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Capital investment decision or Capital budgeting is one of the most important financial decision areas of any business enterprise. The quality of this decision requires great deal of skills & competence to handle, as it not only serves as a fulcrum to other decisions, but determines the future success and profitability of the organisation (Van Horn & Wachowicz, 2005:304; Damilola, 2007:36). The four financial decisions include; investment decision (decision as to the type of projects to invest in, usually, based on its associated value, risk and return), financing decision (how such investments has to be financed, weighing the associated cost of fund), dividend decision (how the returns will be appropriated) and liquidity decisions (ensuring that both current assets and currents liabilities are properly balanced to eschew adverse effect on the firms operations) (Pandey, 2005:4-5).

More so, the limitedness or inadequacy of resources available to firms further explains the cardinality of investment decisions, especial capital assets investment decisions, given the fact that resources have to be strategically allocated to viable project in order to leverage the cash flow potential of such investment. On the other hand the consequences of poor investment decision can be very devastating, to the investing organisation especially to firms with low capacity or abilities to absorb adverse results or huge loses like Small and Medium Scale Enterprises (SMEs).

Unfortunately, this is the most neglected area among researchers and policy makers, as research evidence on Investment decision or the investment appraisals methods used by SMEs and their impact on the their financial performance are rare. (Loizou, 2005; McMahon, 2003). Small and Medium Scale Enterprises (SMEs), in most developing countries are characterised by the paucity of capital and the lack of management and entrepreneurial skills and capacity (Sanusi, 2003; Olutunla, 2008; Umoren, 2003). Hence their inability to effectively analyse investment projects for sound investment decisions. These accounts substantially to situations were funds are channelled to project with either low or zero viability, translating into poor returns to investors or outright failure of the enterprise.

This paper therefore, focuses on the capital assets investment decision of SMEs in Nigeria, adopting a theoretical exploratory methodology, with the major objectives of identifying the most common methods of investment appraisal among SMEs, and to make suggestions as to the most effective methods of investment decision criteria, given their inherent vulnerability to risks. The paper is divided into four sections. Section one introduced the paper, section two deals with the definition of SMEs, its importance to economic development, its inhibitors as well as government efforts towards SMEs development in Nigeria. In section three the general overview of Capital Assets investment decision, the importance of investment decision and capital budgeting techniques are captured, while in the last section common approaches to capital budgeting by SMEs as well as the model investment appraisal option for SMEs take their turn. The conclusion is also housed in section four.

Small and Medium Scale Enterprises (SMEs) in Nigeria

The crucial role played by small and medium size enterprises (SMEs) in driving economic growth and development, has long been recognised by both developed and developing economies of the world, with renewed interest at the turn of the 21st century ( Musa & Danjuma, 2007; Sanusi, 2003; Omoruyi & Okonofua, 2005:13; Cabarrouy,1999). In Nigeria, this recognition can be traced a few decades backward, as it is reported to have shown interest in SMEs development since 1970, although not matched with concrete actions (Ojo, 2006:20). In this section, we wish to define SMEs, mention some of its potentials, some of its inhibitors as well as some measures put in place to enhance its development in Nigeria.

Definition of SMEs

There has been no universal agreement as to what constitute Small and Medium Size Enterprises (SMSs). Different countries classify their industries based on the criteria they adjudged appropriate, with major or minor similarities and dissimilarities. The common criteria used include; number of employees, scale of investment, income generated, turnover among other (Kimambo, 2005.Ayozie, 2008:11). In Nigeria, the most generally accepted definition of SMEs follows the classification of industries by the National Council on Industry (NCI) in 2001, which is on the bases of assets based and the number of employees as shown in table 1. Thus, Small and Medium Enterprise (SME) refers to "any enterprise with a maximum asset base of N200 million excluding land and working Capital and with the number of staff employed not less than 10 or more than 300". This is invariably the definition adopted in the implementation of the Small and Medium Industries and Equity Investment Scheme, launched in August 2001 (SMIEIS), (Sanusi, 2003; Nigeria Business info .com:2002).

