A SURVEY ON CORPORATE INVESTMENT PRACTICES IN NEPAL Introduction Investment and capital accumulation have traditionally been accorded a prime place in the development literature. The evidence from the vast literatures on growth empirics shows investment in capital goods as one of the most robust determinants of cross-country growth (Levine, 1999). Over the last couple of decades, economic liberalization and deregulation policies have been widely adopted by developing countries that assign a central role to the private sector. The emphasis on the private sector as the engine of economic growth and development has brought the focus on the behavior of private investment in developing countries. An efficient selection of investment project is considered as essential for sustained economic growth of any country. In market economy, the decision process about investment can be characterized as bottom to top process. In other words, individual firm carries out investment and the firm itself decides whether to invest or not. The variation of firm investment behavior in a perfect capital market is fully explained by the market opportunity and expected profitability of the proposed project. Therefore, adjusting capital expenditure in response to changes in expected future demand represents rational economic behavior at the firm level that reduces inefficient investment outlays and lead to optimal investment at the aggregate level. Electronic copy available at: http://ssrn.com/abstract=1564179 In case of perfect capital market, the firm's financial structure is irrelevant since the market value of the firm depends only on the expected profit stream from the investment project and not on the financial structure. Firms are thus indifferent between the various (internal or external) means to finance their investment. Investment project will be carried out if their expected return exceeds the (given) cost of capital, which is thought to be the same for all firms fixed in central capital markets. In this neo-classical view of financial market, internal and external funds are perfect substitutes and investment can never be constrained by a lack of internal finance. Due to absence of perfect capital markets in real world, the other factors affecting corporate investment patterns has been identified as the existence of capital market imperfections that restrict access to or increases the cost of funds necessary to maintain, otherwise desirable investment level. As a result, capital expenditure reduction will be accelerated during tough times and opposite results hold during period of strong economic growth. Capital market imperfections lead to firms into different financing hierarchies facing different financing constraints. When firms face financing constraints, investment spending will vary with the availability of internal funds, rather than just with the availability of positive Net Present Value (NPV) projects. Therefore, the corporate investment changes due to the existence of financial constraint have been the subject of much attention by researchers and policy makers for the study of investment pattern and behavior at corporate level. Electronic copy available at: http://ssrn.com/abstract=1564179 Existence of incomplete asymmetric information between the borrowers and lenders of external funds leads to problem of adverse selection and moral hazard. For example, Myers and Majluf (1984) and Myers (1984) provide a foundation for these market imperfections by appealing to asymmetric information problems in capital markets. These problems of asymmetric information lead to a difference between the cost of internal and external funds. The providers of external finance will require a (firm specific) premium because they are unable to monitor or screen all the aspects of investment projects. The size of external finance premium depends on firm characteristics, like firm size or net worth, which provide an imperfect indication for the lender of the creditworthiness of the borrowing firms. Due to external finance premium, firms will albeit to a different degree; prefer to finance their investment by internal funds. The upshot is that internal or external finance are no longer perfect substitute Investment decision is one of the crucial functions of finance as has been recognized by the ample literatures and books of financial theories. The governing factors at making investment decisions ranges too far from more subjective factors like overconfidence or ego of managers, to real financial factors such as project profitability, cost of capital etc. of new investment project. By far, the most popular factors affecting investment decisions as recognized by the literatures of finance more or less seems closer to financial aspects of investment project like cash flow, profitability, cost of capital etc. Hence, the following section intends to obtain information regarding the preferences, views and opinions of finance practitioners concerning different factors that affect investment decision to their firms. Sources of fund and financing mix are other important determinants of investment decision. Whether there is any preferred source of funds over other sources, to finance their investment projects for the Nepalese managers? This section also intends to insight these facts by presenting and analyzing the results of survey. Methodology This survey has been designed primarily to describe, analyze and interpret the preferences, views and opinions of Nepalese finance practitioners regarding the different aspects of investment decision in their respective firms. One hundred closed end questionnaire (shown in appendix) covering nineteen different questions had been distributed to managers, Board of Directors and other finance practitioners from the different line of business. The nature of questions included the yes/no answer type, single and multiple answers/ response type, Likert-scale and ranking answer type. Out of hundred questionnaires distributed, sixty-seven usable responses were obtained which have been presented in the following two sections. The section 2 uncovers the respondents' profile and background information following the other section including the details of qualitative information, views, opinions and preferences of Nepalese managers into the different facets of investment decisions. The statistical tools widely applied to analyze the primary data are the frequencies, percentages, means, medians, mean rankings, standard deviation and rank correlation (spearman rho) coefficients. The testing procedures include the F test (ANOVA), and x2 –test for determining the level of significance. Profile of Respondents In the second half of 2006, a survey was conducted on different types of firms in Nepal to identify key investment determinants, and the strengths and weaknesses of the country's capital markets. The survey was based on a questionnaire distributed to 22 firms, primarily in the manufacturing and services sectors. 