies. Based on size of capital, four companies can be identified, namely: the micro cottage, the small scale, the medium scale, and the large scale manufacturing companies. However, manufacturing companies as is used in this work refers essentially to companies that engage in productive activities and whose liability is limited, irrespective of size or area of coverage.
Micro-Cottage companies are those which have a total capital employed of not more than N1.5 million excluding cost of land and, or a workforce of not more than 10 persons. Small Scale companies have over N1.5 million but not more than N50 million excluding cost of land and, or 11 – 100 workers. The medium scale has over N50 million but not more than N200 million, excluding cost of land and, or 101 – 300 workers. Any company that has a capital of more than N200 million, excluding cost of land and, or more than 300 workers in its employ is classified large scale (National Council on Industry (NCI) 2004, in Eneh, 2005).
According to Eneh (2005) the large sums of capital involved in siting companies in the Urban areas had often made the growing manufacturing companies to be located in the suburb and rural areas. Urban areas Eneh referred to as places with many huge concrete buildings, shops, places of work, entertainment, worship centers, and with large concentration of people industries and social amenities. While rural areas are countryside which lack in some of these amenities and are underdeveloped. Other reasons for siting manufacturing companies in the rural areas which may affect capital budget include: government tax benefits, cheaper land, cheaper manpower, and nearness to raw material deposits.
The manufacturing sector has grown much in size that its level of intensity has become an acceptable index for measuring the economic prosperity of any nation (Okafor, 1983). High level of productive activities gives rise to abundance of consumer goods and services, thus facilitating improvement in the productive efficiency of the factor inputs. The factor inputs comprises of the primary factors (land, labour and other natural resources); and secondary or produced factor inputs of money, machine and other man-made resources. These produced factor inputs
according to Sadler (2003), are otherwise referred to as capital.
Capital consists of assets, monetary and non monetary, contributed by owners of a corporate organization to keep a business afloat. Association of Certified Chartered Accountants (ACCA) (1998) defined capital as the monetary and non monetary assets contributed by the owners of an enterprise (equity capital) and by the creditors (loan capital) to get the organization going. It refers to the right of a company to utilize the services of produced factor inputs. This right can be exercised either in the ownership and control of real assets or in that of the financial assets. Real assets are tangible assets, while financial assets are claims on income to be generated by real assets. The total value of real and financial assets available to an economic unit at any point in time constitutes its stock of capital (Gordon, 2004). Capital is a discrete variable. It is not measured over a given period, rather at a given or discrete time. As such, the design to increase, improve or maintain capital (i.e. investment) has to be planned and returns predetermined. The predetermination of investment returns before venturing into it keeps manufacturing companies on track, in the choice of investment.
Investment refers to assets acquisition by company for the purposes of capital appreciation and income generation (Nweze, 2004). It encompasses all economic activities designed to increase, improve or maintain the productive quality of existing stock of capital. When the stock of available capital falls below the quantity required to achieve the desired levels of output, the need for additional investment arises
(Williams, 2008). Consequently, the desired stock of capital depends basically on two factors; viz: (i) the volume of output, and (ii) the amount of capital stock required per unit of the output. It is the determination of this desired stock level of capital coupled with its relative rates of return (cashflow) that makes budget an inevitable tool for corporate existence.
A budget is a formal statement of a company‟s future plans which is usually expressed in monetary terms. It is an investment analytical tool which aids financial managers to make an informed managerial decision. The Chartered Institute of Management Accountants (CIMA), 2004) defined budget as a plan quantified in monetary terms, prepared and approved prior to a defined period of time, usually showing a planned income to be generated, and or expenditure to be incurred during that period, and the capital to be employed to attain a given objective. In essence, the budget of a company cannot be prepared in isolation of the firm‟s financial status – stock of capital.
Capital budgeting is the process of planning expenditure on assets whose returns are expected to extend beyond one year. Institute of Chartered Accountants of
Nigeria (ICAN) (2006) described capital budgeting as a firm‟s decision to invest its current funds most efficiently in long term assets in anticipation of an expected flow of benefits over a series of years. The ability to take capital budgeting decisions satisfactorily is dependent on the evaluation for proper use of capital budgeting techniques employed for investment analysis. The reason is that, every investment environment is usually surrounded by investment risks. Such risks include the „alpha‟ or non market imposed risks, and „beta‟ or the market imposed risks.