The Significance of SMEs to Economic Development

The renewed interest in SMEs globally has been aroused in recognition of its potentials to make significant contributions to economic growth and development (Sanusi, 2003; Nixon & Cook, 1999; Umoren, 2003:30). In Nigeria for instance, Ubom (2006:20) reported that besides oil and agriculture, micro, small and medium scale enterprises (MSMEs) accounts for more than 95 percent of all productive activities, which positions them as strong agents of economic growth and development. More so, SMEs have been acknowledged for the production of intermediate products for use by large scale industries as well as the utilisation of local resources for producing value added goods (Adelaja, 2004:232). In the same vein, Ojo (2006:24-25) summarised the developmental role of SMEs in Nigeria to include; the capacity to employ over 70% of the work force, ability to contribute about 70% to GDP, as well as the potential to mobilise domestic savings for investment and foster industrial dispersal. All these potentials ultimately, lead to the reduction (if not eradication) of poverty, which is invariably a core millennium development goal.

Inhibitors to SMES Development in Nigeria

SMEs potentials to add value to the economic progress of Nigeria as mention above had not been fully manifested, owing to several constraints which had bedevilled its development. These challenges include; Inadequate funds, and lack of effective financial support system, unstable macro economic environment, poor infrastructural facilities, shortage of skilled man power, financial recklessness/ indiscipline, poor management practices and entrepreneurial skills, restricted market access, overbearing regulatory and operational environment among others (Ojo, 2006:26; Omoruyi & Okonofua, 2005:23-25; Ubom, 2006:24; Sanusi,2003; Ayozie,2008:15-16). These problems are in fact, akin to the problems identified by Iyoha (2003:436) in explaining Nigeria sluggish growth. This goes to suggest that if SMEs are stagnated, the economy stands most probably to be stagnated.

It should be noted that although, the problems of SMEs in most developing countries look similar albeit with differentiated severity (Cook & Nixson, 1999; Ojo, 2006:26-28), the most notorious inhibitor to SMEs development in Nigeria is undoubtedly inadequate finance (Olutunla, 2005). Our contention is that, while financing problem or simply put inadequate funding, stands out as first among equal, the financial constraint will be exacerbated and may persist adinfinitum, because of SMEs poor investment decisions, due to lack of the needed competences and skills for sound investment appraisal.

Government Policies and SMEs Development in Nigeria

The purpose of government is to enhance the humanity of the citizens (Aristotle, 1962; Appadorai, 1975; Rawls, 1972). The State is a means to an end, the end being a better life for the citizens whether conceive in ethical terns or economic end (Locke, 1967; Adam Smith, 1776) In recognition of SMEs as a catalyst of economic development, different regimes have initiated various policy measures ranging from fiscal, monetary and industrial policy measures and incentives, aimed at enhancing the development of SMEs (Omoruyi & Okonofua, 2005:18). Some of these measures as summarised by Sanusi (2003) are as follows;

i. Funding and setting up of industrial estates to reduce overhead costs;

ii. Establishing specialised financial institutions, including the Small Scale Industries Credit Scheme (SSICSs), Nigerian Industrial Development Bank (NIDB), Nigerian Bank for Commence and Industry (NBCI) to provide long-term credit;

iii. Facilitating and guaranteeing external finance by the World Bank, African Development Bank and other international financial institutions;

iv. Facilitating the establishment of the National Directorate of Employment (NDE), which also initiated the setting up of new SMEs

v. Establishment of the National Economics Reconstruction Fund (NERFUND) to provide medium to long-term local and foreign loans for small and medium scale businesses, particularly those located in the rural areas; and

vi. Provision of technical training and advisory services through industrial development centres. (Sanusi, 2003)

The latest of these efforts was the establishment of Small and Medium Industries Equity Investment Scheme (SMIEIS) in 2001 as an antidote to the lingering problems, especially "the dearth of longterm funding and poor business management skills which have inhibited the realisation of the potentials of the small and medium scale industries as the engine of growth in the Nigerian economy" (Sanusi, 2003a).

Other policy measures also identified include the promotion of good governance, SME policy Reforms, government promotion of private sector organisations (PSO), Repositioning / Revitalisation of Industrial Development canter (IDCs), the establishment of Small and Medium Industries Development Agency (SMIDA), promotion of Entrepreneurship Development Programme (EDP) and Funding of SMEs (Ubom 2006:26-32)

However, as already stated, the analyses of the effectiveness or otherwise of these measures are outside the scope of this paper. We will therefore turn to an over view of capital assets investment decision.

