Contents

CAPITAL FINANCING IN SME.................................................................................. 3

1.1

1.1.1

Stage 1: Start-up:.................................................................................... 4

1.1.2

Stage 2: Early growth:............................................................................. 4

1.1.3

Stage 3: Take-off:..................................................................................... 5

1.1.4

Stage 4: Maturity:.................................................................................... 5

1.2

Business life cycle:......................................................................................... 3

Finance gap:................................................................................................... 6

1.2.1

Long-term debt:....................................................................................... 6

1.2.2

Equity:..................................................................................................... 6

1.2.3

Flotation of small businesses:..................................................................6

CAPITAL BUDGETING IN THE SME:........................................................................7

2.1

Capital Budgeting Theory and Small Firms:...................................................8

2.2

Capital Budgeting Assumptions and the Small and medium enterprises:......9

2.3

Project Evaluation Methods in SME:.............................................................10

2.3.1

Gut feel:................................................................................................. 10

2.3.2

Payback period:..................................................................................... 11

2.3.3

Accounting rate of return:......................................................................11

2.3.4

Discounted cash flow analysis:..............................................................12

2.3.5

Combination of methods:......................................................................12

2.4

Summary:.................................................................................................... 13

2.5

The Importance of Capital Budgeting in current scenario:...........................14

2.5.1

Develop and formulate long-term strategic goals:................................14

2.5.2

Seek out new investment projects:........................................................14

2.5.3

Estimate and forecast future cash flows:...............................................14

2.5.4

Facilitate the transfer of information:....................................................14

2.5.5

Creation of Decision:............................................................................. 15

3 THE EFFECTS OF CAPITAL BUDGETING TECHNIQUES ON THE GROWTH OF MICRO

FINANCE ENTERPRISES............................................................................................. 15

3.1

Long-term Implications of Capital Budgeting:..............................................15

3.2

Involvement of large amount of funds in Capital Budgeting:.......................15

3.3

Risk and uncertainty in Capital budgeting:..................................................15

3.4

Long term Effect on Profitability:..................................................................16

3.5

Maximize the owners equity:......................................................................16

3.6

National Importance:................................................................................... 16

REFERENCES:..................................................................................................... 17

TOPIC: A) TYPICAL CAPITAL FINANCING AND

CAPITAL BUDGETING IN SME AND IMPORTANCE OF
THESE FACTORS ON IN CURRENT SCENARIO

TOPIC: B) OWN POINT OF VIEW ON THE EFFECTS

OF CAPITAL BUDGETING TECHNIQUES ON THE
GROWTH OF MICRO FINANCE ENTERPRISES
1 CAPITAL FINANCING IN SME
The SME sector ranges from the one-person sole trader to the manufacturing company with 199
employees. A large proportion of SMEs are, however, very small, having less than 5 employees.
When it comes to financing, the very small firms, and many of the remaining small firms which
do not intend to grow, tend to rely heavily on the equity and debt supplied by the founders,
friends, relatives, private backers, and trade credit, and debt from the capital market (especially
from banks).
Although financial problems figure largely in the reasons for the failure of such firms, these are
probably due more to lack of information and incompetence on the part of owner-managers than
the unavailability of finance.

1.1 Business life cycle:

There are an important, although small, proportion of SME operators who are growth-motivated
and have an enterprise that can grow. Such firms tend to have a business life cycle with
commensurate financing needs. See in the following Figure, which has one axis indicating time
and the other axis with a measure of SME growth (such as sales).

1.1.1
At

the

Stage 1:
Start-up:
start-up stage

the major source of finance is likely to be the private resources of the starter. These will tend to
be limited, even when supplemented in some cases by loans from friends, relatives and the
occasional private backer. Under-capitalization is a common cause of a crisis in Stage 1 with
subsequent failure. Trade credit will often become available, and debt from financial institutions
such as banks will only be available if the owner has collateral security, such as a home or other
property.
1.1.2 Stage 2: Early growth:
Early growth occurs as production, sales or services and a market develop. Staff, often part-time
or casual, will be added. Premises may be rented and equipment leased. Only limited funds come
from retained earnings. Although future prospects may be bright (but uncertain), the track record
of the business is limited and collateral security and personal guarantees have been fully utilized
to obtain short-term and medium-term debt, mainly from trading banks.
In these stages (and Stage 3) owners often resort to bootstrapping, that is, alternative means of
securing resources that do not require traditional funding. They acquire resources from customers
and suppliers as well as using their own resources. They buy used equipment, withhold staff
salaries, accelerate invoicing, negotiate conditions with suppliers, delay payment to suppliers,
and borrow equipment from other businesses.

