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One of the important qualities that accrediting bodies, e.g., the AACSB are

looking for in business schools is learning outcomes that relate theory with

practice. In fact, they encourage business schools to include pedagogical tools

in the curriculum that foster practical applications of complex theoretical

concepts, thereby making them intuitive and somewhat easier to grasp by

students. Additionally, prospective employers, college professors, and students

themselves are interested in learning valuable skills such as conducting

research, team building, leadership, and interdependence that they can take with

them to their job. This paper describes a capital budgeting project that is a real

world simulation of a new business startup. It allows students to acquire the

valuable skills mentioned above. The proposed project is suitable for graduate

(MBA) and upper-level undergraduate courses. The project has been assigned in

an MBA program with great success in the core corporate finance. But it can also

be amended and utilized in the capstone strategic management course. For

undergraduate finance students, this project can be assigned in the second

(intermediate) finance course. The project is particularly appealing to non-

traditional business students, who often desire to establish their own firms. The

project directs their focus on the achievement and profitability of their future

dreams while applying in practice what they learn in theory.

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HeadnoteHeadnote

ABSTRACT

One of the important qualities that accrediting bodies, e.g., the AACSB are

looking for in business schools is learning outcomes that relate theory with

practice. In fact, they encourage business schools to include pedagogical tools

in the curriculum that foster practical applications of complex theoretical

concepts, thereby making them intuitive and somewhat easier to grasp by

students. Additionally, prospective employers, college professors, and students

themselves are interested in learning valuable skills such as conducting

research, team building, leadership, and interdependence that they can take with

them to their job. This paper describes a capital budgeting project that is a real

world simulation of a new business startup. It allows students to acquire the

CAPITAL BUDGETING PRINCIPLES: BRIDGING THEORY AND PRACTICE Saxena, Atul K.

Academy of Accounting and Financial Studies JournalAcademy of Accounting and Financial Studies Journal; Ar; Ar

denden Vol. 19, Iss. 3, (2015): 283-293.

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Burns, Richard M; Walker, Joe. Journal of AppliJournal of Appli ed Financeed Finance; Tam; Tam papa Vol. 19, Iss. 1/2 , (2009): 78-90.

Laux, Judy. American JournAmerican Journ al of Business Eal of Business E ducationducation; Littlet; Littlet onon Vol. 4, Iss. 7, (J ul 2011): 29-37.

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valuable skills mentioned above. The proposed project is suitable for graduate

(MBA) and upper-level undergraduate courses. The project has been assigned in

an MBA program with great success in the core corporate finance. But it can also

be amended and utilized in the capstone strategic management course. For

undergraduate finance students, this project can be assigned in the second

(intermediate) finance course. The project is particularly appealing to non-

traditional business students, who often desire to establish their own firms. The

project directs their focus on the achievement and profitability of their future

dreams while applying in practice what they learn in theory.

INTRODUCTION

Social scientists and academicians have stressed offering students multiple

techniques of pedagogy for better learning outcomes. These techniques include

one-minute papers, more detailed research papers, simulations, power point

presentations, and real-world projects among others. Research has shown that

generation-X actually prefers experiential learning to the more traditional lecture-

based pedagogy (Bale and Dudney, 2000). Frequently professors spend a lot of

time and effort searching for projects to supplement their lectures to enrich their

coursework. The accrediting bodies encourage schools to include such

pedagogical tools that bridge theory with practice. While instructors have always

desired such tools, lately there is an increased demand from employers and

student graduates to obtain these valuable hands-on experiences by simulating

the real world before entering it.

While useful to both graduate and undergraduate students, practical learning

experience is more important for the former group. This paper describes a

project that can be used in upper level undergraduate finance (and strategic

management) courses, but is particularly geared towards graduate students. The

project requires students to apply financial analysis to the startup of a small

company. This project has already been assigned successfully in MBA (and

undergraduate) courses at a business school for a number of years with good

results. Since most of the students enrolled in the core MBA corporate finance

course are classified as nontraditional, they frequently have a dream of

establishing their own company, of being entrepreneurs. This project provides

them the opportunity to apply theoretical concepts and focus on the costs and

benefits of their future plans.

Viewing various business functions on a small scale provides insight in

understanding the interactions among functions in larger, established firms.

