Capital investment practices in the banking industry In Sri Lanka: an empirical study

Introduction

Capital investment is the expenditure to acquire fixed assets. The world has witnessed an increase in the capital investment since the last few decades. Capital which includes buildings, machinery, equipment and factories, is very essential for economic growth of an economy.

Economic growth results in two situations. One, if the quantity of the factors of production has increased. Usually, for most of the countries, it is an increase in the capital brought about by investments. Two, if the productivity of the factors of production increases. More productive capital equipment results in an increase in production. Today, technological progress is given the highest value and utmost priority when it comes to increasing productivity.

An increase in the capital will increase the output of an economy. But investments are required for capital to increase.

Capital investment has increased since the last few decades in both developed and developing countries. Though the developing countries have taken more time to realize the importance of capital investments and to adjust to the rapidly changing world, they have not wasted much time to implement policies similar to those of the developed countries.

It is based on agriculture, services, and light industry. As per a report, “The service sector is the largest of the Sri Lanka economy as it employs 45 percent of the workforce and contributes around 60 percent of GDP” (Srilanka Economy n.d). Sri Lankan economy grew strongly in the first decade of 21st century. Agricultural production for most of the countries contributes up to great level to the economy (Sri Lanka Economy n.d).

Manufacturers and service providers invest huge amounts to build capital in Sri Lanka, but there is not much research done on the investment decision making.

Due to the long civil war, Sri Lanka was not very attractive to multinationals or independent investors. After the end of the civil war, investments were welcomed in the Sri Lankan economy.

Efficient decision-making is very important in the capital investment process because financial resources are very scarce. There are many factors which complicate the decision-making process, namely, uncertainty in the economy, utility, clash of interests and awareness.

On different grounds, capital investment plans are finalized and selected. For example, an individual or a bank or a company may emphasize on investing in projects which ensure immediate returns while some other individual or company may prefer investing in projects which ensure long term growth (Guler 2006). The main goal of capital investment decision is to increase the value of firm either in the short term or the long term.

Well there are constraints in deciding on investment projects. Opportunity cost may be high of some projects as compared to others. The companies which utilize these investments are affected differently (Investment, Investing, Types of Investment n.d).

It is hard to find credible and detailed information about investment decision making practices in Sri Lanka. One major reason for this is that the culture, the belief and the infrastructure of the country are not well acquainted with the modern investment decision making and practices of the world. Though modern capital investment is being taught in educational institutions of Sri Lanka, there is a gap between the theoretical and practical approaches used by the Sri Lankan people to make investment decisions. The researcher has tried to correlate the theoretical and practical aspects of capital investments in Sri Lanka.

Investment banks, multinationals, independent investors and local savers raise the finance for capital investments. In Sri Lanka, banks have developed a reliable infrastructure to boost the investments in capital but rest of the sectors are lagging behind. Human capital is also being developed by the private sector which is now dominant in the Sri Lankan economy due to the implementation of privatization policy by the government (Wignaraja n.d).

The paper discusses some facts and figures related to the capital investments in Sri Lanka, the banks operating in Sri Lanka, privatization, public opinion and the changing world.

Problem background

Capital investment, an area coming under management accounting, has been developed to a great extent during the last few decades. However, there are many untapped areas in this field of study, especially the area of decision making, which has not been researched in depth in the recent past. This may be due to the many behavioral factors involved in the decision making process.

There has been little research done on the subject of capital investment practices and most of it has been conducted in western English speaking countries. Particularly in the Asian region, there is very little evidence of research in this subject. In the Sri Lankan context it was hard to find any research evidence on capital investment decision-making practices. Therefore, it is a difficult exercise to carry out research on capital investment practices.

In fact, capital investment appraisal is one of the subjects in the degree programs conducted by the universities and affiliated Universities in Sri Lanka and abroad. In addition, this area is thoroughly covered in professional exams conducted by the Institute of Chartered Accountants of Sri Lanka (ICASL), Chartered Institute of Management Accountants (CIMA), Association of Certified Chartered Accountants (ACCA) and Certified Financial Accountants (CFA). All students under these programs are taught capital investment decision-making theory in depth. However, there is no evidence that they follow the methods taught as theory when it comes to making capital investment appraisals. On the other hand, lecturers or teachers on these programs do not have much opportunity to get involved in private sector managerial practices. Therefore, teachers also to some extent do not have the required practical experience to properly combine the practice and theory of capital investment appraisal. Therefore, researcher strongly feels that there is a considerable gap between the theoretical knowledge and the practical aspects of this field of study. Hence, the researcher has attempted to correlate some of the practical and theoretical aspects of the capital investment procedures in Sri Lanka.

The Government of Sri Lanka has been following a privatization policy and encouraging the private sector after the liberalization of the economy in 1977. A large part of the Sri Lankan economy is being dominated by the private sector as the engine of economic growth while the public sector’s role in economic development is very small – just fuelling the economic engine.

The contribution from the public sector has been declining after 1977 due to the open economic policies. For the last five years, over 90 percent of the industrial production of Sri Lanka was contributed by the private sector (Central Bank Annual Report, Sri Lanka 2005, p.110). Most importantly, the contribution from the private sector to industrial production in 2005 was a mammoth 96 percent.

It is important to note that the social, cultural, legal and organizational practices of a country like Srilanka cannot be compared with those of a developed country. Our infrastructure facilities are at the infant stage when compared with developed countries and our technological knowledge and capabilities and education systems are far behind theirs. Their organizational practices, policies, systems and procedures are far superior to ours. However, our country follows systems, procedures and policies developed by these capitalistic countries.

Capital investment practices are one such area where the organizations in Sri Lanka are following the foot path of the western countries. Manufacturing as well as service organizations invest enormous amounts of money on capital expenditure. Manufacturing organizations generally invest in premises, plant and equipment, information technology, etc. On the other hand, service organizations invest in premises, information technology, and interior decoration and so on. Sometimes, service organizations have to invest in human resources capital as well. However, both these sectors are compelled to make substantial investments in capital expenditure at regular intervals.

Service sector organizations play a dominant role at present in the Sri Lankan economy. This sector had contributed 54 percent and 55 percent to the GDP for the years 2004 and 2005 respectively (Central Bank Annual Report, Sri Lanka 2006, p.7). In addition, 43.3 per cent of the work force is attached to the service sector (Central Bank Annual Report, Sri Lanka 2005, p.155). The banking and financial sector is one important sector in the service category. The contribution from this sector to the overall service sector was 19 percent and 20 percent for the years 2002 and 2003 respectively (Central Bank Annual Report, Sri Lanka 2003, p.9). Therefore, the banking industry plays a vital role in the present economy.

During the recent past banks made substantial investments in capital expenditure with the development of especially Information Technology. Not only in information technology, but also in other areas banks invest substantial amounts of money such as premises, equipment, interior decorations etc. In addition, banks need to invest in automated teller machines and new branch premises to expand their service.

Furthermore, there are a lot of developments taking place in the banking industry, such as introduction of debit and credit cards, maturity analysis, treasury management, risk management policies, corporate governance practices, money laundering mechanisms and new capital adequacy requirements, to name a few. This situation rather peculiar to the banking industry since other industries have not reached this level of developments during the recent years. Most of these areas need infrastructure or in other words capital investments. Banks need mostly to invest in sophisticated computer systems and other equipment to improve their service standards and to adhere to the rules and regulations of the country. Thus, the present researcher mainly focuses on the capital investment decision-making practices in the private sector with special emphasis on banks.

Problem statement

“Do Sri Lankan banks practice theoretically sound decision-making techniques in the area of capital investment?”

There two types of capital investments Sri Lankan banks undertake, which are short term and long term. Short term for overnight liquidity and long term for various project finance (stock market, debentures, bonds private placement, etc. Most of the private bank use share issues and short term commercial papers also popular capital investment.

It is in this context that the present research addresses the above research problem. As mentioned earlier, empirical evidence reveals that theoretically superior techniques of capital investment are not being practiced and there is a greater adoption of sophisticated capital investment techniques. It must also be noted that these researches have been conducted in Western English speaking countries, where the application of these techniques was facilitated by computer software to a great extent. Particularly in the Asian region, there is very little research evidence in the area of capital investment. Due to the scarcity of research findings on international practices, our understanding of the best practices of capital investment decisions is incomplete. This study makes attempts to understand and fill the gap in the literature on the subject.

Due to the involvement and scarcity of resources, the researcher had to limit his study to a selected sector. Keeping this in mind, the researcher had to limit his scope and therefore selected the banking sector for his study. Therefore, this particular research focuses only on banks operating in Sri Lanka.

Today, there are about 22 commercial banks operating in Sri Lanka, in addition to several specialized banks. Presently, competition among the banks in Sri Lanka is very high. The present Banking Density Index (BDI) is 0.72 as against 0.61 in 2004 (Central Bank Annual Report, Sri Lanka 2005, p.7). This implies that at present there are 0.72 bank branches for 10,000 people as against 0.61 bank branches in 2004. (BDI = Number of bank branches / Total population * 10,000).