100 questionnaires were distributed to the sample firms. The response rate was around 70 per cent. The first part of the questionnaire considered collecting background information of enterprises surveyed. The questionnaire contained the questions relating to the positions of respondents in their organization, respondents qualification, line of business, and age of the sample enterprises. As regards to the positions of respondents in their organization portfolio, 31 (i.e. 46 %) respondents held the managerial positions i.e. chief executives, account officers, finance officers, marketing and administrative officers, 26 respondents (i.e.38.8%) were from the Board of Directors including the chairman of the Board. However 15 percent of the respondents did not like to respond this question so they were categorized as others in this study. Manufacturing firms accounted for eight firms covering 32 out of the 67 respondents. Five respondents were paper manufacturers, which employed as many as 1000 people; and the others included manufacturers of plastics, paint, bricks, and beverages products such as beers, Coca-Cola, and poultry products. Service firms included five in banking, and finance, two in tourism i.e. hotels, three in health services and the remainder in transport, education and retail trading. Most firms were small, with the majority employing fewer than 50 people, and almost one third employing fewer than 25 people. There were, however, three large firms in the sample, including a paper manufacturer that employed 1000 people. Out of the firms that provided information about employment numbers, manufacturing accounted for 39 percent of total responses, services for 34 per cent. More specifically, the business concerned for the survey were plastics and papers, hotels, feed, beverage, trading, education, banking, finance and other service sectors. The survey questionnaire also contained the question related to the age of the sample enterprises. Theoretically the age factor is considered more important for making investment decisions regarding expansion, replacement and diversification of the respective business. This study however does not consider classifying the business investment decisions into expansion, replacement and diversification activities but it is well known that the enterprises having lower age are in favor of expansion and replacement project in comparison of the enterprises having older age. The age of enterprises were categorized into three parts. 39 percent of sample enterprises covered by this study were of less than six years old, about 50 percent of enterprises were of six to ten years, 19 percent of enterprises were of more than 10 years. The survey questionnaire also contained the question requiring information relating to the qualification of the respondents. The maximum numbers of the respondents (i.e. 43 percent) were graduates, 12 percent were below the graduate, 19 percent earned the master degree and the rest of the respondents (25 percent) did not respond at all. Analysis of survey opinions Objective and obstacles to firm investment: One of the salient features of Nepalese business sector is the low investment rate (Biggs et al; 2000). The present survey also rarely observed that in any given year, most firms do invest in plant and equipment and for those that do, net investment is unexciting. Most investment in the sample was to increase capacity or improve the production process. Since most investment is made to increase output and not to improve quality or change the products, it is not surprising that investment is low. Most investment by Nepalese businesses goes to increase output (30%) or replace existing capacity (22%) using the same technologies as is shown in Table 1. Very few firms are induced to invest in improving production techniques (11%) or improving quality of product (16%). Less than 20 percent of the sample reported using their most recent investment to introduce a new product. Table-1 Determinants of investment S.No. 1 2 Questions No. % What is the average level of capacity utilization in your firm during last three years? (Make a tick mark) 22 a. Below 50 percent 30 b. 51 to 75 percent 15 c. 76 to 100 percent d. More than 100 percent What is the major objective of investment in plant and equipment in your firm? (Multiple answer/ response) 33 48 19 - a. b. c. d. e. 3 To improve production process To improve quality of product To increase output To increase plant capacity To introduce new product 14 21 39 30 25 11 16 30 23 19 17 28 25 21 13 9 8 14 24 21 18 11 8 7 What factors are likely to limit your investment in plant & equipment over the next twelve months? (Multiple answer/ response) a. Inability to raise finance b. Uncertainty of demand c. Inadequate rate of return on proposed investment d. Shortage of internal funds e. High cost of external funds g. Shortage of skilled labor h. Others The average level of capacity utilization for the majority of sample was below 75 percent and no sector or size group was above 100 percent. The rate of capacity utilization implicitly influences the growth of investment in plant and equipment. However in this survey, almost 100 percent of the firms were running below the normal capacity. 