While this paper involves the application of financial analysis, the project can be

Burns, Richard M; Walker, Joe. Managerial FinaManagerial Fina ncence; Patrington; Patrington Vol. 23, Iss. 9, (19 97): 3-15.

Bennouna, Karim; Meredith, Geoffrey G; Marchant, Teres a. Management DeManagement De cisioncision; London; London V ol. 48, Iss. 2, (201 0): 225-247.

Marlowe, Justin. Journal of PubliJournal of Publi c Budgeting, Acc Budgeting, Ac counting & Finacounting & Fina ncial Managemencial Manageme ntnt; Boca Raton; Boca Raton V ol. 25, Iss. 4, (Wint er 2013): 693-718.

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modified for any other business discipline, such as management or marketing.

Over the course of study in an MBA program, it can also be used as a continuing

project, adding facets to the study in each discipline. It may be modifi67ed to

provide an examination of the practicalities in setting up businesses for other

professionals, such as medical offices, engineering firms, etc. Its main benefit for

the student is to encourage the disciplined thought and planning required in

establishing a successful business.

The rest of the paper is organized as follows. Section II reviews the relevant

literature. Section III discusses some desirable attributes of a class project

assignment. Section IV explains the project in detail. Based upon procedural

logic, Section IV is further divided into four sequential sub-sections. Section V

summarizes the paper and provides some concluding remarks.

LITERATURE REVIEW

In a classic study on how to frame classroom learning experiences that model

necessary attributes for the foundations of success, Bruner et al. (1999) found

the following as important:

1. Select cases that employ, exercise or explore a tool or concept

2. Highlight the dilemmas of the decision maker

3. Set the numbers and critique them

4. Embrace uncertainty

5. Demand the action recommendations arising from analysis

6. Look for unintended consequences

7. Explore opportunities for further work

If a project possesses several of the above attributes, it is considered good.

Remarkably, the project explained in this paper meets most of the above criteria.

Bale and Dudney (2000) surveyed students to research their preferred mode of

learning. They find from their survey results that for Generation X students (bom

between 1961 and 1981) "hybrid" teaching models incorporating both andragogy

(self-directed, self-motivated) and pedagogy methods are most effective. Making

reference to another related study they go on to conclude that Generation X

wants to see value and relevance in education, otherwise they are not motivated

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to leam new skills. They prefer experiential learning using as many of the five

senses as possible (Caudron 1997). The startup project explained here is an

example of hybrid teaching model that incorporates both andragogy and

pedagogy.

Deeter-Schmelz, Kennedy, and Ramsey (2002) conclude that team projects play a

vital role in modem pedagogy. Moreover, as team projects become even more

common in business courses, an increased understanding of factors

contributing to team effectiveness is necessary for instructors to assist students

in realizing the potential benefits of this pedagogical tool. Their results support

the positive and direct role of cohesion as an input variable on teamwork. Ashraf

(2004) finds that in business schools across the United States, one of the most

common pedagogical tools is the use of group projects. "Passive" instruction

(i.e., lecture only) is considered to be an inferior mode of teaching. He highly

recommends the use of group-based projects as pedagogical tools. Since we

suggest that our project be preferably given as a team assignment,

recommendations of both Deeter- Schmelz et al (2002) and Ashraf (2004) are

met.

A simulation, like any pedagogical tool, must be evaluated in terms of its

effectiveness in achieving course objectives. In a study, Chapman and Sorge

(1999) investigate how well a particular simulation does in achieving course

objectives and compare its performance to the textbook and papers used in the

course. They find that compared to the textbook and research papers, students

consistently gave simulation the highest ratings. In another study, Olson et al

(2006) discuss and encourage the use of simulation as a pedagogical tool. While

their simulation is developed for Eastern European transition economies, it is

applicable to any pedagogical learning situation, specifically to the general

operations of the firm at the microeconomic level of decision-making. Our project

conforms to both studies, Chapman and Sorge and Olson et al.

While most of the above studies pertain to general education and business

courses, there is some literature that is specifically relevant to finance courses.