On the other hand, the corporate survival of any organization depends on the level of customer service. Not only for banks but also for every organization survival is purely dependent on customer service – delighting the customer. In today’s competitive world, the customer is king.

Banks provide a service to customers basically by way of accepting money as deposits and lending money, in addition to providing some ancillary services. Banking business is such that the profitability of a bank mainly depends on volume: the volume of deposits and the volume of advances. Therefore, every bank tries to improve their business volumes; either by getting new business or capturing the competitors’ business. In such a situation, customer service is of utmost importance for survival.

One may argue that this is more important for a bank than for a manufacturing company, since the performance of a bank purely depends on the perception of the general public about customer service. Every bank tries to maintain a competitive edge over its rivals. Therefore, one important aspect of maintaining the competitive edge is rendering a superior customer service over and above its competitors. It may be inside the bank as well as outside the bank. Customers would be delighted if they are treated like kings within the bank premises during normal banking hours as well as outside banking hours. For this purpose, banks need efficient and dynamic employees, superior systems and procedures, convenient lay out of the bank premises, quality equipment and on line real time banking net works, etc.

Most of the items mentioned in the preceding paragraph could be categorized under the common heading of investments; it may be human or material. Training and development of staff and obtaining the maximum potential from them could be considered as the investment in human resources. On the other hand, bank premises and equipment play a vital role in providing customer service. Banks need to design a convenient lay out of its premises, purchase modern and sophisticated equipment, and establish an up to date real time banking network, to mention a few.

Therefore, capital investment plays a vital role in the business of banking it is likely that banks will invest more heavily in property, plant and equipment, especially in the field of information technology, to improve the infrastructure of the bank and give a superior customer service.

Research objectives

The objective of the research is to examine the capital investment practices of the banks operating in Sri Lanka from the point of view of their theoretical soundness.

This dissertation seeks to undertake the following objectives.

• To outline and critically evaluate the preferences, customs and beliefs that influence capital investment decision making approaches of the Srilankan investors.

As mentioned earlier the culture, beliefs and decision making of the Sri Lankan people have been different from what modern investment policies demand. The research will critically evaluate the preferences, customs and beliefs of the people of Sri Lanka.

• To correlate theoretical and practical aspects of capital investment in Sri Lanka.

The disparity between theory and practice leads to the misunderstandings and complications, no matter what subject it is. When it comes to financial and economic decisions, the same rule applies.

• To determine the degree to which Sri Lankan banks practice sound decision making capital investments.

More than 20 banks are operating in Sri Lanka. The research aims to determine the number of the banks practicing appropriate policies and the extent to which the modern investment policies are being applied.

• To outline and critically evaluate the present situation regarding Sri Lankan bank’s capital investments decisions.
• To recommend changes to Sri Lankan bank’s policies and procedures regarding capital investments decisions.

This thesis is based on disparity between the theory and practicality of capital investment decision making and the use of capital investment policies by banks of Sri Lanka.

Scope of the study

The disciplinary scope of this research is restricted to the financial and economic aspects of capital investment decision-making practices. Social implications including behavioral perspectives of such practices and their political dynamics lie outside the scope of the present research. Hence, this research evaluates capital investment practices as an organizational practice, which falls under the broad category of Management Accounting.

Significance of the study

Capital investments involve strategic type decisions in the sense that they decide the long-term resource deployment commitments of the organization. Such decisions decide the future success of the organizations and the risks faced by them. Hence, a sound managerial insight into the various practices, policies, procedures, and techniques of capital investment is vital to the development of successful managerial practices. However, it seems that there is very limited research, especially in the Asian context including Sri Lanka, been done on these aspects.

Thus, this research into capital investment practices will help to develop a rational and theoretically valid managerial belief, which in turn will contribute to the socioeconomic development of the nation and of the region.

Literature Review

Literature review is essential for any research. When it comes to finance and investments, a lot of literature has been published all over the world which has made a valuable contribution to the knowledge and research work in the field.

This study is based on the financial sector and capital investments in Sri Lanka. It must be considered that not much information is available about the Sri Lankan financial sector or the capital investments made in the country. The literature review consists of:

• Finance and Investments in Sri Lanka
• FDI in Sri Lanka
• Identification of potential investments
• Appraisal methods
• Factors influencing investments
• Estimation of Cash flows.

Finance and investments in Sri Lanka

The Financial system includes financial institutions, financial markets and financial instruments that facilitate payments of real sector transactions.

The financial system in Sri Lanka consists of major financial institutions, such as the Central Bank of Sri Lanka, licensed commercial banks (LCBs), licensed specialized banks (LSBs), registered finance companies (RFCs), specialized leasing companies (SLCs), primary dealers (PDs), provident funds, insurance companies, merchant banks, unit trusts and thrift and credit co-operative societies.

The banking sector in Sri Lanka comprises LCBs and LSBs. Therefore, the soundness of banks is very important for the Sri Lankan economy.

Therefore, the efficiency of the financial system depends on the soundness of the financial institutions, especially the commercial banks.

As per Trade Chakra, “Two state banks represented 76.6 percent of the assets of LCB sector and 64 percent of the assets of the banking sector” (Trade Chakra, n.d).

The systemic importance of the LSB sector is comparatively lower than of LCBs in terms of size and influence on the financial system of Sri Lanka (Financial System Stability, n.d).

Many reforms were introduced in Sri Lanka in the early 1990s, which included most of the elements of a modern financial system the world knows today. The commercial banks of Sri Lanka are active in almost all aspects of financial services. The reforms introduced in Sri Lanka in the 90s were responsible for the development of the financial sector in the country along with some technical assistance from other countries. The government also focused on the minimum intervention in the financial sector in order to allow the private institutions to work on market mechanism as direct government intervention increases the risk of reducing the flow of finance and investments and efficiency of the financial sector.

Progress in the financial sector depends on improvements in the law and formalities for financial services, development of infrastructure, and making prudential norms strong.

At the same time the state owned institutions are very important, which consume resources through inefficiency and protect other institutions from cut throat competition, which may harm the economy (ADB, 2005).

Financial sector policy issues

Recently the Central Bank has made efforts to strengthen the financial institutions in the country. Still, some reforms are required to develop the infrastructure for financial services including the legal framework, registry system functions and governance methods and procedures.

The governments play an important part in developong the financial sector of a country. Thus, intervention from the government is a necessity. If the government ignores the need to control the financial sector, problems such as high margins will continue, and citizens of the country will not be enjoying the full benefits of the investments.

A major concern for the policy makers is the hogh cost of credit. as interest rates have declined over the last 2 years, the gap between deposits and investments has increased. However, the high margins are required by the weaker banks to survive in the competitive world and to bear high operating expenses.

Either the weak banks restructure themselves or leave the market, in both the cases the more efficient banks will be benefited as there will be more opportunities to earn higher margins (CBS, 2011).

Investments in the informal sector of Sri Lanka

This section covers some features of investments, savings and loan programs in the informal sector in Sri Lanka which were practiced during the mid 1990s. The analysis is based on the survey conducted by the Central Bank of Sri Lanka – The Report on Consumer Finances and Socio-Economic Survey – 1996-97 (Part I).

The date in these surveys has been classified into three sectors: urban, rural and estate comprising tea, rubber and coconut plantations. Household savings are part of spending unit income which is not consumed by the households. All expenditures made by the households for purchases of consumer goods and durable goods were treated as savings.

The saving rate for all three sectors in the 1990s was 10.4%, and the rate of the informal or rural sector was 10. Consumer durables, back then, accounted for 74% of the savings in the informal sector and in the urban sector the proportion was 26%. Investment from households is the allocation of savings of households for different assets or for future consumption.

It must be considered that the expenditure on consumer durables was not considered, though it is included in the definition of the household savings.

The investments have been categorized into three main categories; financial investments, physical investments and net changes in claims. Financial investment comprise of savings accounts, fixed deposits, government bonds and securities, shares and cash balances in current accounts and cash in hand. The average investment rate or the percentage of income, for all the sectors was 24.3%. Rural or informal investment rate was 26.7% which was the highest among all three sectors. Careful analysis is required to judge the investment rates mentioned in the survey report. It may be possible that the transfer of some towns, which were included in the urban sector previously, to the rural sector led to high investment rates.

Financial investments contributed 1.7% to the total investments and physical investments contributed 72.8% to the total investments in the rural sector.

A change in the claims indicates the change in the position of assets and liabilities of the households. Positive changes indicate that the assets of households have increased while the negative changes indicate that the liabilities of households have increase.

The survey also included the data about the changes in the claims. Five categories of changes in claims were mentioned.

The categories were: insurance premium, provident fund contributions, widows and orphans pension fund contributions, collective informal savings and loans. Changes in claims in the informal sector were positive at 7.5% which indicated the accumulation of assets. Informal group savings were the most attractive claim according to the survey. In the urban sector, the informal group savings constituted 64.7% of the changes in claims. The rural and estate sectors showed changes of 34.2 % and 30.3%.