Stages 1 and 2 comprise the establishment or infant stage of growth, perhaps three years of
critical development before the firm goes through the knothole into Stage 3, or closes.
1.1.3 Stage 3: Take-off:
Into the take-off stage a track record has been established for the ability of the owner and the
success of the product or service. Turnover increases rapidly and projections for future growth
are strong. Long-term funds become essential, especially for working capital, but here is the
problem for the business.
Retention is limited because although accounting profits may be growing, cash flow is low and is
needed to fund working capital. There is no proven junior share market for the flotation of
growing SMEs, and few investors are willing to purchase minority equity positions in unlisted
companies. Long-term debt is very hard to obtain from traditional sources, especially as the firm
has fully utilized its collateral security and the personal guarantees of owners.
This is the growth stage in which good financial management is absolutely critical.
Incompetence in financial management as well as the financing difficulties can create a liquidity
crisis and likely failure, especially if the firm was under-capitalized at inception but managed to
continue to Stage 3.
1.1.4 Stage 4: Maturity:
With adequate financial management and the acquisition of long-term finance, the firm may
continue to grow to a sufficient size to float on the ASX. Equity then becomes available as well
as a variety of other funds, and if it has not already done so, it soon joins the Big Business class.
Our stage model is much generalized, but it is sufficiently helpful to indicate the three trouble
spots in Australia for the financing of growth SMEs:
There is a shortage of long-term debt, especially in Stage 3.
There is a shortage of equity in Stages 1 and 3.
There may be an insufficient proportion of SMEs which proceed to public flotation in
Stage 4.

1.2 Finance gap:

In looking more closely at these three financing aspects, there is a finance gap in Australia for
SMEs.

1.2.1 Long-term debt:

In a 1991 survey by the Bureau of Industrial Economics of the sources of finance for
manufacturing small businesses, more than 80% of the firms received debt from banks, which
provide little long-term debt. The predominant forms of debt were mainly at-call debt (bank
overdraft), short term bills and traditional medium-term debt (term loans and finance leases).
There was limited use of other sources and forms of debt. There are two aspects of the debt gap.
1.2.1.1
The first is a lack of long-term debt:
Separately from residential mortgages, commercial bank debt is limited to term loans or leases of
three to five years or occasionally seven years.
1.2.1.2
Caused by the fact:
The second aspect is caused by the fact that not all small firms can provide collateral security
required by banks for debt finance.
1.2.2 Equity:
Large listed companies obtain their equity from financial institutions, overseas investors, other
companies and private individuals. Small companies seeking equity have a more restricted set of
options. About 80% comes from owners or related family, only 2.5% from financial institutions
and effectively nil from overseas investors. Individual investors and other businesses provide
minimal equity.
Closely held SMEs have difficulty in raising new equity. Finding new partners or investors is
difficult even if the owner is willing to accept some dilution of ownership and control of his or
her business. One reason is that it is difficult to sell such shares at a later date when there is no
recognized market. See later for more discussion of equity for SMEs and their investment
readiness.
1.2.3 Flotation of small businesses:
There are strict requirements and high costs for small companies, such as those in the take-off
stage of growth, wishing to float and be listed on the stock exchange. Moreover, the costs of the
flotation procedure are proportionately higher for small than large companies. See the Focus on
finance, To float or not to float that is the question.