81 percent respondents reported that the average capacity utilization in their firms during last three years was below 75 percent. Given the low capacity utilization and lack of demand there is no reason for firms to add capacity or even maintain the capacity that they have. The lack of or too low investment in plant and equipment might have a series of limitations, which have also been attempted to excavate in this survey. The major factors contributing to the limitations of investment were identified as the finance, market and labor related problems. Managers that we surveyed felt that a lack of demand for their products was a significant obstacle; in fact 24 percent of firms in the sample cited uncertainty of demand as among their major obstacles to investment in plant and equipment. Inadequate rate of return on proposed investment was another obstacle to business investment for 21 percent of respondents. Another major factor in explaining investment is imperfections in the capital markets that prevent firms from obtaining funds to finance desired level of investment. As noticed in the Table-1, a significant factor in the low rate of investment may be inadequate access to finance, in fact 18 percent of firms in the sample cited shortage of internal funds and 14 percent of firms cited inability to raise finance as among their major obstacles to investment in plant and equipment especially for smaller firms. High cost of external funds was also reported by 11 percent of total respondents as the obstacle to their business investment. In addressing these issues it is necessary to look at how firms in Nepal finance their investment, they are shown in Table - 3. Less than 10 percent of respondents reported that shortages of skilled labour are likely to limit their investment in plant and equipment over next twelve months. Priority of investment decision Theoretically, different textbooks on finance consider the three important finance function to be accomplished by each and every enterprise. The functions considered are finance, dividend and investment decisions. The survey questionnaire tried to capture the preferences and views of finance practitioners whether they consider these three decisions to prefer one more important over others. The results of ranking of these three-finance decisions according to their priority are presented in Table –2 In their overall ranks for the importance of major decisions of finance, the highest percentage of respondents (40.29%) gave the first priority to investment decision; second priority to finance decision (40%) and third priority was given to dividend decision (65.67%) These results also support the conclusions regarding the priority for dividend decisions on the survey conducted by Pradhan and Adhikari (2002) as regards to "dividend policy and practices of Nepalese Enterprises." In this respect when the responses of private sector respondents are compared with those of public sector respondents, the priority given to these three decisions were similar to both groups. To test whether the views of the private and public sector respondent is significant across the groups, F test is employed. The significance level of F statistic shows that there is no difference in views of public and private sector respondents across the investment, dividend and financing decisions. Table-2 Descriptive and Summary Result of ANOVA of Finance Function in Nepalese public and private company Finance Decisions/ Rank Investment decision Financing decision Dividend decision Private Public Total Private Public Total Private Public Total 1 2 3 N 15 12 27 16 10 26 5 9 14 18 14 32 12 13 25 6 3 9 3 5 8 8 8 16 25 19 44 36 31 67 36 31 67 36 31 67 Mean 1.67 1.77 1.72 1.78 1.94 1.85 2.56 2.32 2.45 Std. Deviation .632 .717 .670 .797 .772 .783 .735 .909 .822 F Sig. .426 .517 .672 .415 1.346 .250 Preferred source of finance at firm investment decision Theoretically a number of textbooks on finance reveal several financing sources to finance new investment project. Among them internal funds (retained earnings), Bank loans, Owners Contributions, suppliers / trade credits are the major sources for financing new projects. Selection of one source of finance over others is irrelevant for real investment decision in a world of perfect capital market (Modigliani and Miller, 1958). However source of financing is relevant to the investment decision of a firm operating in incomplete capital markets where the cost of external capital exceeds that of internal funds. A large body of finance literatures (for example Myers and Majluf, 1984; Bernanke and Gertler, 1989 etc.) provides a foundation for these market imperfections by appealing to asymmetric information problems and agency cost which cause a premium on external finance. The investment decisions of firms operating in such environment are sensitive to the availability of internal funds because they possess a cost advantage over external funds. In this context, the respondents were asked to rank several financing sources in terms of their importance and the results are presented in Table –3 considering the eight major sources of finance, the respondents were asked whether they prefer one source of funds over others to finance new investment project in their respective enterprises. They were asked to rank different sources of funds on a scale of 1(most important) to 9 (least important) and the responses obtained are shown in Table-3 As is evident from the Table, the majority of the respondents ranked first (mean rank 1.88) to internal source of funds to finance their new project. Bank loans were considered the second (mean rank 2.43) most preferred source of finance by the majority of respondents. Finance companies, suppliers/ trade credits, insurance companies, owners' contributions, private outside sources, and cooperatives were the other preferred sources of finance in diminishing order respectively among the Nepalese practitioners. This finding more or less follows the pecking order hypothesis as suggested by Mayers and Majluf (1984) and suggests that Nepalese managers rely heavily on internal source of funds. The reason to use this fund might be the cost advantage of this fund and asymmetric information problems in Nepalese capital market. Table-3 Preference rankings of source of funds for financing investment in Nepal N Retained earning Bank loans Finance company Owners contribution Insurance companies Private outside source Co- operatives Supplier/ trade credit Others Mean Private Public Total Private Public Total Private 36 31 67 36 31 67 1.86 1.90 1.88 2.31 2.58 2.43 Std. Deviation 1.175 1.399 1.274 .856 .765 .821 36 2.61 1.293 Public Total Private Public Total Private Public