Loans only became popular in rural households. The survey mentions two sources of loans: institutional and non-institutuional. Institutional sources comprised of commercial banks, rural banks, cooperatives which included cooperatives, thrift societies and some NGOs. Noninstitutional sources are the independant moneylenders, family, friends and relatives and others.Moneylenders, as shown by the survey, charge interest on the loans. The survey showed that the informal lending without interest was practiced only by family, friends and relatives. Rural sector raised finance by taking loans from formal sources, approximately 68.6% of the loans. The expansion of rural banking would have contributed alot to achieve these results. Largest informal sources were friends and relatives who provided around 23% of loans competing aggressively with an average of 22.0% for all the three sectors. Trade and business were the main reasons for borrowings in the informal sector accounting for 55.6% of total loans, while the average for all three sectors was 50.2%.

The discussion above shows that the financial dualism has been disappearing at a fast rate since the 1990s (Wickramanayak, J, 2004).

The Changing role of the banking sector

The financial sector comprising commercial banks, specialized development banks and other institution has led to universal banking, as the institutions now offer an entire array of banking services.

The banks now offer consumer banking, investment banking, feebased activities, venture capital, fund management, stock broking and bancassurance.

In the past few decades, there have been many mergers and acquisitions in the banking sector. Mergers and acquisitions indicate that there is over capacity in the banking industry and a weak bank which merge with comparatively a stronger bank could harm the performance of the stronger bank unless the merger is managed effciintly (Boyagonda, Mangala, 2008).

Foreign direct investments (FDI) in Sri Lanka

With the new market oriented policies, which are recognized as the most effective policies for growth, the Sri Lankan government made it a top priority to ensure that the country was attractive enough for foreign investments to enter the economy and the financial sector was stable.

It was largely due to the fact that successive governments in the country continued to liberalize the economy.

The enterprises use a lot of foreign capital because of the export oriented nature of the businesses and the need for large scale, highly developed infrastructure.

Privatization and deregulation of many sectors of the economy have also attracted foreign investments.

As per Trade Chakra, “Foreign direct investment (FDI) flows in Sri Lanka reached 425 million US dollars in the first six months of 2008” (Trade Chakra, 2010). As stated by Anur, “According to Board of Investment, the services sector attracted 362.3 million dollars as investments, the telecom sector with 290.7 million dollars followed and power generation sector with 46 million dollars, in 2008” (Wickramasinghe, Don Anur, 2007). The Sri Lankan government expects foreign direct investment to more than $4 billion by 2012 (Balamurall, N and Bogahawatte, C, 2004).

Identification of potential investments

The presence of investment opportunities motivates investors to invest in those projects or businesses. Investment opportunities have to be studied, analyzed, and appraised before any decision can be taken to invest. There are specialized personnel to identify the capital investment opportunities which either are hired by big companies, governments or work independently. There are investment opportunity search and analysis teams in organizations. Their goal is to create an environment in which the organizations and individuals feel free to explore, analyze and develop new ideas. These teams analyze the market opportunities present, carry out exercises with other organizations to identify areas of poor performance, gather information on international standards, etc. in order to identify new and profitable capital investment opportunities.

Existence of capital investment opportunities leads to analysis and the discussion of those projects. Ideas are not enough for a complicated financial investment decisions. Availability, practicality, profitability and costs have to be considered and analyzed with an in depth study. Some opportunities, even good ones, might not be easily available and it would be necessary to try harder to generate them.

Ccapital investment theories assume that investment opportunities exist and can be identified, but mere identification of an opportunity is not enough. The success of a business depends on its ability to create profitable investment opportunities. There are many capital investment opportunities available all over the world. The selection and appraisal of the best option is the real test of the management of a company. The selection criteria used by any business for assessing capital investment opportunities should help in deciding whether an opportunity is suitable for the business considering the culture of the organization, organizational structure and behavior of the management of the company. These factors must be taken into consideration while analyzing the opportunities during the initial stages.

Reserves evaluation processes

IRR- internal rate of return

“IRR is the rate of return that makes the present value of future cash flows, in addition to the market value of an investment equal to the market price of the investment opportunity. IRR is also known as the dollar-weighted rate of return” (IRR, n.d).

Higher IRR of any project indicates the future returns and makes the investment more desirable. The project with the highest IRR would be the best choice to make an investment (IRR, n.d).

NPV- net present value

Net present value (NPV) includes all cash flows including initial cash flows, for example, the purchasing costs of equipment. NPV compares the value of money today to the value of that same amount of money in the future. Inflation and returns are considered while making the comparison. Positive NPV of an investment project indicates that investing in that project will be favourable. If NPV is negative, it will be useless to invest in that project.

Theoretically, the most appropriate technique for selecting a capital investment project is Net Present Value (NPV). The calculated NPV, for any capital investment proposal contained in an investment project, measures the expected increase in shareholder wealth if the proposal is selected. Other discounted cash flow techniques are also theoretically acceptable, subject to some limitations (Patterson, 1989). However, NPV always maximizes the owners’ wealth compared to other techniques (Northcott, 1992).

ARR- average rate of return

ARR is a method used for purpose of comparison. An issue with ARR is that profits are used to make comparisons, not the cash flows (CBT, 2010). The time value of money is ignored while using ARR (Capital Budgeting, n.d).

Factors which influence capital investment decision

Capital investment decisions are not influenced by one or two factors. The investment problem is concerned with replacing a process in a system with another process which makes the entire system more productive, efficient and effective. Few elements that influence such plans of investment are:

Viewpoint of the executives

A smart and insistent team will support modernism and widen investment applications that would not only be profitable, but would be highly efficient. Capital investments are more readily available for businesses which come up with strong business plans.

Competitor’s strategy

Competition is one of the most important aspects of a free market world. A failure to take decisive and quick action may result in the failure of a company, or a country in this case. Countries like Singapore, Malaysia, and Hong Kong which are also known as the tiger economies, have proved to be very competitive in the modern capitalist world. Commercial activity in the country attracts investments and leads to a healthy economy.

Scientific advancements

Technological changes influence investment decisions to a great extent. Countries or businesses which do not improve their technology become less attractive projects. Often, the technological changes are not evaluated properly.

Market prediction

Critical decisions are often required by capital investments when market forecasts are not very much favorable.

Fiscal incentives

Tax concessions and the methods for depreciation also influence the capital investment decisions.

Cash-flow budget

The cash flow may affect capital investment decision in two ways. “One, the analysis may indicates that the company may require cash to purchase some equipment, or it may show that the purchase of capital assets now may demand for more capital additions after a few years and such expenditure might clash with other expenses which cannot be delayed” (Forex Management, n.d). Secondly, it has been stated that “the cash flow budget shows the time of cash inflows and outflows which may help the management in planning for future investments” (Forex Management, n.d).

Estimation of cash flows

Capital investment can simply be defined as a commitment of resources made in the hope of realizing benefits. Neither the resources nor the benefits need be in the form of explicit cash flows.

Therefore, the magnitude and timing of all cash flows associated with investment projects must be determined by the firm as a prelude to final acceptance or rejection of projects. It is essential to have two types of estimated information for a capital investment evaluation, i.e. cash flows and the hurdle rate. Existing capital investment literature has paid comparatively little attention to cash flow estimation though the task is perceived to be most difficult.

In capital investments we have to analyze the net cash flows of the investment projects, not the profits only. Cash is the most liquid asset which can be invested in any project. Also cash is used to make payments, pay dividends and pay interest and to lenders. Cash is also used to pay the costs of supplies, labor, managers, and taxes.

The success of businesses depends on the capability of the business to generate positive cash flows. Cash inflows and outflows are considered as two of the most important elements which predict the future of a business (Damodaran, Aswath, n.d). The capability of the business to generate funds and the projects in which the business invests those funds are the two factors which are responsible for convincing potential investors and encouraging them to invest in the business (Map of World, 1999).

Objectives of a cash flow statement

• assessing the ability of the business to pay off short-term and long term liabilities
• assessing the effect of major investments on the financial position of the business.
• showing increase and decrease in cash held by the business.

Capital structure refers to equity, debt and the marketable securities used by the business to finance its operations. In simple language, the capital structure shows how much the business owes to its creditors and shareholders. The value of the company is affected by its capital structure. The management must be very careful while making the decision about the capital structure of the business. The management of the business has to consider factors like bankruptcy, agency costs, taxes, and information asymmetry while deciding the capital structure of the business.

Most of the books published on the subject accept that the cash flows for capital investment projects must adhere to the incremental cash flow concept (Edirisuriya, Piyadasa, 2007). Incremental cash flows are the cash flows occurring because an investment project is undertaken. Adjustment of incremental cash flows for incremental expenses such as taxes caused by the project completes the specification of incremental cash flows (Boyagonda, Mangala, 2008). A study revealed that the most common method used in estimating cash flows was to first predict net income and then adjust this for non-cash items such as deprecations (Herbst, Anthony F, 2002).

Methodology

Research method

Surveys are the most practical means for such research as they answer many of the unanswered questions which have not been included in other researches related to the topic.

