After reading the chapters and the article, Capital Budgeting Techniques Used by

Question

After reading the chapters and the article, Capital Budgeting Techniques Used by Small Business Firms in the 1990s by Stanley Block, respond to the following scenario.

You are providing consulting services to small businesses with a goal of helping them to maximize the use of their capital budgets. You are equipped to provide the pros and cons of various methods of calculating ROI. A client named Katherine engages your services with questions on how to expand their operations by opening new office locations. Katherine asks you to help determine her return on investment (ROI). She says, "I prefer to have a 3-year payback on my capital investment.” To which you reply

Explanation / Answer

In recent times, small business firms have created 80 percent of the new jobs in the United States. Thus, their methodology for capital investment decisions is very important, though it continues to be somewhat different from that used by larger business firms. A questionnaire survey with 232 small business respondents indicates that the payback method is still the preferred approach by 42.7 percent of the firms. Unlike many larger firms, their time horizon is often the period over which a financial institution will extend them funding. In any event, the “average” minimal payback period in the survey averaged 2.81 years, a time period far shorter than the useful life of the asset and one that would indicate a required return far higher than most firms anticipate. Somewhat encouraging was the increased use of discounted cash flow methods (27.6 percent), which is a higher rate of utilization than that indicated in other surveys of smaller firms over the last few decades

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