To counter such problems, second boards were established by the stock exchanges in each state
between 1984 and 1986. Activity peaked on the second boards in 198687listed companies
had a market value of $2,600 million, but following the share market crash of October 1987 and
the subsequent economic recession, the new boards collapsed. These second boards were
discontinued from 30 June 1992. The Newcastle Stock Exchange (NSX) reactivated in 2000 and
the Bendigo Stock Exchange (BSE) revived in 2001 to provide for small listings are yet to
achieve general acceptance and a viable volume of activity
Most commentators argue that there is a finance gap for growth small businesses in relation to
long-term debt, equity and flotation in Pakistan. This has also been found in other Western
countries.
The small business growth cycle did not include the development of the high-growth technologybased SME which undertakes research and development, develops samples and commercializes
its innovations prior to Stage 1 (start-up). Although such enterprises may be able to reach Stage 1
by using personal funds and government assistance, actual start-up and early growth require
equity beyond the owners resources.
Although there is evidence of a finance gap for the three aspects discussed, there is no consensus
regarding its causes. There can be supply-side considerations due to gaps in the capital market
for unlisted companies.
There are also demand-side issues for SMEs that wish to grow but are unwilling to accept
external long-term funds. Small business literature provides theoretical and empirical support for
the pecking order approach by small business operators seeking funds.

2 CAPITAL BUDGETING IN THE SME:

Capital budgeting is a process that attempts to determine the future. Before any large project
begins, the capital budgeting process should be utilized. Without capital budgeting, your
company could make a fatal mistake. Here are a few aspects of the capital budgeting process and
why each one is critical to your success.

There are several reasons small and large firms might use different criteria to evaluate projects.
First, small business owners may balance wealth maximization (the goal of a firm in capital

budgeting theory) against other objectives such as maintaining the independence of the business
when making investment decisions. Second, 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. Finally, some small firms face capital constraints, making project liquidity a
prime concern. Because of these small firm characteristics the capital budgeting decisions of
large firms are not likely to describe the procedures used by small firms.
To document the capital budgeting practices in SME the results are taken from different surveys.
Information about the types 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 firms use of other planning tools (e.g., cash flow projections, capital budgets, and tax
planning activities), and the owners willingness to finance projects with debt.
Not surprisingly, we find small and large firms evaluate projects differently. While large firms
tend to rely on the discounted cash flow calculations favored by capital budgeting theory
(Graham and Harvey, 2001), small firms most often cite gut feel and the payback period as
their primary project evaluation tool. Less than 15 percent of the firms claim discounted cash
flow analysis as their primary criterion, and over 30 percent of the firms do not estimate cash
flows at all when they make investment decisions.

2.1 Capital Budgeting Theory and Small Firms:

Brealey and Myers (2003) present a simple rule managers can use to make capital budgeting
decisions: Invest in all positive net present value projects, and reject those with a negative net
present value. By following this rule, capital budgeting theory says firms will make the set of
investment decisions that will maximize shareholder wealth. And, because net present value is a
complete measure of a projects 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.
Yet, small firms often operate in environments that do not satisfy the assumptions underlying the
basic capital budgeting model. And, small firms may not be able to make reliable estimates of
future cash flows, as required in discounted cash flow analysis.

2.2 Capital Budgeting Assumptions and the Small and

medium enterprises:
Capital budgeting theory typically assumes that the primary goal of a firms shareholders is to
maximize firm value. In addition, the firm is assumed to have access to perfect financial markets,
allowing it to finance all value-enhancing projects. When these assumptions are met, firms can
separate investment and financing decisions, and should invest in all positive net present value
projects (Brealey and Myers, 2003).
There are at least three reasons to question the applicability of this theory to small firms.
First, shareholder wealth maximization may not be the objective of every small firm. As Keasey
and Watson (1993, p. 228) point out, an entrepreneur may establish a firm as an alternative to
unemployment, as a way to avoid employment boredom (i.e., as a life-style choice), or as a
vehicle to develop, manufacture, and market inventions. In each case, the primary goal of the
entrepreneur may be to maintain the viability of the firm, rather than to maximize its value.3
Second, many small firms have limited management resources, and lack expertise in finance and
accounting (Ang, 1991). Because of these deficiencies, they may not evaluate projects using
discounted cash flows. Providing some support for this conjecture, Graham and Harvey (2001)
find that small-firm managers are more likely to use less sophisticated methods of analysis, such
as the payback period.
The final impediment is capital market imperfections, which constrain the financing options for
small firms. Some cannot obtain bank loans, because of their information-opaqueness and lack of
strong banking relationships (e.g., Petersen and Rajan, 1994 and 1995, and Cole, 1998). Ang
(1991) notes that access to public capital markets can be expensive for certain small firms, and
impossible for others. These capital constraints can make it essential for small firms to maintain
sufficient cash balances, in order to respond to potentially profitable investments as they become
available (Almeida, Campello, and Weisbach, 2004). Thus, capital constraints provide small
privately held firms with a legitimate economic reason to be concerned about how quickly a
project will generate cash flows (i.e., the payback period).