Overview of Capital Assets Investment Decision

Capital investment decision or capital budgeting has been defined as "the process of identifying, analysing and selecting investment projects whose returns (cash flows) are expected to extend beyond one year" (Van Horn & Wachowicz, 2005:304). It involves the allocation of capital or commitment of funds to long term assets or capital assets, whose benefits, in terms of cash flows are, expected in the future (Pandey, 2005:5, Uremandu, 2004:4). It is the most basic financial decision of any organisation, and is usually arrived at, after evaluating or analysing the relative attractiveness of the long term assets, in terms of value, risks and expected return (Damilola, 2007:36). It can be likened to the "hen that lays the golden eggs", as it determine the revenue generating ability of the firm, or as asserted by Van Horn & Wachowicz (2005:304) ..."the firm's future success and profitability depend on long-term decision currently made".

Specifically, capital budgeting decision involves five major stages namely; "generating investment project proposal consistent with the firm strategic objectives, estimating the after-tax incremental operating cash flows for investment projects, evaluating project incremental cash flows, selecting projects based on a valuemaximising acceptance criterion and re-evaluating implemented investment projects continually and performing post audits for completed projects" (Van Horn & Wachowicz 2005:304). Each of these steps requires care, skills and competence to handle.

For instance, to generate investment project proposals consistent with the firm's strategy, which is the starting point of capital budgeting, require efficient administrative procedure in channelling any investment request, be it a new product development, expansion of existing products, replacement of asset, research and development, exploration and so on. Such investment requests are to be considered in terms of its compatibility with the long term objective of the firm in order to avoid needless analysis. However, the administrative procedures for screening investment proposal depended on the firm involve and the circumstances of such project under consideration (Van Horn & Wachowicz 2005:304).

Also, estimating the after tax incremental operating cash flow of the project is considered the most crucial stage in capital budgeting, because, according to (Van Horn & Wachowicz 2005:304), cash, and not accounting income is central to all decisions of the firm. For this reason, the future benefits from every project should be express in terms of cash flows and not income flows. Cash flows should be determined on an after-tax basis. That means that, the initial outlay, the appropriate discount rate, as well as all forecasted flows must be stated in after tax terms. Also, the analyses are to be presented on incremental basis, so that only the difference between the cash flows of the firm with and without the project are analyse. This entails among other things, ignoring sunk cost, considering opportunity costs and providing for anticipated inflation and taxation as appropriate.

In the same vein, evaluating project incremental cash flows, selecting projects based on a value-maximising acceptance criterion and reevaluating implemented investment projects demand care and competence, in order to maximise the overall benefits of investing in such projects.

Importance of Investment Decision

We have earlier noted that investment decision is the most basic financial decision of any organisation be it small, medium large or even multinational, as it determine to a very large extend the future success and profitability of the company. Pandey (2005:142) identified five specific reasons that accounts for the special attention that investment decisions requires. First, Capital investment decision has a significant influence on the rate and direction of growth of an entity, as a wrong investment decision, an over-investment or under investment decision could strangulate the company and makes it uncompetitive.

Secondly, investment decisions requires large amount of funds, which can be sorted internally and or externally. This made it imperative for careful evaluation of investment decision. Thirdly, in view of the fact that the future is difficult to predict, it is therefore risky to commit funds for a long time. Hence, projects are evaluated in terms of risk and return. Fourthly, because of the irreversibility of most investment decisions, coupled with the difficulty in finding a second hand market for the acquired capital items, as poor decisions can lead to heavy losses on the company. And finally, investment decision is said to be among the firm most complex decisions. This is both in terms of the uncertainties of estimating the future cash flow streams, as well as the impact of economic, political social and technological forces on such estimates which increases its complexities.