Total Private Public Total Private Public Total Private Public Total Private Public Total 31 67 36 31 67 36 31 67 36 31 67 36 31 67 36 31 67 36 31 67 2.58 2.60 3.97 6.84 5.30 5.97 4.19 5.15 4.94 6.03 5.45 7.69 7.61 7.66 7.17 4.87 6.10 8.47 8.39 8.43 1.361 1.315 .810 1.715 1.939 1.612 1.493 1.786 1.472 1.378 1.520 .624 .558 .592 .811 1.668 1.716 1.108 1.116 1.104 F .018 Sig. .894 1.897 .173 .009 .926 80.02 .000 21.70 .000 9.643 .003 .313 .578 53.58 .000 .098 .756 However, the finding seemingly contradicts for public and private sectors respondents when it is compared as regards to the owners' contributions, suppliers/ trade credits, private outside sources and insurance companies. For public sectors respondents' insurance companies and suppliers trade credits are more significant source of finance over owners' contributions and private outside source but the finding is just overturning in the case of private sectors respondents. These results are tested by F statistics (ANOVA) at 1 percent level of significance. The differences in views of public and private sectors' respondents as regards to owners' contributions, suppliers/ trade credits, private outside sources and insurance companies are significant at 1 percent level of significance. But as noticed in the Table-6.3, retained earnings and banks loans are the first and second preferred source of finance for both the private and public sectors respondent however the differences are not significant as tested by F statistics. The present findings are consistent with the findings of the study made by Pinegar and Wilbricht (1989) In order to establish the degree of relationship between the responses of or the ranks assigned by the private and public sector respondents, rank correlation coefficient was computed. The rank correlation thus computed was revealed to be +0.845, which shows the high degree of relationship between the ranks assigned by the public and private sector. P-value for the said rank correlation coefficient was 0.004, which indicates that the said rank correlation coefficient is significant at 0.01 level of significance. It was also attempted to assess the rank correlations of different sources of funds employed by the Nepalese enterprises to finance their new projects. The correlations of responses to the respondents' preference in sources of finance are presented in Table-4. Table-4 Spearman's Rank Correlations for sources of finance (variables) Retained earnings Retained earning Bank Finance company Owners contribution Private Insurance outside company source Supplier/ Cotrade operative credit 1.000 Bank loans -.268* 1.000 Finance company .053 -.331** 1.000 Owners contribution .032 .047 .026 1.000 Insurance companies -.230 -.097 -.088 -.597** 1.000 Private outside source -.104 -.056 -.060 .354** -.646** 1.000 Co- operatives -.206 .170 -.199 -.143 .005 .192 1.000 Supplier/ credit -.005 -.315** -.051 -.679** .509** -.520** -.162 trade * Correlation is significant at the 0.05 level (2-tailed). ** Correlation is significant at the 0.01 level (2-tailed). As noticed from the Table, the retained earning is negatively correlated with bank 1.000 loans, finance from insurance companies, private outside source suppliers/ or trade credits and co-operatives but it is noticed the positive correlations of retained earning with the funds from finance companies and owners contributions The correlation coefficients between bank loans and retained earnings are negative and significant at 5 percent level of significance. This result suggests that as the level of retained earning increases, the enterprises tend to decrease their bank loans to finance their new investment projects. The result in the Table also suggests that the firms having good relations with the suppliers and financing their investment through trade credits tends to decrease their bank loans, private outside sources and owners contributions. Informal sources like private outside source are positively correlated with the owner's contribution (another informal source) but it is negatively associated with the bank loans, finance companies, insurance companies, supplier/ trade credits and other formal sources. Overall the rank correlations coefficients in the table do a good job of measuring the relationship of variables for different sources of finance in Nepalese enterprises. When the correlation coefficients of private sectors and public sector responses are computed separately (as shown in appendix), the results are somewhat different. For private sectors respondents, the correlation coefficients of retained earning is negative with the bank loans and private outside sources significantly and the strength of negative relationship is very strong but the same is not true for public sectors respondents. Retained earning is negatively correlated with the bank loans but the strength of relationship is not so strong as is in the case of private sector and the coefficients are not significant also. However in the case of public sectors respondents, the correlations coefficients of retained earning is negatively correlated with the cooperative finance and the insurance companies finance and they are significant at 5 and 1 percent level of significance respectively. In sum, the conclusion can be derived that there is the significant difference between the correlation among the financing source variables in public and private sector of Nepalese firms. Relationships with bank Access to credit is usually a major problem for firms in developing countries and the situation is no different in Nepal (Biggs et al; 2000). Though the majority of firms in Nepal have access to at least some external finance, high formal procedures, large collateral requirements and other factors makes reluctant to firms from obtaining as much finance, as they need as is depicted in Table- 5. Despite the presence of a wide variety of lending institutions, finance companies, aid agencies and informal sources, the majority of finance is short-term bank credit and most firms are unable to access long-term credit. The Table 6.5 presents the respondents' opinion regarding Nepalese firms' relationship with banks. What is remarkable to the study result, is that most firms, even among the smallest, deal with multiple banks — the average firm deals with more than three