Corporate Governance, Capital Markets, and Capital Budgeting

Traditional capital budgeting or investment appraisal practices have not developed enough to cope with the constantly changing modern economy which significantly uses information technology (IT) (Schniederjans et al. 2004) and capital market and organisational interactions. Traditionally, capital budgeting uses a one-off objective in the form of net present value (NPV) to evaluate long-term capital projects. The existing economic conditions, on which decisions are based, do not remain constant for the life of the capital investment, therefore organisations undertake rigorous risk management appraisal before deciding to go ahead with the projects. However, this is not sufficiently adequate and there is a need to develop a new capital budgeting model which factors in not only risk (Levary and Seitz 1990), but also multiple objectives, interdisciplinary impacts on investment appraisal decisions (Khan 2008), and agency costs (Elali and Trainor 2009). Effective capital budgeting decisions should consider corporate governance principles, the regulatory environment, capital markets and organisational interactions, and accounting practices and methods. In the modern economy, it is necessary to develop a new capital budgeting model which incorporates all these economic interdisciplinary interactions mentioned above. This study integrates the principles of corporate governance, risk and uncertainty, and capital budgeting principles in financial management in the e-commerce and airline industries based on capital market research in accounting. In this study, the impact of the integration of the above disciplines on investment appraisal decisions is analysed.

This chapter critically reviews the existing literature in some areas of business that impact investment appraisal decisions. These areas include capital budgeting, corporate governance, capital markets, accounting practices, and investment appraisal methods. To discuss these concepts and their interrelationships, some relevant theories are discussed including the following: agency theory, stakeholder theory, stewardship theory and resource dependence theory. The capital market variables include interest rates (cost of capital) and agency costs, which impact on corporate governance, which in turn have an impact on capital budgeting decisions (Ruiz-Porras and Lopez-Mateo 2011). There are two main sources of capital – equity and debt (Whitehead 2009). Debt is an external source of capital which bears a specified interest rate. It is mainly supplied by capital markets including commercial banks, investment banks and other financial institutions such as insurance companies, superannuation funds, etc. The company (the borrower) and the financial institution (the lender) enter into a contract which specifies the interest rate to be charged and other restrictive debt conditions which have to be observed during the life of the debt. Through the interest charges and other conditions imposed on the borrower (investor), the capital markets influence the firm’s corporate governance, agency costs and capital budgeting decisions. Therefore, making capital budgeting decisions without considering capital market interactions ignores one of the major factors that influence investment appraisal decisions.

The main aim of this chapter is to propose a conceptual framework for the inter-disciplinary analysis of (1) various disciplines including corporate governance, capital markets, accounting practices, agency costs and financial accounting information, and (2) the discounted cash flow analysis, and MOLP modelling of capital budgeting.

As discussed before, the aim of this study is to incorporate the principles of corporate governance, capital markets and risk management into the investment appraisal principles that a firm in the e-commerce sector should adopt. Accordingly, this chapter analyses the impact of corporate governance principles, capital markets, accounting standards and the regulatory environment in Hong Kong on Tom.com discounted cash flows (DCF), net present value (NPV) and the required rate of return (RRR) methods used to maximise the firm’s value. It also discusses some selected advanced techniques used in investment appraisals such as real options and how other areas of discipline impact on them. The impact of capital markets such as that of the main bank-based financial system which allows the supplier of debt capital to actively participate in the firm’s operational and strategic decision making used in Japanese corporations is also discussed for undertaking a comparative analysis of this issue.

The use of optimization models in decision making in the airline industry has become the norm in the modern economy. Optimization models in airline operations can be used for scheduling crews to provide professional services without overworking them, assigning high-capital equipment efficiently, selecting flight routes to cover demand for the services, and scheduling arrival slot allocations (Papadakos 2009; Sun et al. 2011).

The aim of this chapter is to further analyse the major findings of this study and discuss the practical implications of capital budgeting in financial decision making. The use of cash flow, DCF and MOLP in the investment appraisal process in the e-commerce sector and in the airways industry is something of high significance. Tom.com, a company used to analyse discounted cash flow in this study, was valued using accounting multiples despite their widely well known limitations. In this study the limitations were aggravated because the company, Amazon.com in the U.S, whose multiples were used to value Tom.com in Hong Kong, operated in an economy that had a different level of economic development from that of Hong Kong.

The purpose of this study was to integrate the principles of corporate governance and the interactions of capital markets into the investment appraisal process. This study is significantly important in the modern economy which uses IT, because of the inherent high risk created by rapid technological changes. Companies invest large amounts of capital into physical assets with the intention of generating future cash flows whose present value (PV) exceeds the PV of the initial investment. The investment appraisals may include investments in completely new equipment, plant and machinery, replacement of obsolete equipment, and research and development. The fact that some equipment has high risks, coupled with the large amounts of money required to purchase this equipment, decision makers, in most cases financial managers, are required to be careful and diligent when making investment appraisal decisions. Capital budgeting decisions are not easily reversible. However, if investment appraisal decisions are prudently made, they should maximise the value of the firm. Therefore, maximising the value of the firm is regarded as the main objective of all firms. It is achieved through investing in long-term non-current assets or capital projects.