Capital Budgeting Techniques

After an estimate of cash flow is being made and the required rate of return or opportunity cost of capital decided, a decision rule will need to be applied for the right choice of investment to be made. This investment decision rule, otherwise called capital budgeting techniques or "evaluation criteria" requires a sound appraisal technique to measure the economic worth of an investment project (Pandey, 2005:143). Investment projects can be evaluated using either discounted cash flow criteria such as the Internal Rate of Return (IRR), Net Present Value (NPV), profitability index (PI) etc, or non-discounted cash flow techniques such as Pay Back Period (PBP), Discounted Pay Back Period (DPBP) or Accounting Rate of Return (ARR). Each of these criteria has its own merits and demerits, but the essential attribute of a sound appraisal criterion, as advocated by experts is that it should ultimately lead to the maximisation of shareholder wealth (Pandey, 2005:143)

However, before we look at this appraisal techniques, it will not be out of place to adumbrate certain characteristics which a sound investment evaluation criterion should possess as identified by Pandey (2005:143);

I. It should consider all cash flows to determine the true profitability of the project.

II. It should provide for an objective and unambiguous way of separating good project from bad project.

III. It should help ranking of projects according to their true profitability.

IV. It should recognised the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones

V. It should help to choose among mutually exclusive project, that(is) project which maximises shareholders wealth

VI. It should be a criterion which is applicable to any conceivable investment project independent of others

It should be noted that the soundness or otherwise of any criteria is assessed on the basses of the above criterion. We will now discuss the most commonly used investment evaluation techniques, at least two discounted and two non discounted methods.

Pay Back Period (Non-Discounted)

CIMA official terminology defines Pay Back Period (PBP) as "the period, usually expressed in years, which it takes the cash inflows from a capital investment project to equal the cash outflows". Simply put, payback period is the period it take a company to fully recoup the initial outlay of a capital project. It is the most popular and most widely recognised traditional method of evaluating investment projects (Pandey, 2005:149).

For a project with uniform annual cash flow, the PBP is calculated as the initial outlay, divided by the annual cash flow. If the streams of cash flow are not uniform, the PBP is calculated by adding up the cash inflows until the total equal to the initial cash outlay. On the basis of this criteria therefore, a project is selected or accepted if it's PBP is less than the maximum or standard PBP set by management (Pandey 2005:149; Akinsulire, 2006:72).

The popularity of PBP in practice is attributable to its associated virtues, which includes simplicity, cost effectiveness, risks shield, short term effect, and liquidity. In spite of these virtues PBP is not a desirable investment criterion because of its inherent drawbacks, which include the lack of consideration of cash flow after pay back, lack of consideration of the time value of money (unless discounted payback is used). It is also criticise for it avoidance of the pattern of cash flow, and above all its inconsistency with shareholders value maximisation objective (Pandey, 2005:149-150).

Accounting Rate Of Return (Non-Discounted)

Accounting Rate of Return (ARR) measures the profitability of an investment, using accounting information as revealed by financial statement (Pandey, 2005:151). ARR is an average rate, which is determined as an average after tax profit, divided by the average investment.



On the basis of the above formula, projects that earn an ARR higher than the minimum target set by the management are accepted, while projects with lower ARR are rejected. The strength of this method lies in the fact that, it is simple to understand and use, it uses accounting profit which is readily available and the fact that it considers the entire stream of income from the project. (ICAN, 2006:28; Akinsulire, 2005:68)

However, ARR has many inherent weaknesses that made it not conducive for the evaluation of risky projects. The most notorious of them are; the use of accounting profit which is difficult to define, the fact that it ignore the time value of money and the use of arbitrary cut off rate. While ARR is suitable for performance evaluation, it is adjudged to be undesirable for investment appraisal. (Pandey, 2005:152)

Net Present Value (NPV) (Discounted method)

NPV is one of the discounted cash flows techniques use in evaluating investment projects. It measures the present value of the proposal's net cash flows less the proposal's initial cash outlay (Van Horn & Wachowicz, 2005:323). In other word, "it is the present value of the future cash flows minus the present value of initial capital investment" (ICAN, 2006:30). It can be determined using the formula below;


Where, CFi...n is the expected net cash flow from year i to year n, ICO is the initial cash outlay and ? is the required rate of return (Van Horn & Wachowicz, 2005:323).

Under this criteria, individual projects are accepted if there result in a positive NPV, otherwise there are rejected. In selecting between mutually exclusive projects, the project with the highest positive NPV is selected (ICAN, 2006:31).