banks. The majority of respondents i.e. 81 percent reported that they deal with more than one bank. Less than 20 percent respondents do borrow mostly from one bank. The enterprises seem to have selective upon banks about their borrowing terms and conditions. Table -5 Relationship with Bank and firm investment S.No 1 2 3 4 5 6 7 8 Questions How many banks do you deal with? a. One bank b. Two banks c. Three banks d. More than three banks Do you switch between banks; whichever offers the best interest rate and other formal terms? c. Yes d. No Is there any loan limit on what you can borrow? a. Yes b. No Are you at or very near the loan limit? c. Yes d. No Do you think that the managers are unwilling to invest in fixed assets when they have excessive debt burdens at their firms? a. Yes b. No In case of shortage of cash, which of the following events is likely to occur a. Banks will automatically extend loan b. Banks will be tight in negotiating interest rate c. It is hard to convince banks on profitability of new investment d. Banks will be rigid in negotiating covenants e. Banks stop providing loan In periods of tight money, do you think that banks will a. Restrict your firm from borrowing b. Treat all companies equally c. Favor your company d. Favor other companies over yours What are the major obstacles to obtaining loan from banks and finance institutions? (Multiple answer/ response) a. b. c. d. e. High interest rate Unlimited liability of owner Banks internal rules and regulation Large collateral requirement Small size of domestic banking system No % 13 16 24 14 19 24 36 21 34 33 51 49 37 30 55 45 25 12 68 32 42 22 65 35 12 13 10 18 14 18 19 15 27 21 16 20 12 19 24 30 18 28 38 22 18 45 12 25 14 12 29 8 f. Others 18 12 The majority of enterprises switch between the banks which ever offers the best interest rate and other formal terms and conditions. The majority of respondents believed that there is a limit on what they can borrow. Out of which 68 percent respondents reported that they are at or near the loan limit. 65 percent of respondents believed that the managers are unwilling to further invest in fixed assets if they have excessive debt burden at their firm but the 35 percent respondents rejected this opinion. While loans may be expensive and hard to obtain, banking services appear to be available to even the smallest enterprises. In case of shortage of cash in their respective firms, 21 percent of respondents believe that the bank will stop providing loan, and 79 percent believe that the bank will provide loan but they will be tight in negotiating the interest rate (19%), will be rigid in negotiating covenants (27%), and the bank will automatically extend the loan (18%). correspondingly. In the period of tight money, 30 percent respondents believed that the bank will treat all companies equally but 28 percent believe the bank favor other companies. Twenty four percent respondents opine that the bank restrict their companies from borrowing in periods of tight money. Though the vast majority of firms in Nepal have access to at least some external finance, rigid formal terms, large collateral requirements and other factors prevent firms from obtaining as much finance, as they need. A large collateral requirement is the major problem of obtaining loan from bank and financial institution for the 29 percent of respondents. For twenty five percent of respondents high interest rate has been considered as an obstacle to obtaining loan. Unlimited liability of owner, small size of domestic banking, and banks internal rules and regulations are minimally considered as other obstacles to obtaining loan from banks and financial institutions. This finding is consistent with the findings of past studies made by Ang and Pradhan (1994) The banks are offering different types of loan on the basis of time and other binding constraints. The respondents had been asked to rank the type of loan on the order of priority for their preference and the results of analysis are presented in Table-6. As is noticed from the Table, the bank loan of one to five years is the most preferred type of loan for the public as well as private sectors respondents. The respondents ranked the 'term loan' in second and 'bank loan of less than one year' in third place from the both sectors. In aggregate the 'bank loan of more than five year' and 'bank overdraft' had been ranked in fourth and fifth place respectively. But it is noticed the conflicting views in public and private sector respondents as regards to bank overdraft and bank loans of more than five year in their ranking when it is computed separately. Table-6 Preference rankings of bank loan Types of bank loan Bank loans of one to five year Term loan Bank loans of less than one year Bank loans of more than five year Bank overdraft Others Private Public Total Private Public Total Private Public Total Private Public Total Private Public Total Private Public Total N 36 31 67 36 31 67 36 31 67 36 31 67 36 31 67 36 31 67 Std. Mean Deviation 2.00 1.146 1.97 1.169 1.99 1.148 2.50 1.699 2.19 1.493 2.36 1.602 3.06 .955 2.90 1.193 2.99 1.066 4.36 1.199 4.03 1.560 4.21 1.377 3.83 1.875 4.84 1.036 4.30 1.614 5.19 .710 5.06 .574 5.13 .649 F .013 Sig. Rank .910 1 .606 .439 2 .337 .564 3 .950 .333 4 7.05 .010 5 .664 .418 6 As the above table presents the bank overdraft has third priority for private sectors respondents where as it is ranked as fourth by the public sectors respondents. The difference in opinion is tested by employing F statistics. The Table shows that there is a not significant difference in the views of public and private sector respondents in their ranking for different types of loan except for bank overdraft. But the differences in the views of public and private sector respondent is significant at 10 percent level of significance for the case of bank overdraft (F-value 7.05 and p-value 0.01). Reasons on the preference of internal funds Pecking order hypothesis suggests that aggregate investment outlays are predominantly financed by internally generated funds. New stock issues play a relatively small part. Moreover, as Donaldson (1961) has observed, this is what many managers say they are trying to do. Asymmetric information and agency problems are the most observed causes to prefer retained earning by the managers