Entrepreneural Issues

Chapter 10
Capital Budgeting

The capital budgeting techniques discussed in this chapter are appropriate for use when evaluating proposed investment projects in both small, or entrepreneurial, and large firms. Conceptually, there is no difference between the value-maximizing capital investment techniques used by large and entrepreneurial firms. In practice, however, there are often significant differences between the capital budgeting procedures used by entrepreneurial firms and larger firms.

As we have seen, larger firms tend to use the net present value and the internal rate of return approaches to evaluate proposed capital expenditures. A study by Runyon of firms with a net worth under $1 million found that nearly 70 percent used payback or another technically incorrect procedure, such as the accounting rate of return, to evaluate capital expenditures. Several of the firms surveyed reported that they performed no formal analysis of proposed capital expenditures.12

Several reasons have been advanced to explain the dramatic differences in the practice of capital expenditure analysis between large and entrepreneurial firms. First, many entrepreneurs may simply lack the expertise needed to implement formal analysis procedures. Or managerial talent may tend to be stretched to its limits in many entrepreneurial firms, such that the managers simply cannot find the time to implement better project evaluation techniques. Also, one must recognize that implementing and maintaining a sophisticated capital budgeting system is expensive. Large fixed costs are associated with putting a formal system in place, and continuing costs are associated with collecting the data necessary for the system to function effectively. In entrepreneurial firms, investment projects tend to be small, and they may not justify the cost of a complete, formal analysis.

The emphasis on the use of payback techniques by entrepreneurial firms may also reflect the critical cash shortages that face many small and rapidly expanding firms. Because of their limited access to the capital markets for additional funds, these firms may be more concerned with the speed of cash generation from a project than with the profitability of the project.

Regardless of these impediments to the use of value-maximizing capital budgeting techniques, entrepreneurs have an excellent opportunity to improve their competitive position by implementing effective managerial control techniques. Entrepreneurs who rely on incorrect techniques, such as payback, to make their project accept-reject decisions are more likely to make poor investment decisions than managers who analyze their investment projects correctly.

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