The preference of this method by expert is askance from its associated advantages; such as its time value of money consideration, consistency with the shareholder wealth maximisation objectives, as well as its consideration of the entire cash flow stream over the project life. NPVs major draw back is that it is complex to understand and use (Akinsulire, 2005:76)

Internal Rate of Return (IRR) (Discounted Method)

IRR is the rate that equates the present values of inflows to the present value of outflows (Solomon 2005). That is the rate that yields an NPV of zero (Akinsulire, 2005:78). It is also called the cut off rate, the hurdle rate, the DCF yield, the target rate, the marginal efficiency cost of capital, the DCF rate of return and the break even cost of capital. It is computed as follows


Where, IRR is the internal rate of return, LR is an estimated lower rate, HR is an estimated higher rate, and NPV is the net present value (Solomon, 2005). Note that the positive and negative NPVs are obtained sometime by the process of trial and error using present value tables (Van Horn & Wachowicz, 2005:322). The decision rule under IRR is to accept project with an IRR higher that the company cost of capital or the cut off rate set by the company.

IRR share most of the merits and demerits of NPV, with the IRR having more short falls than NPV due to the trial and error process involved.


We have earlier heralded the importance of capital assets investment decision or capital budgeting, which applied to every company, whether it is a small, medium or large enterprise. But it should be understood that it is sound investment appraisal that births sound investment decisions which give rise to the said benefits. This implies that, making sound investment decisions through the application of appropriate evaluation techniques is critical not only to large companies but much more to SMEs which are even considered riskier (Ojo, 2004)

The existence of a "financial gap" among SMEs in developing countries explains why the issue of SMEs funding had been over burden by researchers, with almost blatant neglect to the issue of proper allocation of funds to viable project which require sound decision criteria (Carter & Jones Evans 2000:286:33). Stressing the importance of efficient resource allocation among SMEs, Katz (1970) in Carter & Jones Evans (2000:286) suggested that "...small businesses must focus and conserve its resources ... by planning activities carefully to ensure resources are allocated to activities in relation to their contribution to the business"

McMahon (2003) reported that, while large scale enterprises employ the most sophisticated techniques available for evaluating capital project because of their vested interest in ensuring that their capital investment decisions are correctly made, so that only value-adding project are undertaken, the skills and competence for such analyses may be lacking in most SMEs. Hence, most SMEs do not use discounted Cash flow techniques in judging investment opportunities (ICAN, 2006:158; Akinsulire, 2006:582). It has also been found that in majority of situation SMEs does not apply any quantitative technique in evaluating capital projects (McMahon et al, 1993 in McMahon (2003). This is consistent with the conclusion of Keasey and Watson (1993:230) in McMahon (2003) that;

... the small firm environment is such that any attempts to use the discounted cash flow technique to evaluate investment projects are so fraught with conceptual difficulties that its benefits (if any) would be unlikely to prove sufficient to justify its consumption of scarce management time.

In this situation, the real possibility of wrong or faulty investment decision that may seriously undermine the profitability and viability of the SMEs business cannot be ruled out. This could account substantially to the mortality rate of SMEs in developing economies of the world including Nigeria (Sanusi, 2003).

The preference of non- discounting cash flow techniques amongst SMEs, notably, the Pay Back Period (PBP) and the Accounting Rate of Return (ARR) had been largely attributed to the following reasons.

i. The PBP and ARR are simpler to calculate and use than the DCF techniques

ii. ARR for instance uses readily available accounting data and present the analyses in terms of familiar percentage figure that can easily be understood by many users, including the financially less aware managers.

iii. The pay back period is the least affected by uncertainties of all the appraisal methods, since it focuses on the short term and emphasizes liquidity. For the lower the PBP the more liquid the company becomes.