For example, Gumani (1984) extensively reviews and compares capital budgeting

concepts as advocated in theory with the methods employed by industry. Capital

budgeting is an interdisciplinary function, involving diverse areas such as

engineering, finance, and management. The ability of a firm to make sound

decisions in this area rests not only on the theoretical techniques employed but

also on the judgment, intuition, and creativity of the analysts and decision

makers. He claims that the academic literature has concentrated heavily on

developing and refining quantitative evaluation criteria, methods of measuring

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return, risk analysis techniques, and procedural aspects of capital investment

decision making. However, academic research has been criticized because it

tends to be essentially concerned with accuracy of analysis, sophistication of

methodology, and improving conditions in a laboratory setting without regard to

the realities of corporate decision making. One reason for the gap is a lack of

bridging theory with practice at the school level. We feel that this project is the

perfect bridge.

Benton Gup (1994) surveys academics and practitioners and ranks those finance

concepts considered most important for students to acquire. The academics

rank time value of money capital budgeting, CAPM, capital structure, and

valuation as the top five financial concepts for this purpose. It is striking that all

five are included to some degree in the project discussed in this paper. The

practitioners ranking excluded CAPM and valuation but included accounting and

cost of capital. This project requires a critical understanding of the cost of

capital concept.

In what has to be one of the most comprehensive and impressive studies in

corporate finance, Harvey and Graham (2001) sampled 4440 firms receiving

responses from 392 chief financial officers (CFO's) to examine the proverbial

bridge between theory and practice. Their findings are both reassuring and

surprising. It is reassuring to them that NPV is dramatically more important now

as a project evaluation method than it was 10 or 20 years ago. The CAPM is also

widely used in the real corporate world. However, they find it surprising that more

than half of the respondents would use their firm's overall discount rate to

evaluate an investment in an overseas market, even though the investment likely

has different risk attributes than the overall firm. This indicates that practitioners

might not apply the CAPM or NPV rule correctly, perhaps indicating a need for a

better bridge between theory and practice. A class assignment such as proposed

in this paper would be useful to reinforce this bridge.

Weaver and Michelson (2004) suggest a project that could accompany a

corporate finance course to enhance the learning of theoretical concepts. It is a

simple Excel model that provides measures of the standard deviation of

forecasted internal rate of return (IRR) given traditional data inputs such as

annual cash flows, terminal values and equity. The model first calculates IRR

using traditional discounted cash flow methods and then provides heuristic

estimates of variability measured in terms of "high," "low" and "most likely"

values. It also provides an actual measurement of risk in terms of mean and

standard deviation and upper and lower quartiles, along with a graphical

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presentation of various risk parameters. While the Excel model just described is

a good class project, our startup project is more comprehensive in nature

covering a wider variety of financial concepts.

DESIRABLE ATTRIBUTES OF A CLASS PROJECT

Project assignments vary widely in their complexity and the amount of time

needed for completion. For example, an economic ordering quantity (EOQ) model

with imperfect quality items can be rather challenging for a typical corporate

finance course, it may be well suited for a decision science course (Wang, Tang,

and Zhao, 2007). Most finance class projects do not necessarily have to be as

complex as EOQ models. The project outlined in this paper is rigorous yet

relatively simple. It is a real world simulation of a firm and the decision making

that goes on within it by its financial managers. As discussed above, Chapman

and Sorge (1999) recommend the prudent use of such pedagogical tools.

However, designing an appropriate project can be tricky and time consuming.

From our own experiences in the classroom, we have found that certain key

factors must be considered when designing a project assignment.

First, a well-designed class project must logically follow the concepts learned in

class and/or the text. There ought to be opportunities for students to clearly and

easily relate to certain key theoretical concepts and apply them in practice

through the project. Second, it must be doable within the term of the course,

which is the case of the proposed assignment. Another issue is whether a

project can be done individually or in a group setting. Most instructors

encourage projects to be done in small groups of 3 or 4, depending on the class

size. Despite the potential for the classic free-rider problem (Ashraf 2004), group

projects support the important goals of team building, leadership, responsibility

and mutual trust. Business program accrediting bodies, e.g., AACSB, put

enormous weight on these values. Moreover, there are alternative means of

mitigating free ridership, e.g., peer evaluation by team members. However, a

situation may arise that is not suitable for teams and group assignment. For

instance, if the class size is very small or students are extremely busy

(executives, etc.) who do not have enough flexible time to meet in teams. A

desirable project can be done individually, as is ours.