Survey research is a systematic way of collecting data by obtaining answers from selected respondents. Surveys can be conducted through e-mail, face-to-face interviews, telephonic interviews, mail, Websites, observation, focus groups, and some other methods. The questionnaire is one of the most common and practical ways to conduct surveys and gather relevant data.

Survey research is helpful in the study of real practice without the researcher’s manipulation and biased opinion. There are many examples in which the researchers have manipulated the results to satisfy their own desires and achieve their objectives even though the data gathered during the research contradicted their expectations and desires. Therefore, a basic principle is followed by the researcher in this study. That principle is, to find out and report the actual data as it is. The researcher has avoided subjective judgments and biased conclusions.

As the research is on the capital investments and the financial sector of Sri Lanka a survey is required.

The main focus of the research is to explore the actual capital investment practices of the Sri Lankan banks and other financial institutions. The finance managers of these institutions happen to be the most suitable sources to provide information about the investments in the country. It is a unanimous opinion of the researchers on similar topics that the managers of the financial institutions are the most reliable sources of information on finance and investment practices in any country.

A detailed study requires the scope of the research to be wide. It would be a blunder to narrow the scope of the research as it may exclude information which may be essential for an in-depth study of the financial sector of country. The strategy used for the research allows the researcher to cover a wide range of interrelated areas in the field of finance and investments in Sri Lanka.

The questionnaire was the main element of the methodology for the research.

The validity of the results from questionnaire survey mainly depends on the size of the sample, the part of the population that the sample represents and the sincerity of the sample. In order to conduct a survey with valid results, the researcher had to organize a large survey. It should be mentioned that surveys minimizes the personal bias of the researcher and provide impartiality or neutrality to the research. Thus, survey research procedures produce data that are accurate, reliable, and representative, so that the findings can be generalized from a sample to the large population or to different research situations.

Sample selection

All commercial banks except a few foreign banks and a few licensed specialized banks operating in Sri Lanka were selected for the study. Commercial banks operating in Sri Lanka can be broadly divided into three main categories: Government commercial banks, private commercial banks, and foreign banks. Private commercial banks can be further divided into two main categories: the banks listed on the Colombo Stock Exchange (CSE) and those not listed on the CSE. Licensed specialized banks include, Development Finance Institutions, Savings Banks, Mortgage Banks, Rural Development Banks and others. The composition of the selected sample can be summarised as follows:

The questionnaire method

The questionnaire method was chosen to collect primary data for the survey. A few interviews were arranged with the managers of the banks in Sri Lanka, for the collection of primary data. The same questionnaire was emailed to the managers of the banks who were out of reach for the researcher.

There were three main reasons for using the questionnaire for the research:

• The questionnaires are convenient in gathering relevant data
• The bank managers are usually very busy to sit and talk. So the questionnaires are preferred by them for research purposes
• The questionnaires provide impartiality to the research.
• The functional role of the respondents in the sample.
• Information about the financial institutions and their investment projects, the value of assets, and the size of the investments.
• Opinions of the managers of the financial institutions on the capital investments in the country.
• Implementation of investment plans and programs by the financial institutions of the country.
• Problems faced by the institutions in attracting investments
• Impact of investments on the country.

The Questionnaire-based Survey

Span of the Questionnaire

Structure of the questionnaire

The questionnaire was based on three parts: Part I includes general information, such as turnover of the company, number of employees and so on. Part II covers the general issues of capital investment decisions. This part has fifteen questions, all of which except one are multiple type questions and three of which are scale questions. Part III of the questionnaire covers the technical issues of capital investment decisions. This part has sixteen questions, all of which except one are multiple type questions and eight of which are scale questions.

Sub sample categorization

Dot plots are usually used for presenting quantitative data.

The Dot Plot analysis used to sub sample the banks which responded, resulted in the identification of three unique groups of responding banks. The groups identified were distributed into categories of small, medium and large banks.

The data showed that there were no companies where the turnover is between Rs.752.5 million to Rs.1, 321.8 million and Rs.6, 044.4 million to Rs.9, 973.6 million. Thus, it was logical to categorize companies according to the clusters identified.

Such sub clustering of the total sample needs statistical validation. For this purpose, a test of difference was conducted to check whether the turnover values of the sub clusters are significantly different in statistical terms. Information given in Table 4.3 statistically validates the clustering of the total sample into three sub categories of small, medium and large, in the sense that the differences are significant at 95 percent confidence level. (All calculated p values are less than 0.05).

Some concepts related to the research

A conceptual understanding of the research issue in hand is central to any research work. This chapter serves the purpose of conceptualizing the research issue in order to construct a platform for reviewing the empirical capital investment research literature and for conducting the research.

First the theoretical foundations of capital investments will have to be studied. These theoretical foundations help generalize the issues in capital investments.

Secondly, the technicalities of the research have to be explained at micro level with the use of the theory on capital investments.

Neo-classical economic model of the firm

In neo-classical economic theory, market forces are the mechanism for controlling the economic activities of all the economic agents such as firms, households and governmental units. The firms, households and the government units achieve their economic objectives at the point where the market forces of demand and supply intersect, the equilibrium. According to this theory which is taught all around the world, the firm is just a body made by individuals to help them achieve their economic ends. Everyone participating in the market is supposed to have some interest in the participants. In the case of capital investments, the investors have an interest in providing finance to the firms in order to earn returns on the amount invested.

Neo classical economics is now the most extensively taught form of economics all over the world. The neo classical economics has been criticized by many people for several reasons. A major drawback of the neo classical theory is the assumption that all participants in the market are rational. It fails to acknowledge the human element. Humans are vulnerable to the influence of other factors, such as other people, governments, disasters, etc. In addition to that, humans, usually, can behave irrationally on many occasions. Irrationality according to the neo classical theory may mean a person submitting to his or her emotions. Human emotions and feelings are ignored by the neo classical theory.

Inequalities such as global debts, income disparity and labour issues are neglected by the neo classical theory as it propagates that the market mechanism will fix these problems automatically. Another criticism is that the focus of the firms, profit maximization, usually, leads the management of the firms to neglecting the ethics of business.

The capital investments, today, are made through the use of market mechanisms or the neo classical theory. Investments in commercial activity are the only behaviour, in neo classical theory, which shows the rationality of the investor. If a person with excess money donates that amount to a charity organization that would be termed as irrational behaviour.

Capital investment as an institutional practice

The firm operating in a system based on market mechanism depends on several functions and practices within the firm. These internal functions help establish and maintain a relationship with the external factors affecting the firm.

The firm has to maintain a relationship with the financial market as the market and its mechanism are the foundations of the firm. This is the financial function of the firm. It is the financial function of the firm that helps the firm in financial rationalization. Financial rationalization is the reason for the existence of the firm. According to mainstream or neo classical financial theory, the rationale for the existence of firms, in the long run, is wealth maximization.

The financial function deals with the determination of sources and uses of funds with the aim of maximizing the wealth of the business. It operates in the areas of both short-run which includes working capital, and the long-run which includes capital investment decisions. However, the research in this study is on the capital investments, which are a part of the capital budgeting process, of a country not the working capital of a firm.

Capital budgeting is concerned with the following: determination of the best and the most profitable investment projects the firm or a country may opt for, determination of the capital expenditure requirements and determination of the modes of finance which must be used for financing these projects.

Capital investment decisions usually include the decisions about uses and sources of funds and how to use the available funds efficiently for the best investment projects. Capital investment decisions, at the same time, have a direct influence on the risk that the firm undertakes. The present research conceptualizes capital investment as the activity of making, communicating, and implementing decisions about investment in long-term, risky capital assets.

An efficient allocation of capital is the most important finance function in modern times. It involves decisions to commit the firm’s funds to long-term assets.

Capital investment decision-making has developed some technical and theoretical propositions, which provide a theoretical framework for managers to help them in making appropriate investment decisions. These technical and theoretical propositions are assumed to be the criteria that are to be used as evaluation tools by the managers responsible for the finance of a firm or a country.

The decision making process of capital investments

Based on the above broad set of propositions, a more focused capital investment process/approach practised by the present day organizations can be summarized as follows:

Financial objectives of the firm

Capital budgeting is a process of long range planning for acquiring assets that will render some sort of service over several accounting periods. The finance manager of an organization has to choose, from many options, the investment projects which guarantee satisfactory cash flows and rates of return. The finance managers are required to be capable of judging and selecting the best options for investments.

According to the neo-classical economics there is a short run and a long run. In the short run the firms focus on profit maximization, while in the long run the firms must focus to wealth maximization.

Investors who seek to maximize the firm’s wealth follow the rule that the marginal increases in the wealth of the firm should be greater than the marginal increases in the capital stock. In more economic terms, a comparison is made between the marginal cost of capital and the marginal efficiency of investment.

Time preference for money

The element of time is also common to investment. There is a delay between the present time at which the capital investment is made or undertaken and the date at which future cash is received upon conversion. Although time is continuous, it is often convenient to work with discrete intervals of time: minutes, hours, days, months or years.