In other words, the effectiveness of capital budgeting as an investment tool for optimal investment decision is dependent on the management‟s ability to functionally utilize the capital budgeting evaluation criteria to obviate or minimize investment risks. Capital budgeting evaluation criteria is a combination of capital budgeting techniques and the risk adjusted techniques. The capital budgeting techniques include the discounted and the non discounted investment evaluation criteria, while the risk adjusted techniques are management strategies adopted by companies to avert or minimize investment risks. They include, the risk adjusted statistical techniques; the conventional techniques of risk analysis; the scenario analysis; and the sensitivity analysis.
In most companies, the finance unit constitutes a department, headed by the finance director. In the capital budgeting section, the management staff that usually constitute members are; the managing director, the finance manager, the internal auditor and the purchasing manager. The managing director is often the president of the firm and is responsible for all top level decisions including the introduction of change into the organization. The finance manager who is usually the head of the budgeting unit is responsible for obtaining and managing the company‟s fund. The internal auditor monitors, evaluates and reports to management on the internal control system of the company. While the purchasing manager takes charge of stock control and management, both of goods and property (Surridge and Gillespie, 2008).
However, most small and medium scale companies, due to capital constraints and cost implications of establishing a budget unit, utilize the services of an external provider. In essence, manufacturing companies that were not viable enough to establish a budget unit would require to outsource its capital budgeting decisions in order to achieve efficiency. Outsourcing refers to the utilization of external resources, the commission of the execution of tasks, function and processes as cannot be efficiently handled in-house to an external provider specializing in a given area (Koszewska, 2004).
Effective capital budgeting presupposes adequate timing of assets acquisition and rate of returns forecast. A manufacturing company which foresees the need to procure capital assets in time has the opportunity to install the assets before its sales are at capacity (Elijelly, 2004). Wrong forecast of capital assets‟ requirement plunders companies into adverse business consequences that may be very difficult to reverse. It can result in loss of company‟s market share to rivals, capacity underutilization, poor earnings and losses.
To achieve effective capital budgeting, management has to be guided by the company‟s corporate plan. Corporate planning entails establishing goals and suitable courses of action for achieving such goals. Management in order to achieve effective capital budgeting shall comply with the procedure established for such goal attainment. Nwude (2001) elaborated on the typical procedure en-route effective capital budgeting to include, establishing selection criteria; investigating proposals to determine their value and feasibility; comparing alternative projects; determining the financial needs, costs and resources; deciding on the projects to be implemented; allocating funds to their development; and controlling and reviewing results. This procedure otherwise referred to as capital budgeting decision process, is, according to Pandy (2006), termed capital investment analysis.
Investment Analysis entails adequate knowledge of cost of sales, estimate of yield, and formulation of optimal mix of securities to obtain higher yielding portfolios. It involves the evaluation of an investment through the establishment of cash flow, estimation of the required rate of return (the opportunity cost of capital) and the application of a decision rule for making the choice (Leloup, 1998). The implication is that, the most accurate investment analysis and subsequent decision can only be achieved in a predictable investment environment.
Nigerian investment environment is full of uncertainties that are often responsible for investment failure. These uncertainties Eneh (2005) elaborated, include: the uncertainty in the occurrence of future expectations caused by political factors; the uncertainty of economic climate caused by interest rate fluctuations, inflationary pressure, monetary and fiscal policy inconsistencies; uncertain social and cultural factors caused by the mood and belief inconsistencies of the citizenry; and the ever growing technological factors which affect the utilitarian purposes of capital asset‟s procurement. These uncertainties pose threat and are danger signals to the
Nigerian manufacturers; hence they are potentials for their incessant failure. Examples of moribund manufacturing companies in Enugu and Anambra states include, Niger-Delta Floor Mill, Umunya; Anambra Machine Tools and Foundry, Onitisha; Premier Breweries, Onitsha; Science Equipment Manufacturing Company, Akwuke; Brick Manufacturing Company, Akegbe Ugwu; Anambra Vegetable Oil, Nachi; Aluminum Product (ALPUM), Ohebe-Dim; to mention but a few.