2.3 Project Evaluation Methods in SME:

In this, responses about the primary tool firms use to assess a projects financial viability:
payback period, accounting rate of return, discounted cash flow analysis, gut feel, or
combination. The most common response is the least sophisticated, gut feel selected by 26
percent of the sample firms in Pakistan.
2.3.1 Gut feel:
The use of gut feel is strongly related to the business owners educational background. Owners
without a college degree resort to it most frequently and owners with advanced degrees least.
The use of gut feel is also inversely related to a firms use of planning tools. Firms with written
business plans and firms that make cash flow projections are significantly less likely to rely on
gut feel.
While the use of gut feel is concentrated in the least sophisticated of small firms, it is also widely
used by firms that make primarily replacement investments. A firm may have limited options
when it replaces equipment, and estimating future cash flows (i.e., incremental maintenance
costs or efficiency gains) for each option might be difficult. For example, if a firm must replace a
delivery truck, it may be difficult for the firm to estimate differences in the future annual
operating costs of two replacement vehicles under consideration. Moreover, if an investment is
necessary for the firms survival (and the owner is committed to maintaining the business as a
going concern), the maximization of firm value may not be the business owners primary
objective. Instead, the owner may simply look for the alternative promising the required level of
performance at the most reasonable cost. Thus, it is not surprising to find that small business
owners use relatively unsophisticated methods of analysis to evaluate replacement options.
Gut feel is also used extensively by firms in the service industry. Although some service firms
make substantial capital expenditures, the investments of many service firms might be limited to
business vehicles or office equipment. Because a firms primary considerations when evaluating
this type of purchase decision may be cost, reliability, and product features, structuring a
discounted cash flow analysis of these investments can be difficult.

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2.3.2 Payback period:

The definition of payback period for capital budgeting purposes is simple. The payback period is
the number of years it takes to payback the initial investment of a capital project from the cash
flows that the project produces.

Payback period is the second most common response, selected by 19 percent of the small
enterprises. The payback period is used slightly more often by firms that will wait for cash, as
expected. Firms using the payback period are significantly more likely than other firms to
estimate future cash flows (because cash flow estimates are required for this calculation). Finally,
use of the payback period appears to increase with the formal education of the business owner.
These results suggest that the payback period conveys important economic information in at least
some circumstances. For example, the payback period can be a rational project evaluation tool
for small firms facing capital constraints (i.e., firms that do not operate in the perfect financial
markets envisioned by capital budgeting theory). In this case, projects that return cash quickly
could benefit a firm by easing future cash flow constraints.
2.3.3 Accounting rate of return:
Accounting rate of return (also known as simple rate of return) is the ratio of estimated
accounting profit of a project to the average investment made in the project. ARR is used in
investment appraisal.
ARR =

Average Accounting Profit

Average Investment

The accounting rate of return is the next most frequent choice, identified by 14 percent of the
firms as their primary evaluation method. The use of accounting rate of return increases with
firms growth rates; it is significantly higher than the sample mean for firms entering new lines
of business. Each of these characteristics can indicate high borrowing needs. The accounting rate

11

of return is thus especially important if a firm must provide banks with periodic financial
statements, or is required to comply with loan covenants based on financial statement ratios.