to finance their investment projects. Berle, Berle and Means and Donaldson have interpreted firms' reliance on internal finance as a byproduct of the separation of the ownership and control: professional managers avoid relying on external finance because it would subject them to the discipline of the capital market. Another argument could be made for internal financing to avoid issue costs, and bankruptcy cost. Considering the major reasons of using internal funds as observed by the different theory of modern finance, the respondents were asked to rank them in order of preference. The results of rankings are presented in Table-7. The information asymmetry is taken as the first and most significant reason for using retained earning to finance their investment by Nepalese managers. The statement 'it is hard to convince outsiders on profitability of new investment' has been taken as a most significant observation and had given it as the first rank by the majority of respondents. The mean rank value for this statement is 2.36. This statement is also the first priority to both the public and private sector respondents. 'Cost of retained earning is less than cost of new equity' is another reason to use internal funds by the majority of respondents and it has been ranked as second priority. The respondents placed the statement 'Firm does not want to dilute control from selling stock (shares) to outsiders' as third important reason and the observation Table-7 Reasons to use retained earning for new investment Std. Reasons for using retained earnings Sig. Mean N Mean Dev. F .228 .634 1 1.132 .291 2 1.969 .165 3 .905 .345 4 1.622 .207 5 It is hard to convince outsiders on Private 36 2.44 1.594 profitability of new investment Public 31 2.26 1.591 Total 67 2.36 1.583 Cost of retained earning is less than cost of Private 36 2.56 1.297 new equity Public 31 2.90 1.375 Total 67 2.72 1.335 Firm does not want to dilute control from Private 36 2.61 1.271 selling stock (shares) to outsiders Public 31 3.03 1.169 Total 67 2.81 1.234 The banks may have too much voice in the Private 36 3.69 1.167 management Public 31 3.39 1.476 Total 67 3.55 1.318 Company does not want to pay too much Private 36 3.78 1.098 dividend Public 31 3.42 1.205 Total 67 3.61 1.154 Rank 'The banks may have too much voice in the management' has been taken as the fourth important reason for using retained earning. These both reasons more or less emanate from the "managerial views" of corporate finance indicating that a central theme in much of the corporate-finance literature–with a lineage going back to Berle and Means (1932), and including the influential work of Jensen and Meckling (1976), that the managers of publicly-traded firms pursue their own private objectives, which need not coincide with those of outside stockholders. So there are many possible manifestations of the manager-stockholder agency conflict. 'Company does not want to pay too much dividend' has been taken as least preferred reason for the use of retained earning by the Nepalese finance practitioners and it has been placed as the fifth rank. It was also attempted to test whether the opinions of the private and public sector respondents is significantly different across the groups, by employing F test .The significance level of F statistic shows that there is no difference in views of public and private sector respondents across the reasons for using the retained earning. This finding is inconsistent with the findings of past studies made by Ang and Pradhan (1994) Relative preference for the application of internal fund A survey of literature reveals several activities that the enterprises tend to use their available internal funds. The prominent activities among them are: investment in positive NPV project, payment of dividend, maintaining internal liquidity, payment of debt and repurchase of stock. In this context, respondents' relative preference towards the use of internal funds to different financial activities of a firm is presented in their rankings of five financial activities summarized in Table –8. The financial activities selected for the use of internal funds are widely prevalent and pervasive in nature for each and every type of firms. The respondents were asked the question to rank those five activities according to their preference, if they had sufficient internal funds to finance in either of the given activities. Table-8 Priority for uses of internal funds a Investing in new projects Payment of debts Maintaining internal liquidity Payment of dividends Refund of shares a. Private Public Total Private Public Total Private Public Total Private Public Total Private Public Total N Mean 36 31 67 36 31 67 36 31 67 36 31 67 36 31 67 2.36 2.10 2.24 2.89 3.35 3.10 3.17 3.06 3.12 3.36 3.13 3.25 3.22 3.35 3.28 Std. Deviation 1.659 1.640 1.643 1.116 1.199 1.169 1.276 1.124 1.200 1.417 1.384 1.396 1.416 1.380 1.391 F Sig. .427 .516 Mean Rank 1 2.71 .104 2 .119 .731 3 .456 .502 4 .150 .700 5 Means are calculated by assigning scores of 1 through 5 for rankings for most preferred to least preferred respectively and by multiplying each score by the fraction of responses within each rank. A score of 0 is assigned when a score is not ranked. Given the sufficient amount of internal liquidity, the majority of respondents preferred to make new investment in positive NPV project as a first rank. Payment of debt, Maintaining internal liquidity, Payment of dividend and Refund of equity had been ranked as second, third, fourth and fifth priority by the majority of respondents. This result suggests that internal fund is the dominant source for financing new investment, which implies that investment decisions of majority of firms are sensitive to current liquidity. It was also attempted to test whether the opinions of the private and public sector respondents is significantly different across the groups, by employing F test. The significance level of F statistic shows that there is no difference in views of public and private sector respondents across the areas for application of retained earnings. Factors affecting investment decisions A survey of finance literatures reveals several factors affecting investment decisions. The prominent among them are availability of financing source, projected cash flow and profitability of new