Time table

If an individual behaves rationally, he values the opportunity to receive a specific amount of money today, which is higher than waiting for one or more years to receive the same amount. This phenomenon is referred to as an individual’s time preference for money. According to Bierman (1975), there may be three reasons for this time preference for money.

Uncertainty

Many investments are risky. The future receipts of cash are unknown to the businesses. As a result the uncertainty of the investments leads the investors to either prefer short-term returns or back off from investing.

Preference for consumption

An actual or potential investor may prefer present consumption over saving for future. This may be due to the urgent needs of the investor or the risk of losing the invested amount only which may lead to future problems.

Investment opportunities

The value of, for e.g. $1 today will be more than the value of $1 a year after. This happens due to the ever increasing inflation. To take full advantage of the present value of a dollar, the potential investors may decide to consume the dollar instead of investing it.

Technical tools for capital investment decisions

There are several technical tools used by the business world to evaluate investment projects. After a discussion on the concepts related to the research, it would help make this study more informative if the tools used for capital investment decision making are added to it.

Inexpensive cash flow measure

Net Present Value (NPV)

NPV is the difference between the initial amount invested and the sum of discounted cash flows to be received in future as a return on investment. In other words, it is the maximum amount a firm could pay for the opportunity of making the capital investment without being financially worse off. The expected present value is an unrealized capital gain from the investment, over and above the cost of the investment.

In the calculation of NPV a discount rate is required. The rate used is usually the firm’s cost of capital or the marginal cost of capital of the firm. If an investment yields a discounted return greater than its discounted cost, it will have the NPV greater than 0.

On the other hand, if the discounted cost exceeds the discounted expected returns, it will have NPV less than 0. Investments with NPV greater than 0 are acceptable while those with NPV less than 0 are supposed to be rejected.

The underlying decisional rule of NPV is quite straightforward.

Projects with a positive NPV are acceptable for making investments while the projects with a negative NPV are unprofitable and unacceptable for making investments. The case where NPV = 0 is an indifference condition where the investment may or may not be undertaken. NPV is considered the most theoretically superior tool in capital investment decisions.

Internal rate of return (IRR)

Another measure for assessing investment opportunities was suggested by the ‘Keynes’ or the followers of John Maynard Keynes. This measure has been taught in all the macroeconomics and finance literature all over the world. This is the marginal efficiency of investment criteria, which is alternatively known as IRR in the field of finance and accounting. The marginal efficiency of an investment project, m, is defined as the rate of interest (cost of capital) that will discount the NPV of the project to zero. In other words, the internal rate of return method requires that the firm calculate the internal rate of return of an investment project and compare that return with the required rate of return, k.

Thus, m is defined by;

If, with any given Co and A stream, Equation 2.2 is solved for m, the resulting m is the IRR that discounts the project’s net return back to zero.

Investment projects can be ranked by m, in a way similar to the Net Present Value method. It would seem that a project with a high returns stream would have high NPV and thus require a high m to discount the net return stream to zero. Hence, the decision criterion is such that m (=IRR) should be larger than the required rate of return k, which is the least cost of capital to accept a given investment.

Profitability index (PI)

In this method, a project with a PI greater than 1 is termed as acceptable, but a project is rejected when its PI is less than 1. This method is connected to the NPV method. If the NPV of a project is positive, the PI will be greater than 1, and if the NPV is negative, the PI will be less than 1.

When there are capital rationing problems, the theory suggests PI, which can be used to rank the independent investment projects.

Non-discounted cash flow criteria

Payback Period (PBP)

This is one of the traditional ways of assessing the feasibility of a capital investment decision. The payback method was widely used prior to the development of present value techniques and continues to be an important decision making tool for many years. It is defined as the period required recovering the original cash outlay invested in a project.0

Today, many banks and other companies around the world use Pay Back Period method as a reliable criterion for either accepting or rejecting an investment opportunity. The payback period method is also used If PBP calculated for a project is less than the maximum PBP set by management, it would be accepted; if not, it would be rejected.

Accounting rate of return (ARR)

Another traditional non-discount evaluation technique that has been used in the industry is ARR. This method uses accounting information as revealed by financial statements to measure the profitability of an investment. ARR is calculated for different purposes. For instance, ARR could be calculated to measure the profitability of an investment from the manager’s point of view or from the owner’s point of view. According to these purposes, the method of calculating ARR could be changed. In this study, ARR relates to the owner’s point of view.

Capital investment process

Most of the authors who have written on capital investment hold a common conception of capital investment as a process. The term “process” denotes the sequential order of capital investment, where information flows into some ‘black box’ where it is digested and turned into a recommendation for action, which is then implemented as output from the process.

However, this type of characterization of capital investment decision-making arrangement may not be appropriate in practice and cannot be seen as it is. On the other hand, the problems faced by organizations are quite different to each other due to differences in the organizational culture, risk appetite of the organizations, behavioural aspect of the decision makers, etc. Therefore, it is always appropriate to design a suitable process for capital investment after considering all these aspects.

Findings of the survey

Perceived significance of the capital investment process

Over here the perceptions of the financial managers, of the Sri Lankan banks, about the importance of capital investments are analyzed.

Responses regarding the perceptual significance of the capital investment process were recorded on a six-point scale from 1 (Not Important) to 6 (Most Important).

According to the survey data, 54 percent of the 22 banks operating in Sri Lanka that responded to the survey considered that the capital investment process plays a ‘most’ or ‘very’ important role in their companies. Only five percent considered that the role played by the capital investment process in their company is of ‘no’ or ‘minor’ importance.

It is observed that when the size of the bank increases the mean and medium scores also increase. Large banks recorded the highest mean and median scores. This shows that large banks have a higher perceived significance for capital investment practices than the small banks.

Though there is a clear difference between the sizes of companies, it will be valuable to observe whether the statistics give importance to the size of a company and the comparison between the companies on the basis of size. The Kruskal-Wallis ANOVA by rank test was used for this purpose. The rationale behind the use of this test is that it is the best test to test the statistical difference among k independent samples with non-parametric distribution of ordinal variables (Siegel, 1956) (See 4.6.1 Chapter 4 for more details). The sizes of k=3 independent samples were 8, 8 and 6 respectively for small, medium and large size banks. (See 4.5-sub sample categorisation in Chapter 4, methodology for the discussion of segregation of sample sub segments in size).

Managerial perception on the firms’ objectives of capital investment decision-making

It is understood that the objectives of capital investment decisions affect some stages in the capital investment process especially in the analysis, acceptance and implementation. Thus, it is worthwhile looking at the extent to which various organizational objectives guide the company’s capital investment decisions.

Theoretically, the primary financial objective of a capital investment decision is to maximise the net present value of estimated cash flows discounted at the cost of capital. The theory suggests that the maximisation of net present value of a project is equivalent to maximisation of the shareholders’ wealth. The objectives related to other stakeholders would also be achieved by companies in investing projects, which is financially feasible. Therefore, capital investment decision-making involves a variety of behaviours. The sole objective of maximising shareholder wealth or other ancillary objectives of other stakeholders should be achieved through this capital investment process.

The empirical evidence revealed that many firms appear to use a combination of measures (NPV, Pay Back Period, IRR etc.) to evaluate capital investments. The likely reason for the use of several criteria is that the firms are attempting to satisfy multiple objectives.

On the other hand, firms also try to satisfy themselves by using a combination of measures to evaluate capital investment projects. If there is an omission or lapse in one particular method, it may be detected by applying another method. This is one of the plausible explanations why the companies use more than one method to evaluate the capital investment projects.

With this theoretical understanding of the implications of a multiplicity of financial objectives, the researcher surveyed the preference levels of different financial objectives in evaluating a capital investment decision. In simpler terms, the objective was to find out which financial objectives guide the capital investment decision in an organisation or what objective drive the firms to make an investment decision with regard to long-term assets.

The respondents to the question were asked to examine the extent to which organisational objectives guide the company’s capital investment decisions. The following table summarises the answers received from the financial managers.

77 percent and 72 percent of the banks thinks that maximisation of customer satisfaction and maximisation of competitive edge respectively are the next two most important factors for making capital investment decisions. However, other objectives are not so important when compared with the first three objectives. Maximisation of ROA, ROE, and growth in turnover, EPS growth and improving the market value per share is not identified as main reasons for capital investment decision. Thus, it can be concluded that the banks do not consider that much about the theoretically recommended objective of shareholder’s wealth maximization.

Search for capital шnvestment opportunities

In many organizations, especially the big ones, there are managers who are responsible for identifying and analyzing new capital investment opportunities. At the same time, there are many organizations which make use of the benchmarking exercise to identify and analyze new investment opportunities. These organizations evaluate the deficiencies in their service standards through this benchmarking exercise and finally identify the areas needing improvement, which may be in the areas of human resources and/or customer service. Development of infrastructure facilities with a view to providing a better customer service may be one of the things identified in this exercise. On the other hand, customers prefer the place which gives them the best service. Since the banks belong to the service industry this aspect has some relevance to the process of identifying capital investment opportunities. Identification of potential capital investments is the “triggering” phase of capital investment.