2.3.4 Discounted cash flow analysis:

Capital budgeting with discounted cash flows (DCF) allows you to value a project, based on the
time value of money. In essence, you are discounting the value of future cash flows to determine
if the value today makes the project worthwhile
Discounted Present Value (DPV) = Future Value / (1 + interest rate) ^ time period
The most theoretically correct method discounted cash flow analysis is the primary investment
evaluation method of only 12 percent of the firms. Not surprisingly, owners with advanced/
professional degrees are most likely to use this method; 17 percent of these firms identify it as
their primary evaluation tool. Firms with written business plans and those that consider the tax
implications of investments are also significantly more likely to use discounted cash flow
techniques. Thus, firms using this project evaluation method are among the most sophisticated of
the small firms.
Firms extending existing product lines are also significantly more likely to use discounted cash
flow analysis. This result is evidence that discounted cash flow analysis is most useful when
evaluating projects with cash flow profiles similar to current operations (such as projects
extending existing product lines), because it is easier to obtain reliable cash flow estimates in this
case.
2.3.5 Combination of methods:
Of the specific evaluation techniques firms could choose from, combination of methods was
selected least often, by 11 percent of firms. Use of this approach does not appear to be strongly
related to any of the firm characteristics.
The results which are discussed above are very different from results in Graham and Harvey
(2001). Approximately 75 percent of their firms evaluate projects using estimates of project net
present value or internal rate of return. The vast majority of their firms also appear to consider
multiple measures of project value in making investment decisions. However, even the smaller
firms in the Graham and Harvey study are much larger than the firms in our sample, and are thus
more likely to have complete management teams. It is therefore not surprising that their firms
use more sophisticated methods of project analysis.

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2.4 Summary:
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 discounted cash flow analysis less frequently than gut feel,
payback period, and accounting rate of return.
Many small-business owners have limited formal education, and their firms may have
incomplete management teams. Therefore, a lack of financial sophistication is an important
reason why the capital budgeting practices of small firms differ so dramatically from the
recommendations of theory. Small staff sizes also constrain the amount of capital budgeting
analyses the firms can perform. Beyond this, there are also substantive reasons a small firm
might choose to use methods other than discounted cash flow analysis to evaluate projects.
The primary reason is that many small businesses do not operate in the perfect capital markets
that capital budgeting theory assumes. Most of the firms in our sample are very small (with
fewer than 10 employees); they have short operating histories (almost half have been in business
under 10 years), and their owners are not college educated. These characteristics may limit their
bank credit, posing credit constraints. If so, these firms may be required to finance some future
investments using internally generated funds, and it would not be surprising for the owners to
consider measures of project liquidity (such as the payback period) when making investment
decisions.
Second, many of the investments that small firms make cannot easily be evaluated using the
discounted cash flow techniques recommended by capital budgeting theory.
Many investments by small firms are not discretionary (a firm either makes a specific investment
or it goes out of business), and future cash flows can be difficult to quantify. For example, if a
firm is introducing a new product line, estimates of future cash flows can be imprecise (and
market research studies required to obtain better cash flow estimates may not be cost effective).
When future cash flows cannot be easily estimated, discounted cash flow analysis may not
provide a reliable estimate of a projects contribution to firm value, and it is not surprising that a
firm might resort to gut feel to analyze the investment.

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For these reasons, small firms face capital budgeting challenges that differ from those faced by
larger firms. Thus, it is possible that optimal capital budgeting methods for large and small firms
may differ. However, a fully integrated capital budgeting theory identifying the conditions under
which discounted cash flow analysis is appropriate has yet to be developed. The question of how
to better tailor the prescriptions of capital budgeting theory for small firms remains unanswered.