THE PROJECT

There are several steps involved in this project assignment. The first step

involves selecting the type of business to be established. Step two entails

setting the assumptions under which the financial analysis will be performed.

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The third step involves calculating a financing rate (the cost of capital),

estimating the revenues and expenses over an extended period of time (say a 5-

year period). The fourth step consists of applying various capital budgeting

techniques to reach an accept/reject decision. The final step consists of

evaluating and assessing the risk involved in the cash flows and profitability.

Each step is explained in detail in the following subsections.

A: Selection of the Business Type

It is helpful to select a business that does not depend on results of research and

development activities, exploration, etc. These unknown or future factors add

considerable complexity to the project and undermine the task of estimating

probable cash flows from the business by making the whole project seem unreal.

Business types such as retail, most manufacturing, consulting, construction, or

service make the project more manageable for the student. For those students

who do not have a specific type of business they would like to establish, a

business run by a family member or friend can be a good choice since

discussions with these owners can provide a solid base for estimating the

startup requirements, revenues, costs and growth potential.

Occasionally, students run into problems with certain business selections. For

instance, franchises can be problematic if estimates of revenues, costs,

franchise fees, and other data are not provided by the franchiser. Buying an

existing business for project analysis moves the student outside the procedures

provided in classroom discussion in the MBA's core corporate finance course

and therefore makes the project more difficult for them. This activity is best

analyzed with acquisition procedures rather than capital budgeting used in this

project. Indeed, this variation of the project can be used for a finance course on

Mergers and Acquisitions.

Not-for-profit businesses are frequently avoided by students because they

assume that they are not suitable for a profit analysis. However, since these

businesses must take in at least as much money as they spend to stay in

existence, they are as appropriate for this project as a forprofit business.

Businesses that require very large capital outlays at startup for assets with lives

longer than the project horizon (say 5 years) will generally not be profitable

within the analysis period. This problem can be overcome and is discussed in

Section IV-C.

B: Statement of Assumptions

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A statement of assumptions used to estimate cash flows is an important habit

for students to build. While in the project its function is strictly to build the initial

cash flow estimates and provide a base for risk analysis, in an actual

establishment of a firm it allows periodic reassessment of the progress

expected. Should what initially appeared to be a profitable venture fail to meet

projections or economic conditions worsen beyond expectations, the owner may

need to either take alternative measures or shut down before losses become

excessive. For a project manager in an established firm, changing assumptions

may invalidate prior capital budgeting cash flow estimates. It is the responsibility

of the project manager to keep upper management informed of these changing

circumstances and to re-estimate the probable profit of the project. Failure to do

so can significantly impact the profitability of the firm and in turn have a

devastating effect on the career of the project manager. Finally, assumptions are

also required for the instructor to evaluate the student's ability to apply the

concepts. Assumptions generally include such things as the economic

conditions, growth in revenues/costs, hiring of employees, increases in fixed

assets, cost of capital, termination revenues and expenses, initial inventories and

fixed assets, etc. Table 1 contains an example of the set of assumptions to be

used for this case.

As suggested in the simplified example in Table 1, the best estimate for sales

growth is projected to be 10% annually. Students might more reasonably predict

sales growth of 25% in year 2, 15% in year 3 followed by 5% growth in the last two

years. As examples, assumptions might also include a significant increase in

payroll in year 3 as a planned administrative staff addition occurs. At the same

time one might see increased office expenses and depreciation. Students need

to be encouraged to be creative, imaginative, yet realistic when making these

assumptions.

C: Cost of Capital and Cash Flow Estimates

Since the project involves a startup company, a basic assumption is that at least

initially, it is a sole proprietorship and the cost of capital is composed of the

student's own required rate of return plus the cost of borrowing money. Students

are asked to call a financial institution to determine what lending rate would be

required for a business of the type chosen. The weighted average of these two

rates is used as the discount rate for capital budgeting purposes. Students may

wish to assume additional investors and incorporate their required rates as well

when computing the overall cost of capital.

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Students are also asked to estimate cash flows for the initial startup costs and

revenue/expenses for five years at which time the business is shut down or sold.