The researcher posed three interrelated questions in the survey to discover the practices, of identification and analysis of new investment opportunities, used by the banks. The sequential order of the questions was as follows.

• Does the bank carry out any benchmarking exercise
• Does the bank systematically evaluate the deficiencies in the service standards

Is the identification of new capital investment opportunities based on this bench marking exercise or is it more on an ad hoc basis

The respondents to the second question were asked to assess whether they systematically evaluate the deficiencies in the service standards.

A similar response was received for both questions. This shows that 59 percent of the banks carry out a benchmarking exercise systematically. Most of the banks selected for the study are financially strong and have a proper organization structure in place. Some of the banks have a separate research and development unit. Experienced and professionally qualified staff man most of these organizations. These banks carry out a benchmarking exercise systematically.

The next question was centred around whether new capital investment opportunities are identified through this bench marking exercise or more on an ad hoc basisIn other words, do banks systematically search for investment opportunities or follow a more ad-hoc approach to identifying capital investment opportunities.

Forty one percent of Finance Managers of the responding banks perceived that the function of identifying new capital investment opportunities is done systematically. Surprisingly, a majority of fifty nine percent perceived that they have more of an ad hoc basis for identifying capital investment opportunities. This is rather strange when compared with the previous two questions. Even though they carry out a proper analysis of their service standards, identifying new capital investment opportunities are not based on this analysis. However, sixty two percent of medium size banks identifies that the process of identifying the capital investment opportunities is more systematic, but large and small size banks do not give much weight to a systematic identification process. However, this difference between the banks is not statistically significant as the p value (0.09617) given by the Kruskal Wallis ANOVA by Rank test is greater than 0.05.

Some of the banks selected for the study are very large. Naturally, they have a lot of strategic issues to deal with. The capital investment decision or process is not a priority for these large companies. Therefore, in only about half of the large responding banks do capital investment ideas come from top management. In large size banks, 33% of the ideas come from middle management and 17 percent ideas come from outside consultant firms. Since they are very large in size, they have financial capabilities and resources to deploy outside consultancy firms.

62.5 percent of the middle size banks show that most of the ideas come from the top management level. 7 out of 8 banks (87.5 percent) in the small size category mentioned that most of the ideas come from top management. In small banks, sometimes they don’t have the same financial capabilities as in large banks and every decision on capital investment may be a strategic decision for them. This may be one reason why the top management involvement of small banks is relatively higher when compared with large and medium size banks.

It is significant to note that none of the banks in the sample get new capital investment ideas from lower level of staff. This may be due to the fact that the rapport between the top and lower level staff may not be that strong and lower level staff are not as experienced or professionally qualified as middle or top level staff, and their average competency levels may be low.

After the identification of capital investment opportunities, the next significant step is the primary evaluation.

Assessment of whether the companies do a primary evaluation of the capital investments was needed. The participants in the sample were asked whether they conducted primary evaluation of the potential capital investments or not.

In most of the banks, there is an accounts department with professionally qualified staff. Staff in the middle and lower management level in those departments do banking exams for which financial accounting and management accounting are subjects. Therefore, the staff has a basic conceptual knowledge of accounting. The results received represent the true picture of the capital investment practices in the banking industry in Sri Lanka. Even in small banks 87.5 percent carries out a primary evaluation of the identified capital investment. However, to check whether company size in regard to primary evaluations is statistically significant, the Kruskal Walls ANOVA by Rank test was carried out.

As explained earlier, without exception all banks carry out primary evaluations on the identified capital investment opportunity. Thereafter, the researcher tries to identify whether the banks carry out secondary evaluation after the initial evaluation. It is important to identify whether in-depth secondary evaluations of all identified capital investment are being carried.

A very similar picture of the primary evaluation received from the respondents for the secondary evaluation too. Even though the banks carry out an initial study, still the banks are highly dependent on the secondary evaluation as well. The bigger the size of the bank, the greater is the weight assigned for the secondary evaluation. There is a positive relationship between the size of the bank and the carrying out of the secondary evaluation. Therefore, we can conclude that the overwhelming majority of banks carry out both primary and secondary evaluations on the capital investment identified.

Out of all the banks, 64 percent of the respondents stated that specialised internal staff carries out the secondary evaluation. Most of these banks have separate departments called Investment, Treasury or Corporate Finance Units to evaluate these types of investments. Specialised staff is attached to these departments. This specialised staff would carry out the secondary evaluation on the proposed capital investment. In around 32 percent of the sample population, Chief Financial Officer carries out the secondary evaluation. Importantly, in 50 percent of the small banks, The Chief Financial Officer carries out the secondary evaluation. This may be due to the fact small size banks do not have specialised departments to carry out the secondary evaluation. The direct involvement of the Chief Financial Officer may come into play in those instances. Further, the importance given to the services of any firm or person outside the bank commissioned to carry out the secondary evaluation is very minimal or even negligible. On the other hand, the level of involvement of the different staff in the organisation may be differing according to the magnitude of the investment.

After the secondary evaluation, decision makers must come to a decision on the proposal by considering all the relevant factors. Despite the fact that the different parties play different roles at this stage, it is essential to know the ultimate decision maker when there is a disagreement on or incongruity in the proposal. The empirical situation in Sri Lanka in this regard is explored in the present study. Though, the sole participation of the Chief Executive Officer in this regard is as low as ten percent, the Chief Executive Officer is an active participant in the Board of Directors. In addition to the higher weight-age given to the Board of Directors and the special committee appointed, 25 percent of the decisions in small banks are ultimately taken by the Chief Financial Officer. However, it is important to note, except for these three identified staff (Board of Directors, special committee and Chief Financial Officer), no person inside or outside the organisation is involved in the ultimate decision making process regarding of capital investment.

In most of the organisations, the Board of Directors makes the ultimate decision. In this survey, the Board of Directors and the special committee appointed received equal importance in making a capital investment decision. This may be due to fact that most of these organisations are fairly large and a lot of complicated strategic issues are handled by them. Sometimes the capital investment decisions are not a strategic issue as far as the size of the organisation is concerned. Therefore, that aspect may be handled by staff down the line.

The survey tried to identify whether there are limits imposed to the size of the capital investment. The respondents were asked to identify whether any limit was imposed in taking a decision with regard to capital investment. The responses received show that all the banks have imposed limits as to the size of the capital investment. Capital investment is a frequent activity in the banking industry. Purchase of equipment and computer items has to be carried out at regular intervals. Without exception, all banks have placed restrictions on the size of the investment.

Assessment of funding and the leverage

Respondents were asked to assess whether they carry out a financial evaluation on the most optimum or the best source of funding.

In the small and medium category, 62.5 percent carryout a financial evaluation to assess the best source of funding while it has come down to 50 percent for large size banks. As mentioned earlier, the liquidity and profitability position of the large banks may be strong. Sometimes, they do not want to analyze and see the best source of funding due to their financial capabilities unless it is a very large project. On the other hand, due to their financial capabilities and strengths, these large banks can raise money at any moment from the domestic market and sometimes from the international market. Contrary to this, evaluation of the best source of funding is more important in the case of small size banks. This may be due to the fact that they are not financially strong and have a weak liquidity position unlike in the bigger banks in the industry.

In the next question respondents were asked, to assess the importance given to the degree of leverage when making an investment decision as an interrelated question to the earlier question. Responses received on the importance assigned to the degree of leverage were recorded on a six-point scale from 1 (not important) to 6 (most important).

Post –audits in capital investment decisions

After implementing the selected capital investment project, there should be ongoing project monitoring to ensure that the project is running as planned. This is called the post-audit of capital investment projects and provides a follow-up, through which the success of the projects is assessed in a proper manner and reported to the interested parties. As post-audits are time-consuming and costly, all capital investment projects are not expected to be post-Audited. Thus, companies make a limited selection of capital investment projects for post-auditing, on the basis of, which ones require the greatest expenditure, or which ones involve high risk or are strategically important.

The Kruskal Wallis ANOVA by Rank test was conducted to test whether the difference in company size in respect of carrying out post-audits is statistically significant at 95 percent confidence level.

Technical issues

The present study concentrate mainly on two issues of capital investment, namely general issues and technical issues. As already discussed, general issues cover such aspect as link of capital investment to the hierarchical controls, policy making, significance of the process and underlying objectives, etc. This section of the chapter deals with the technical aspect of capital investment decision- making practice.

The coverage includes the familiarity of discounted cash flow techniques; extent of use of quantitative capital investment techniques in analysing and making capital investment decisions; selection preference of specific capital investment techniques: methods used for cash flow estimation; determination of required rate of return, determination of equity cost; assessment of adjustment of risk factor; identification of problems in relation to capital investment decisions.

Acquaintance with inexpensive practices of cash flow

There are two main theoretical bases for capital investment evaluation techniques: accounting concepts and economic concepts. Accounting concepts concentrate more on liquidity (measures short-term financial success) and profitability (measures long term financial success) and adopt a traditional accounting perspective in measuring profitability and liquidity with no considerations given to the time value of money and other aspects such as risk.