2.5 The Importance of Capital Budgeting in current

scenario:
In the world of business, capital budgeting is one of the most important steps that a company can
take. Many in the business world do not properly understand the importance of capital budgeting.
Here are the basics importance of capital budgeting.
2.5.1 Develop and formulate long-term strategic goals:
The ability to set long-term goals is essential to the growth and prosperity of any business. The
ability to appraise/value investment projects via capital budgeting creates a framework for
businesses to plan out future long-term direction.
2.5.2 Seek out new investment projects:
Knowing how to evaluate investment projects gives a business the model to seek and evaluate
new projects, an important function for all businesses as they seek to compete and profit in their
industry.
2.5.3 Estimate and forecast future cash flows:
Future cash flows are what create value for businesses overtime. Capital budgeting enables
executives to take a potential project and estimate its future cash flows, which then helps
determine if such a project should be accepted.
2.5.4 Facilitate the transfer of information:
From the time that a project starts off as an idea to the time it is accepted or rejected, numerous
decisions have to be made at various levels of authority. The capital budgeting process facilitates
the transfer of information to the appropriate decision makers within a company.
Monitoring and Control of Expenditures:

14

By definition a budget carefully identifies the necessary expenditures and R&D required for an
investment project. Since a good project can turn bad if expenditures aren't carefully controlled
or monitored, this step is a crucial benefit of the capital budgeting process.
2.5.5 Creation of Decision:
When a capital budgeting process is in place, a company is then able to create a set of decision
rules that can categorize which projects are acceptable and which projects are unacceptable. The
result is a more efficiently run business that is better equipped to quickly ascertain whether or not
to proceed further with a project or shut it down early in the process, thereby saving a company
both time and money.

3 THE EFFECTS OF CAPITAL BUDGETING TECHNIQUES ON

THE GROWTH OF MICRO FINANCE ENTERPRISES
3.1 Long-term Implications of Capital Budgeting:
A capital budgeting techniques has its effect over a long time span and certainly affects the small
enterprises future cost structure and growth. A wrong decision can prove disastrous for the longterm survival of the small enterprise. On the other hand, lack of investment in asset would
influence the competitive position of the small enterprise. So the capital budgeting techniques
determine the future destiny of the small enterprise.

3.2 Involvement of large amount of funds in Capital

Budgeting:
Capital budgeting decisions and techniques need substantial amount of capital outlay for wise
and correct decisions. If an incorrect decision is taken by any small enterprise then incorrect
decision would not only result in losses but also prevent the small firm from earning profit from
other investments which could not be undertaken. And thus the SME sectors could not grow
because of the incorrect decisions and incorrect techniques.

3.3 Risk and uncertainty in Capital budgeting:

Capital budgeting decision is surrounded by great number of uncertainties. Investment is present
and investment is future. The future is uncertain and full of risks. Longer the period of project,

15

greater may be the risk and uncertainty. The estimates about cost, revenues and profits may not
come true which has negative impact on the small enterprises.

3.4 Long term Effect on Profitability:

Capital expenditures have great impact on business profitability in the long run. If the
expenditures are incurred only after preparing capital budget properly, there is a possibility of
increasing profitability of the small firms due to which the small enterprises grow positively and
improve their performances and make more profit.

3.5 Maximize the owners equity:

The value of owners equity is increased by the acquisition of fixed assets through capital
budgeting techniques. A proper capital budget results in the optimum investment instead of over
investment and under investment in fixed assets. The management chooses only most profitable
capital project which can have much value. In this way, the capital budgeting maximize the
worth equity of the owners. When the owners increases the different types of new small firm
establishes by the owners.

3.6 National Importance:

The selection of any project results in the employment opportunity, economic growth and
increase per capita income. These are the ordinary positive impact of any project selection made
by any small firms.

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4 REFERENCES:
http://www.investopedia.com/university/capital-budgeting/importance.asp
https://www.researchgate.net/publication/222640632_How_Planning_and_Capital_Budgeting_I
mprove_SME_Performance
https://www.questia.com/library/journal/1P3-2922990971/capital-budgeting-governmentpolicies-and-the-performance
http://www.financepractitioner.com/balance-sheets-best-practice/managing-capital-budgets-forsmall-and-medium-sized-companies?page=1
http://www.questionpro.com/a/showSurveyLibrary.do?surveyID=363821
http://www.finweb.com/financial-planning/the-importance-of-capitalbudgeting.html#axzz49fDhy0Vn
http://accountlearning.com/need-and-importance-of-capital-budgeting-decisions/

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