project, availability or ability to borrow by the company, market growth potential of project, and risk factor in investing new project. In this context, respondents were asked to rank these five factors on a scale of 1(most important) to 5 (least important) and the result are presented in Table –9 The majority of respondents ranked the projected cash flow and profitability of new project as the most important factors affecting investment decision. The risk factor in investing new project, the availability of financing source, and market growth potential of the new project were ranked as the second, third and fourth important factors by the majority of respondents. Ability to borrow by the company has been considered as the least important factor governing the investment decision and the respondents placed it as the fifth rank in comparison to others factors. Table –9 Respondent's priority on factors affecting investment decision Projected cash flow or earning of assets to be financed Riskiness of the assets to be financed Availability of financing source Market growth potential of the Project Ability to borrow by the company N Mean Private Public Total Private Public Total Private Public 36 31 67 36 31 67 36 31 2.53 2.29 2.42 2.36 2.55 2.45 2.53 2.90 Std. Dev. 1.558 1.395 1.479 1.222 1.261 1.234 1.207 1.274 Total 67 2.70 1.243 Private Public Total Private Public Total 36 31 67 36 31 67 3.47 3.58 3.52 4.03 3.68 3.87 1.341 1.409 1.364 1.000 1.275 1.140 F Sig. .426 .516 Mean Rank 1 .380 .540 2 1.531 .220 3 .104 .748 4 1.587 .212 5 This result suggests that the investment decisions in the majority of the Nepalese enterprise are affected by projected cash flow and profitability of the new project. Virtually, the availability of funding source also affects and explains the investment behavior of Nepalese enterprises. However, if the separate mean ranking is computed for public and private sectors, the results are contradictory for the first and second priority. For the private sector respondents, the riskiness of assets to be financed is more important factor for making an investment than the projected cashflow or earning of the assets to be financed. But the same is not true for public sectors respondents. For them, if the projected cashflow or profitability of the project is good then it becomes the first and most important determinant for making any new investment. Only after it they consider the riskiness of the project as another determinant of the investment decision. But there are no any significant differences in public and private sector responses across the different factors affecting investment decisions. F –statistics shows that there is a not significant difference in views of public and private sector respondents. The standard deviation of responses ranges from 1 to 1.558 to their mean ranking indicating the higher consistency in responses among the respondents. The first and second mean ranking score of these two factors is tentatively equal to each other. Hence, it seems that the riskiness of the assets to be financed is equally important factor affecting investment decisions in new project with respect to its projected cash flow and its expected future profitability. In aggregate the mean ranking lies between the 2.42 to 3.87 score. It indicates that the factors considered are the central and equally important determinants for the investment decisions. Project Evaluation Methods A number of studies have been extensively surveyed regarding the companies’ capital budgeting practices. Among the numerous surveys including those reported by Mao (1970), Klammer (1972), Fremgen (1973), Petty, Scott, and Bird (1975), Gitman and Forrester (1977), Schall, Sundem, and Geijsbeek (1978), Kim and Farragher (1981), Hendricks (1983), Klammer and Walter (1984), Bierman (1993), and Trahan and Gitman (1995) etc focused on methods of evaluating project profitability and risk. They revealed that the sophistication of the analytical techniques used by US executives has increased over time. DCF techniques have become the dominant method of evaluating and ranking proposed capital investments. Bierman, one of the pioneers in capital budgeting study, (1993) reported that 99% of the respondents in his 1992 survey of Fortune 500 companies used IRR or NPV as either the primary or secondary evaluation measure. Correspondingly, the use of non-DCF techniques such as payback as the primary evaluation measure has declined. In this context, the respondents were asked to rank five important evaluation methods of capital budgeting in terms of their importance and the results are presented in Table –10. Considering the five major evaluation methods of capital budgeting, the respondents were asked whether they prefer one method over others to evaluate new investment project in their respective enterprises. They were asked to rank different methods on a scale of 1(most important) to 5 (least important) and the responses obtained are shown in Table-10 The Table shows the NPV and payback period methods have been found to be very popular among Nepalese enterprises. Respondents had given first rank to 'Net Present Value Method' and second rank to 'payback period method'. 'Internal Rate of Return' simply ranked third and Profitability index and Accounting Rate of Return ranked fourth and fifth respectively Table-10 Respondents’ preference on project (investment) Evaluation Methods Evaluation Methods Net Present value method Payback Period Internal rate of return Profitability index Accounting Rate of return Sector Private Public Total Private Public Total Private Public Total Private Public Total Private Public Total N 36 31 67 36 31 67 36 31 67 36 31 67 36 31 67 Mean 1.97 1.77 1.88 2.33 2.42 2.37 2.50 2.29 2.40 3.75 3.87 3.81 4.47 4.65 4.55 Std. Deviation .941 .805 .879 1.121 .848 .998 1.320 1.131 1.232 1.251 1.204 1.222 .506 .486 .501 Rank F .843 Sig. .362 1 .122 .728 2 .479 .491 3 .161 .689 4 2.01 .161 5 . The private and public sector respondents, the both gave first priority to NPV method to evaluate their projects. But as regards to second rank, there is conflicting opinion among the public and private sector respondent. The public sector respondents gave second rank to IRR method where as private sector respondent gave second rank to payback period method. To