In the South Eastern states, the Bureau for Public Enterprises noted that, most manufacturing companies disappeared in the last two decades due to unpredictable government policies, lack of basic raw materials (most of which are imported), high interest rates, non implementation of protective existing policies, lack of effective regulatory agencies, infrastructural inadequacies, unfair tariff and low patronage (BPE, 2004). Despite these risk factors noted above, and uncertain investment environment, Nzelibe (2000) contends that the prospects of Nigeria manufacturers are bright. According to him, giving the nation‟s nascent democracy, a market size of 140 million people, rich mineral and other resources, size of the West African market, as well as cheap and abundant labour; the prospects of manufacturing in Nigeria are bright.
Statement of the Problem
The manufacturing sub-sector in every economy serves as an engine for economic development, yet the manufacturing sub-sector in Nigeria, and Enugu and Anambra States in particular, has continued to decline in growth. This slow pace in growth can be traced to the „risk averse‟ economic environment which has discouraged diversification and expansion of local industries. The situation is further complicated by the political, economic and socio-cultural inconsistencies (Eneh, 2000).
A recent survey conducted by Eneh (2005) showed that 97.6% of Nigeria‟s industrial and manufacturing sub-sectors are made up of Micro Cottage, Small and
Medium Scale Enterprises (MSMSE‟s), and that three out of four of these firms fail every year; while nine out of the ten prospective entrepreneurs did not venture into the business. Similarly, Nzewi (2007) classified the state of the Nigerian Manufacturing Companies as follows: 30% closed down; 60% ailing and 10% operating at sustainable level. Nzewi furthered maintained that one of the major constraints identified is the business environment – the enabling conditions in terms of government policies, institutions, physical infrastructure, human resources and administrative services, are lacking. Nigeria‟s manufacturing sub-sector witnessed a
12% growth in 1976, and its contribution to Gross Domestic Product rose from 4% in 1973 to 13% in 1983; but turned a negative value of – 0.9% in 1999, from – 2.6% in 1994 (CBN Statistical Bulletin, 2001).
These rates of failures though may be partly blamed on the socio-political and economic inconsistencies of Nigeria investment environment, the adequacy, extent of use, and the efficiency of capital budgeting need to be ascertained. This is necessary because of the materiality of capital budgeting decisions, which its efficient application or otherwise, could determine the future prospect of the company. The problems of predicting events with certainty in an uncertain economic environment; the complex nature of capital budgeting application and method of computation; the sophistication of the capital budgeting evaluation techniques and risk measurement devices; and inadequate infrastructure and manpower, affect manufacturing companies‟ effective operations. These problems also militate against efficient utilization of capital budgeting for investment analysis in most manufacturing companies. The mass failure of industries in the manufacturing sub-sector which is presumed to have resulted from the improper use of capital budgeting for optimal investment analysis by manufacturers in Enugu and Anambra States necessitated this study.
Purpose of the Study
The major purpose of this study was to determine the extent to which capital budgeting is being utilized as a tool for optimal investment analysis in manufacturing companies in Enugu and Anambra states. Specifically, the study sought to:
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ascertain the extent to which capital budgeting processes aided corporate planning for long term survival of manufacturing companies,
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determine the extent of management‟s compliance to the use of capital budgeting techniques for investment decisions,
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determine the extent to which manufacturing companies utilize capital budgeting investment evaluation criteria for investment decisions,
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ascertain the extent to which outsourcing is utilized by manufacturing companies in taking capital expenditure decisions,
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determine the extent the use of capital budgeting techniques for investment analysis enhance the earnings of manufacturing companies,
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find out the constraints to effective use of capital budgeting for investment analysis‟ and
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determine the strategies for improving on the effective use of capital budgeting for investment analysis in manufacturing companies.
Research Questions
The following research questions guided the study:
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To what extent does the use of capital budgeting decision processes aid corporate planning for long term survival of manufacturing companies?
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What is the extent of management compliance to the use of capital budgeting techniques for investment analysis?
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To what extent does manufacturing companies utilize capital budgeting investment evaluation criteria for investment decisions?
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To what extent does manufacturing companies utilize outsourcing for capital expenditure decisions?
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To what extent does the use of capital budgeting techniques for investment analysis enhance the earnings of manufacturing companies?
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What are the constraints to the effective use of capital budgeting for investment analysis?
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What are the strategies for improving on effective use of capital budgeting for investment analysis?
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