The five year life span may appear somewhat arbitrary at first. However from

experience, this is a long enough horizon to include most of the changes a new

company may encounter so students have the opportunity to manage the

growth. At the same time, a 5-year life span of the project is not so long as to

make long-term estimates of cash flows too unrealistic and far-fetched. The

process and organization of cash flows in this paper follow that presented by

Titman, Martin, and Keown (2014).

To demonstrate knowledge of technology (a desirable tool by AACSB),

spreadsheets are required for the organization and estimation of cash flows. The

initial outlay includes all cash flows that occur at the beginning. Table 2 provides

a complete output of the capital budgeting analysis. It shows that our sample

project requires modifications to the proposed property as well as furniture and

fixtures to open. It also has deposits and opening expenses. These could be

utility and phone deposits, operating licenses, and the initial advertising

campaign. Working capital requirements might include cash.

The next cash flow category includes revenues and expenses occurring

throughout the five-year life of the project on an annual basis. Generally called

after-tax cash flows, these include annual revenues, annual expenses,

depreciation, and taxes. The format of these cash flows follows the general

format of an income statement except that interest expense is not included. All

after-tax financing expenses are recovered by the level of the interest rate used

to discount the cash flows. The final cash flow category is the terminating cash

flows. These include all one-time cash flows occurring at shut down and could

include after-tax salvage value, disposal/restoration expenses, sale of business

revenue, etc. Since these cash flows occur in year 5, they should be netted with

the year five after-tax cash flows. At this point students should have six cash

flows: total initial outlay and cash flows for years 1-5 (year 5 includes the

terminal cash flow). Additional instructions given to students in this phase can

include:

- After-tax cash flows in years 1-5 must vary. Texts frequently repeat the use of

year 1 cash flows in all succeeding years of the project life for ease of classroom

instruction. Requiring variability forces a more realistic picture of a firm.

- Record cash flows as they occur. While the after-tax cash flows format

resembles an accounting income statement, it does not follow accounting

practices. Cash flows should coincide with cash going into and out of a bank

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account.

- At termination students can assume a complete shutdown with or without

salvage value or the sale of the company. For firms that had costly and long-lived

fixed assets, realistic profitability will require the sale of the assets or the

company in year 5.

- Categories estimated in the after-tax cash flows should be moderate in breadth.

For instance, estimates for total revenue and total cost are too broad. For a retail

outlet, estimating revenue and costs for every item sold is too detailed.

- Straight line depreciation or MACRS can be used.

Students who are seriously considering starting the business analyzed in the

project are permitted and encouraged to be as detailed as they feel necessary.

D: Capital Budgeting Techniques and Acceptability Analysis

Once the net cash flows are obtained, the acceptability of the business is

evaluated. Students are required to use several decision criteria methods:

payback period, discounted payback period, net present value (NPV), profitability

index, internal rate of return (IRR), and modified internal rate of return.

- Payback period provides the number of years required for the initial outlay to be

recovered from the after-tax cash flows. Since this is strictly an accumulation of

the cash flows in years 1-5, it fails to account for the time value of money and is

considered to be a less than accurate method and, financially speaking, a naïve

way of evaluating the acceptability of the project. Acceptability of the business

depends on owner-set criteria. For example, the initial outlay must be recovered

within 3 years. If the pay back is equal to or less than this hurdle, the business is

acceptable. Despite its limitations, the payback period method remains a popular

capital budgeting technique (Fiarvey and Graham, 2001). It is frequently used as

a preliminary screening measure in large firms and as the sole requirement in

cash poor firms.

- Discounted pay back corrects for the lack of use of the time value of money in

the pay back method by discounting each year's cash flow to )?ear zero using the

cost of capital as the discount rate. Therefore, this technique is regarded as an

improvement on its predecessor and not as naïve. It is interpreted in the same

manner as pay back but will obviously take longer to recover the initial outlay

since the cash flows are in present value terms. Once again, the owner must set

the acceptability criterion.

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- Net present value (NPV) is the present value of the cash inflows minus the

present value of the cash outflows and provides the dollar estimate of the

change in the value of the firm. The business is acceptable if the NPV is positive.

- Profitability index is the present value of the cash inflows divided by the present

value of the cash outflows and provides the dollar return for each dollar invested.

The business is acceptable if the profitability index is greater than one.