test whether the differences in opinion of private and public sector respondents are significant with respect to project evaluation method, the F-test is employed. The significance level for F-statistics shows that the p values are not significant at 5 % level of significant. It shows that there is no significant difference in the opinions between private and public sector with respect to project evaluation method. Observations on corporate investment practices in Nepal At the end of questionnaire, the respondents were provided with a list of eleven different statements of observations on corporate investment practices in Nepal and they were asked to rank them in order of importance. In order to highlight the significance of the selected statements of observations, mean and standard deviation values of responses for each statement of observation have been computed. The first criterion applied is the value of mean. The higher value of mean indicates that the observation is highly important to majority of respondents. To assess the variability of responses, standard deviations are computed. The higher the value of standard deviation indicates the higher variability in responses among the respondents. Applying these criteria, the statements of observations with their mean and standard deviation value have been presented in order of importance in Table- 11 Table 11 Observations on corporate investment practices as viewed by all respondents SN Observations N Mean Std. Deviation 1 Managers prefer running large firms as opposed to simply profitable ones. 67 3.90 1.075 2 Managers have better information than outside investors about the most aspects of firm's investment. 67 3.87 1.127 3 Company should not pay dividends when profitable investments are on hand. 67 3.85 1.118 4 Good financial health of a firm encourages to further Investment in fixed assets 67 3.84 1.123 5 Equity (external) issues generally carry bad news in the market 67 3.76 1.156 6 Firms with more cash on hand and less debt generally invest more in fixed assets. 67 3.51 1.364 7 Firms with better access to banks have higher investment ratio. 66 3.21 1.504 8 The access to credit is the major problem for investment in Nepal 67 3.12 1.482 9 Raising equity externally is more expensive than internal fund 67 3.09 1.311 10 Uncertainty of future earning discourages the further investment in fixed assets. 67 3.06 1.434 11 Investment in fixed assets will decrease with high debt ratio. 67 2.73 1.366 The mean values of observations statements varied from 3.90 to 2.73. Among the statements,' Managers prefer running large firms as opposed to simply profitable ones’ has been regarded as the most significant observation. The statement ‘Managers have better information than outside investors about the most aspects of firm's investment.' carries the mean value of 3.87 and it indicates that the majority of respondents agree the asymmetric information problems in Nepalese capital markets. The least significant observation for the majority of the respondents is ' Investment in fixed assets will decrease with high debt ratio'. These results imply that there are many possible manifestations of the managerstockholder agency conflict in Nepalese enterprises. The conclusion is that even firms which are extremely in need of external finance (external equity and debt)– say because they have good investment opportunities but scarce internal resources–may even be unable or unwilling to raise it. Conclusion In this paper, it has been tried to explore and describe the different facets of investment practices of Nepalese firms. We can summarize the results of study as follows: 1. For the importance of major decisions of finance, the investment decision is considered the most important decisions for Nepalese finance practitioners. Finance and dividend decisions are taken as second ad third important decisions for finance. 2. Among the different sources of fund, the Nepalese managers preferred to use internal funds (retained earning) as the most preferred source of fund to finance their investment. At the same time, the managers equally ranked the bank loan as another important source of finance for their investment. It is note worthy to present here that the internal funds and bank loans are equally important sources of funds for both the public and private sector's respondents. As regards to other sources of finance, the preferences and rankings are different for public and private sector's respondents. 3. As regards to the reasons of preferences for the use of retained earnings, the private as well as public sectors respondents indicated the high cost of external finance and asymmetric information problem as the most remarking causes to their preferences for internal funds. 4. The respondents' relative preference towards the use of internal funds indicates that the ‘investment in positive NPV project’ is the first choice and ‘payment of debt’ is another activity to be accomplished by the Nepalese managers, provided they have enough internal funds. 5. The respondents were given the different alternative factors influencing investment decisions to rank in order of importance. Among them the cash flow streams and profitability of the project most attracted to the managers to undertake their investment decisions. Simultaneously, the availability of financing source also plays the prominent role to influence the investment decisions for the majority of respondents. 6. The method that the managers used and preferred to use to evaluate their investment project was another question asked to the respondents. Net Present Value method and payback period methods were the most preferred methods for evaluating the projects. 7. Uncertainties of demand, low rate of return, inability to raise adequate finance are the major factors that discourage further investment in Nepalese enterprises. The Nepalese enterprises even the smaller ones seem to have the approach with banks and they are selective upon the banks and finance institutions to their terms and covenants. On the basis of the findings of this study it can be concluded that it is necessary to facilitate and further reform the Nepalese capital markets so that easy access of funds can be ensured to all Nepalese firms. 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