(ICAN, 2006:159; Akinsulire, 2006:582)

Other institutional factors that favour this preference include;

iv. The lack of expertise in financial management and other skills necessary to carry out sophisticated evaluation of projects,

v. The limitedness of resources available to SMEs including finance and manpower debar them from more complicated criteria which are sometime also expensive,

vi. Lending institutions' policies inhibit SMEs from undertaking high return projects to secure timely payback and therefore handicap the effective allocation of company financial resources

(Loizou, 2005; Sanusi, 2003; McMahon et al, 1993 in McMahon, 2003)

Model Investment Appraisal Option for SMEs In Nigeria

Small and medium size enterprises anywhere in the world are considered risky. This is not just in terms of their lack of recourses, but much more in terms of their owner-manager characteristic as well as their inability to evaluate long term investment opportunities for the purpose of efficiently allocating limited funds for the needed capital formation. It is for this reasons that experts have advocated the use of modern or discounted cash flow techniques in line with the 'dictates of modern finance theory' (McMahon, 2003; ICAN, 2006:159 and Akinsulire, 2006:582, Ojo. 2004:). This position was also supported by Uremadu (2004:142) when he maintained that the effects of inflation and taxation should be incorporated into investment decision. This by implication suggested the use of sophisticated appraisal tools.

The specific reasons for these advocacies are in terms of the several advantages inherent in DCF tools. Such merits include;

i. They look at cash flow of a projects and not accounting profit, unlike ARR which has inherent definitional problems,

ii. They are concern with liquidity and not with profitability

iii. They take accounts of the timing of the cash flow of the projects; giving bigger naira values to earlier years than later years

iv. They are risk adjusted techniques, as the risk and inflation can easily be incorporated into the cost of capital use to discount the cash flows.

(ICAN, 2006: Akinsulire, 2006: Pandey, 2005; Van Home & Wachowicz, 2005).

In concluding this section, it will be germane to use a hypothetical case to buttress this advocacy.

Suppose a company is faced with two mutually exclusive projects as follows

Project 1; A five year project expected to yield a uniform cash flow of 100,000 annually, with initial investment of N200, 000 and the cost of capital of 12%.

Project 2: With similar data as project one, except that the expected cash flow will be 50,000, 80,000, 150,000, 200,000 and 300,000 for years one to five respectively.

If we evaluate these two projects using a non -discounted cash flow technique say Pay Back Period (PBP), our decision will be to invest on project 1 with a shorter pay back period of 2 years and reject project2 with a longer PBP of 2 years and 6 months. On the other hand, when we appraise the two projects on the bases of a discounted cash flow technique say Net Present Value (NPV), project 2 with a higher NPV of N3 12,510 will be preferred to project 1 will a lower NPV of N160,400. The detail computations are shown below:

This hypothetical illustration makes our argument clearer, and is supportive of the need for SMEs to used DCF tools for their investment appraisals.

Conclusion and Recommendation

The potentials of SMEs to contribute significantly to the economic progress of any nation are no longer in doubt, but the full manifestations of such potentials are yet to be evident. This "performance gap" has been attributed to the "lingering" problems confronting SMEs in Nigeria, with the paucity of finance (financial gap) identified as chief. In Nigeria several governments has adopted measures aimed at solving these problem with less than commensurate achievements. The latest being the establishment of small and medium industries equity investment scheme (SMIEIS) set up principally to deal with the issue of inadequate funding for SMEs especially, long-term funds.

However, while availability of funds is crucial to the SMEs development in Nigeria and anywhere else , ability and skills to effectively and efficiently allocate those financial resources is equally important if not more important. But because of lack of managerial and financial management skills, most SMEs are still captured in the cobweb of faulty investment decisions due largely to the use of traditional methods of investment appraisal, or outright avoidance of quantitative appraisal with its associated excruciating and crippling effect on the business profitability.

It is therefore our recommendation that SMEs in Nigeria be encourage to apply discounted cash flow techniques which are more effective and risks adjusting into the evaluation of their investment projects. That will enable SMEs to improve on their capital assets investment decisions, and to leverage on the inflows from viable projects as a panacea to their financial quagmire and ultimately improve their contribution towards the economic wellbeing of Nigeria.


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Author affiliation:

Ben-Caleb, Egbide & Uwuigbe, Uwalomwa PhD

Department of Accounting

School of Business

College of Development Studies

Covenant University

Ota, Ogun State

Godwyns Ade* Agbude

Department of Political Science and

International Relations

College of Development Studies

Covenant University,

Ota, Ogun State

Author affiliation:

* bencaleb

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