- The internal rate of return (IRR) is the discount rate that equates the present

value of the future cash flows to the initial outlay. It provides the percent return

on funds invested assuming that the cash flows are reinvested at the internal

rate of return as they flow into the firm. This is known as the reinvestment rate

assumption. If these funds cannot be reinvested at that rate, the return will not

be achieved. For this reason, sometimes the IRR rule is regarded as too

optimistic, and the modified IRR is computed as discussed in the next paragraph.

The internal rate of return must be greater than the firm's cost of capital for the

business to be profitable.

- When the reinvestment rate assumption cannot be met, or when a relatively

more conservative technique is desired, the modified internal rate of return is

calculated. All the cash flows are compounded to the final year (year 5 for the

project) using a reasonable rate for reinvestment, generally the cost of capital,

and totaled to arrive at the future value of all cash flows. The modified-IRR is the

implied rate that equates the initial outlay with the future value just calculated.

This modified-IRR must be greater than the cost of funds.

If the business is unprofitable, students are asked to discuss some methods that

might make it profitable. For example, operating from a home office or obtaining

lower cost facilities might delay costs, or slowing/increasing the growth rate

might provide a greater spread between revenues and costs. Students are not

required to apply these suggestions.

E Risk Assessment

Students are also asked to analyze business risk using one of four risk analysis

techniques and to discuss their findings. The methods suggested are sensitivity

analysis, scenario analysis, decision tree analysis, and simulation. In all cases,

the student can also determine the probability of the net present value falling

below zero since this requires the average of several estimates of the net present

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value and its standard deviation. Although these techniques carry different

nomenclature depending on the source, their definitions below should be familiar

to faculty.

- In sensitivity analysis, the assumptions used in the analysis are changed one at

a time to determine those with high impact on the net present value. These are

called driver variables and generally require a high degree of confidence in the

estimate or the ability to be well managed for an overall assessment of low

business risk.

- Scenario analysis involves modifying the expected scenario already presented

with the worst case and best case estimates of the assumptions used to create

the model. This has the advantage of incorporating the interactions of all the

variables into the analysis.

Decision tree analysis provides re-evaluation points as the establishment of the

business progresses. Owners can incorporate their experience at these points to

re-estimate profitability. They may decide to expand/contract the business,

modify facilities, shut down, etc. The decision tree provides "legs" to determine

the net present values for each of the possible paths that the firm might take.

The expected net present value and its standard deviation can assist in the risk

assessment.

Simulation provides estimates of the net present value by randomly selecting a

value from each variable's probability distribution and combining them for the

trial NPV calculation. Computer simulation software is generally instructed to

make 1,000 to 10,000 trail runs, creating a net present value probability

distribution. The area under the curve below a net present value of zero provides

an assessment of the risk of the business.

Summarization of the acceptability of the business including both the decision

criteria and the risk analysis concludes the project. Since risk analysis provides

no definitive answer for how much risk is acceptable, students must apply their

own risk preferences to this decision. Depending upon the preparedness of

students, this section can be excluded from undergraduate finance courses if it

becomes too overwhelming for them.

SUMMARY

This paper describes a capital budgeting project for the startup of a new

business (e.g., a sole proprietorship). It is a real-world project that is do-able in a

semester. It is preferably assigned as a group project, but can be adapted for

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individual student assignment. The company/business type is chosen by the

student(s). Based on the types of assets and sendees required, students

estimate the initial startup cost, the recurring revenues and expenses over the

life of the business and any terminating cash flows. Once the cash flows are

estimated, the business is evaluated for profitability and risk using the capital

budgeting techniques of the net present value (NPV) and the internal rate of

return (IRR). Students then must decide if they would proceed with that "dream"

business.

The project can be assigned to MBA students in their core corporate finance

course or with slight modifications it can also be included in courses such as

management, marketing or entrepreneurship. A remarkable characteristic is that

the project can be used as a thread connecting much of the MBA curriculum,

creating a management business plan, a marketing plan, a cash budget, etc. in

different classes. The described project has also been used in undergraduate

finance classes by eliminating the risk analysis. Certain non-business

professional programs, such as health care or engineering, where students

frequently plan to open their own business, may also find it beneficial to include

it in their curriculum.

ReferencesReferences

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AuthorAffiliationAuthorAffiliation

Atul K. Saxena, Georgia Gwinnett College

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