Economics and Finance theories, on the other hand, have introduced a new philosophy of financial success. This theoretical orientation is concerned less with liquidity and profitability, and more with the maximization of shareholders’ wealth and the consideration of risk. The maximization of shareholders’ wealth has become widely accepted over the last few decades as the primary financial objective of the firm not only among academics, but also among the financial practitioners.

It is important to note that in Economics and Finance theory, the concept of time value of money is considered, which is nevertheless not considered under traditional accounting techniques. Due to a set of given reasons, cash flows occurring in different time periods cannot be compared without considering the time value of money. Discounting future cash flows into present value enables a comparison of cash flows occurring in different time periods.

Thus, it is expected that finance managers are thoroughly familiar with discounted cash flow techniques in capital investment. For the purpose of assessing whether the finance managers are familiar with the discounted cash flow techniques, a question was posed to the respondents with a scale of 1 (No knowledge of Techniques) to 6 (knowledge and confident about the use of techniques).

Apparently, small banks and medium size banks are less knowledgeable about discounted cash flow techniques than large size banks. There is a positive relationship between the size of the bank and the familiarity level on discounted cash flow techniques. Large size banks degree of awareness is the highest among the three categories. Using Kruskal – Wallis ANOVA by Rank test of independent samples was tested to identify whether this difference is statistically significant or not.

Extent of use of quantitative capital investment techniques in analysing and making capital investment decisions

In theory, much emphasis is given to quantitative financial analysis in capital investment decision-making. In practice, in addition to quantitative analysis, qualitative information may play an important and influential role. However, empirical investigations reveal that a combination of quantitative and qualitative information was used for capital investment decisions. It would bring favourable results to the organisation when taking a capital investment decision that both qualitative and quantitative are given due consideration.

A question was asked in this study to reveal the extent of the use of quantitative capital investment techniques in analysing capital investment decisions.

More than 59 percent of the responding banks indicate that they “always” or “usually” use quantitative capital investment techniques to analyse investment decisions. Only 13 percent of the banks “never” or “rarely” have used quantitative techniques. 83 percent and 63 percent of large and medium size banks respectively “always” or “usually” use quantitative capital investment techniques. The corresponding figure for small companies is only thirty seven percent. Thus, in general, it can be concluded that the tendency to use quantitative techniques in large and medium size banks are higher than that in the small size banks.

Using the Kruskal Wallis ANOVA by Rank test of independent samples, it could be revealed whether this difference in sample groups is statistically significant or not.

With regard to qualitative and quantitative information, another question was asked in this study to find out the weight given to quantitative factors (as opposed to qualitative or strategic factors) in making capital investment decisions.

63 percent of the responding banks given more than average weight to quantitative factors in making capital investment decisions. 32 percent of the responding banks given average weight (3 in the rating scale) to quantitative factors in making capital investment decisions. On the other hand, 75 percent of the small size banks consider qualitative factors are more important while that percentage has come down to 62.5 percent in small size banks. It has further reduced to 50 percent when large size banks are concerned. When size of the bank increases, the level of importance given to quantitative factors decreases. There is a negative correlation between the size of the bank and the level of importance given to quantitative factors.

Selection preference for specific capital investment analysis techniques

Another question was asked from the respondents to assess on what factors they decide the capital investment technique. May the bank give preference to theoretically correct, easy to understand, easy to do a sensitivity analysis or reasonably quick to use.

The capital investment literature characterised and promoted discounted cash flow techniques as sophisticated and theoretically valid capital investment techniques. Theoretically, the most appropriate and recommended capital investment technique is Net Present Value (NPV) since it is always consistent with the objective of maximizing shareholders’ wealth. NPV recognises the true time value of money principle and it is expressed “a rupee received today is worth more than a rupee received tomorrow” and it gives due recognition for all cash flows accruing over the entire life of the project.

There are another three discounted cash flow techniques, which is widely used namely, Internal Rate of Return (IRR), Profitability Index (PI) and Discounted Pay Back Period (DPBP), which are theoretically accepted, irrespective of some practical implementation shortcomings (Pandey, 1959)

As mentioned in the literature review (Chapter 3), though there is theoretical unsoundness in non-discounted cash flow techniques, the empirical research on capital investment revealed than non discounted cash flow techniques such as payback period and accounting rate of return are widely used in practice.

The extent of the use of capital investment techniques in banks operating in Sri Lanka is surveyed in this study as a technical issue of capital investment decisions.

All banks selected for the study responded. All responded banks indicated that the use of more than one technique. 68 percent of banks responded stated, that they have been using 3 capital investment evaluation methods at least “rarely use”. All banks responded that they have been using Net Present Value techniques at least “sometimes”. 73 percent of the responding banks stated that they have been using more than one discounted cash flow techniques at least “some times”. This result could be compared with 74 percent in a New Zealand study by Patterson, (1989) and with 98 percent in a Malaysian study by Northcott, (1996).

As revealed in Table 5.23, the most popular technique used by the banks is the Net Present Value (NPV). The next best method selected by banks is Internal Rate of Return (IRR). They selected the Discounted Pay Back Period (DPBP) method as the third highest preference method. Most importantly, all these techniques are discounted cash flow techniques. It shows the bankers are more concerned with the “Time Value” concept may be much higher than that of another industry. All banks operating in Sri Lanka are having a separate department called “Treasury” to maintain the liquidity position on a daily basis as mandated by the Banking Act. Most of these treasury departments are highly computerized and manage the daily liquidity position of the bank. In such an operation, “Time Value” concept is one of the most important philosophies. They are really concerned about the money value and always try to earn a rupee today rather than waiting till tomorrow.

The above generally known facts could be justified with the following few sentences. All banks selected for the study that means 100 percent, use Net Present Value technique at least “sometimes”. Further, 91 percent of the banks selected use Net Present Value technique at least “usually” (rating No. 4 in the scale). 32 percent uses this technique “always” (rating No.5, the highest rating in the scale).

73 percent of the banks selected for the study, use Internal Rate of Return (IRR) technique at least “sometimes”. Forty five of the respondents use this technique “usually”.

68 percent of the banks selected for the study, use Discounted Pay Back Period (DPBP) technique at least “sometimes”. 27 percent of the responding banks use this technique “usually”.

However, it should be mentioned that irrespective of the theoretical inferiority of the Pay Back Period and Accounting Rate of Return, those techniques are widely being used by the banks operating in Sri Lanka. Still there is some popularity of these techniques are in the practice in Sri Lanka. It can be justified by the fact that, 55 percent of banks using Pay Back Period at least “sometimes”.

The weighted usage score was calculated using weights of 5 for “always use” and 1 for “not used” and resulted in a maximum score of 5 and a minimum score of 1 that a given technique could obtain.

The most popular capital investment technique in all banks is Net Present Value (NPV). As mentioned earlier, all banks use Net Present Value technique without exception.

In small banks most common method has been the Net Present Value technique. 75 percent of small banks use this technique at least “usually”. Interestingly, the second best method was Accounting Rate of Return (APR). That implies the small size banks use this non-discount cash flow technique more than some of the discount cash flow techniques. Internal Rate if Return (IRR) technique was placed in the third position while Discounted Pay Back Period (DPBP), Pay Back.

Conclusion

Introduction

The present chapter reports the conclusions on general and technical issues related to capital investment practices and makes recommendations in the light of these conclusions. The researcher tries as much as possible to present fair conclusions based on the findings of the responses received by the banks. Finally, further research potentials will be analyzed at the end of the chapter.

Overall assessment of general issues in capital investment

The apparent significance of the capital investment process was considered high in the most of the banks in Sri Lanka. 54 percent of the banks confirmed that this process is either “very important” or the “most important” in their organization. It was comparatively higher in the medium and large size banks than in the small size banks according to the descriptive statistics used in the study.

The objectives of capital investments include improvement in the cost efficiency, maximization of customer satisfaction and maximization of the competitive edge. These objectives were considered more important by managers in the banks than the other objectives. The reason for these objectives being more important is that the process of capital investments is, by nature, such that it leads the management of commercial banks and other financial institutions to pursue several objectives instead of pursuing only one objective. The pursuit of several objectives further increases the responsibility of the management; in addition to that, capital investments also increase the risk undertaken by the bank. All these factors lead the managers of the banks to attach more importance to these objectives.

One of the practices of majority of the banks is benchmarking. Through benchmarking, the managements of these banks get a chance to improve their system and take actions to eliminate inefficiency, if identified, in the process. Some of the capital investment opportunities are identified through this benchmarking process. Surprisingly, 59 percent of the banks identified new capital investment opportunities on an ad hoc basis. Only 41 percent of the banks selected, identified new capital investment opportunities in systematic manner.

There is a negative correlation between the top organisational levels’ involvement in idea generation and the size of the bank. Importantly, none of the banks selected for the study, generate new capital investment ideas at the lower organisational level, implying that Sri Lankan banks are only minimally oriented towards the lower level of the organisation in creating capital investment projects. It was found in the literature that, in general, lower level involvement is high in the operational aspects while top-level involvement is high in strategic level decisions. Capital investment can be considered a process, which involves deployment of present resources in exchange for a future benefit; it is a strategic level activity to be handled by the top hierarchical level in the organisation. Thus, Sri Lankan experience conforms to the theoretical perspective on the subject.

A primary evaluation is carried out by all the banks for new investment projects. There are no exceptions in this case as every project, big or small, has to be evaluated. Later, a secondary evaluation is also carried out, which is based on the primary evaluation.

In the majority of the banks, there are qualified personnel hired for carrying out secondary evaluation on the capital investment opportunities. In some banks a single person is responsible for the secondary evaluation, in other banks there are teams of personnel responsible for secondary evaluation. In 32 percent of the banks, Chief Financial Officers do the secondary evaluation. Involvement of outside firms or any other person is very marginal as far as secondary evaluation is concerned. The involvement of the specialised internal staff increases with the size of the bank.

When it comes to the stage of ultimate decisions making, the involvement of the Board of Directors and a special committee appointed for the purpose is equally important. This could be seen at every level selected for the study. However, generally the ultimate decision maker depends more on the value of the investment project rather than on other considerations. All banks have imposed limits on the size of the investment.

68 percent of the banks stated that they carry out an evaluation to assess the best source of funding. There is a negative relationship between the size of the bank and carrying out an evaluation to identify the best source of funding. Small banks are more concerned about the mode of funding than the medium and large size banks. The level of importance assigned to the degree of leverage is not very important to Sri Lankan banks when funding a capital investment project. Only 41 percent of the respondents stated that the importance assigned to the degree of leverage as at least “very important” or “most important”. There is a negative relationship between the size of the bank and the importance assigned to the degree of leverage when funding a capital investment project.

The majority of the banks selected carry out post-audits of all major capital investment projects. However, 75 percent of medium size banks do post-audit while that percentage has come down to 33 percent where large banks are concerned. Large banks are not so concerned about carrying out post audits possibly because the capital investment is not a significant factor where the size of the bank is concerned. However, this assumption is not in line with the accepted principle of Pareto analysis, which states a company puts in to place more checks and balances in keeping with the increased level of investment.

Overall assessment of technical issues in capital investments

The majority of the banks in Sri Lanka are familiar with discounted cash flow techniques. 55 percent of banks gave a ranking of either No. 6 or No. 5 in the ranking scale (the two highest rankings in the scale) for their knowledge level or degree of awareness about the discounted cash flow techniques. Most importantly, none of the banks mentioned “no knowledge of techniques” (the lowest rankings in the scale) as their familiarity level with the discounted cash flow techniques. The large size banks have a higher awareness compared to small and medium size banks. This difference in relation to bank size is not statistically significant at 95 percent confidence level.

59 percent of banks had indicated that they use quantitative capital investment techniques at least “usually” or “always”. It is observable that there is a positive relationship between the size of the bank and the extent of using capital investment techniques

Sri Lankan banks give more weight to quantitative factors in making capital investment decisions. A negative relationship between the size of the bank and the weight given to the quantitative factors was found in the analysis. 75 percent of banks in the small category give a higher weight (rated either No. 5 or 4; the two highest ratings in the scale) to quantitative factors while this percentage has come down to 62.5 and 50 percent respectively in the case of medium and large size banks. However, this difference among the size of the bank is not statistically significant.

“Theoretically correct” and “easy to understand” are the two main criteria used by banks in selecting a capital investment technique. An almost, similar trend could be observed in banks all sizes: large, medium and small.

The Net Present Value method is used as the common standard for the evaluation of a capital investment project. 91 percent of banks use this technique at least “usually” or “always”. The Net Present Value is the more popular technique for deciding on capital investments among Sri Lankan banks than the other capital investment appraisal techniques. Sri Lankan banks selected three discounted cash flow techniques as their preferred options over other capital investment techniques. Internal Rate of Return and Discounted Pay Back Period were selected as the second and third best techniques. The popular Payback Period technique was placed in the fourth position while the Accounting Rate of Return technique was placed 5th.

Banks of all three sizes selected the NPV technique as the best method of capital investment evaluation. Notwithstanding its theoretical drawbacks, the Accounting Rate of Return technique is widely used in small and medium size banks as the second preference. The profitability index – the theoretically recommended technique for capital rationing – was not very popular among Sri Lankan banks.

“First predict cash flow data and then adjust this for non cash items such as depreciation” was the most used method for cash flow data estimation by Sri Lankan banks. Judgements based return was the most popular technique in determining the required rate of return. Weighted average cost of capital was the second best method selected by banks in determining the required rate of return. 37 percent of small and medium size banks used judgement based return in determining the required rate of return while this percentage had increased to 67 percent in the case of large size banks.

Judgement of opportunity cost was the most common method used by banks to determine the cost of equity. Use of the theoretically recommended capital asset pricing model was very low. Small banks prefer actual cost of equity while medium and large banks prefer judgement of opportunity cost in determining the cost of equity.

50 percent of the Sri Lankan banks make an average attempt to explicitly differentiate between projects based on risk. Larger banks in Sri Lanka carry out this task more often than smaller banks, in conformity with general expectations. However, this difference between company sizes is not statistically significant. Methods popularly used by banks in Sri Lanka to adjust for risk in capital investment projects are adjusted cash flows, risk adjusted required rate of return and expected net present value.

Deciding on qualitative factors to be considered and deciding on the cost of capital were identified by banks as the two most difficult problems they faced when evaluating a capital investment decision. Medium and large size banks identified deciding the cost of capital as the most difficult problem while small banks identified deciding qualitative factors to be considered the most difficult problem.

Recommendation for the improvement of capital investment practice

A recommendation for the banks is that the management of the banks must design a formal capital investment policy. The policy must be designed after considering the size of the bank, the size of the investments, the risks to be borne, by the management, of the investments and other factors. It is accepted the world over that following a well-designed policy is major factor behind the consistency of the banks and the efficiency in investment planning.

Infrastructure of the banking facilities is essential for all the banks in the modern world. As the Sri Lankan banks are a part of the service sector, the infrastructure of banking facilities must be developed in order to improve the overall system both internally and externally. Standards must be set for performance to make comparison between actual and planned performance easy.

Rather than looking for more investment opportunities on an ad hoc basis, banks should search for capital investment opportunities in a systematic way. (Only 41 percent of the Sri Lankan banks systematically search for capital investment opportunities).

Banks should try to get the lower and middle organizational levels to generate capital investment ideas. (In the Sri Lankan banking context, none of the lower level staff are involved in capital investment idea generation).

All banks should do a primary evaluation for every opportunity identified and this would enable them to do an in-depth secondary evaluation of selected capital investment opportunities.

Banks should have separate qualified, skilled and experienced people responsible for secondary evaluation; this would lead to an accurate evaluation of proposals.

Banks should use the theoretically recommended net present value technique for capital investment evaluation; this would satisfy the objective of maximising shareholders’ wealth. (In the Sri Lankan banking context, this was satisfactory).

Banks should improve the use of sophisticated risk analysis techniques such as sensitivity analysis, simulation, PERT/CPM and LP; this would improve the consideration of every combination and minimise faulty decisions.

Banks should consider quantitative information as well as qualitative information, when making capital investment decisions.

The ultimate decision should be made by a group of people in the top management (e.g. Board of Directors); this would minimize incorrect decisions.

Banks should have an on-going project to monitor (post-audit) the implemented projects which involve high cost and/or high risk or which are strategically important.

Finally, banks should update the knowledge of finance personnel on recent trends in computer technology and the developments in capital investment theory; this would ensure efficient evaluation of decision making on capital investments.

Further research potentials in capital investment practice

This research gave a general summary of capital investment practices of the commercial banks in Sri Lanka. Such a study could be extended initially to the entire financial services industry in order to observe whether there is a difference between sectors. Finally, a similar study could be extended to other sectors, especially the non-service sectors like manufacturing organisations. This would enable us to examine the overall situation of capital investment practice in Sri Lanka and compare the differences between the manufacturing and financial services industry. Further, this study could be extended to explore behavioural perspectives of the capital investment decision-making process among the banks in Sri Lanka. Similarly, a study could be carried out to find out why some sophisticated capital investment techniques are not so popular among the organisations in Sri Lanka

Capital investment news of the company and the volatility of share prices is another area, which the present study was not concerned with, but this is an area where further studies can be carried out. This area of exploration is crucial especially in understanding the causal connections between financial market performance of companies and their internal capital investment decisions.

Capital investment sophistication and company performance can be studied in order to assess their interrelationships and to judge the financial validity of using sophisticated capital investment techniques.

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Capital investment practices in the banking industry In Sri Lanka: an empirical study. (2019, Apr 14). Retrieved from https://phdessay.com/capital-investment-practices-in-the-banking-industry-in-sri-lanka-an-empirical-study/

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