AMBO UNIVERSITY

SCHOOL OF BUSINESS AND ECONOMICS

DEPARTMENT OF ACCOUNING AND FINANCE

FACTORS AFFECTING CAPITAL BUDGETING DECISIONS;
A CASE OF AMBO MINERAL WATER SC, ETHIOPIA

BY
ABDISSA DIDA WODAJO

ADVISOR
PRASSAD (Dr.)

A PROPOSAL SUBMITTED TO THE SCHOOL OF GRADUATE STUDIES OF AMBO

UNIVERSITY SCHOOL OF BUSINES AND ECONOMICS IN PARTIAL FULFILMENT
OF THE REQUIREMENTS FOR THE DEGREE OF MASTERS OF FINANCE
AMBO UNIVERSITY
SEPT 2020

Ambo

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Table of Contents Pages
Abstract....................................................................................................................................................3
Chapter One.............................................................................................................................................4
1 Introduction...........................................................................................................................................4
1.1Statement of the Problem...............................................................................................................5
1.2Objectives of the study....................................................................................................................5
1.2.1General objective......................................................................................................................5
1.2.2Specific Objectives...................................................................................................................5
1.2.3Research questions...................................................................................................................6
Chapter Two............................................................................................................................................7
Review of literature.................................................................................................................................7
2.Review of Related literature.................................................................................................................7
2.1Theoretical Reviews..........................................................................................................................7
2.2Over views of Capital budgeting decision.......................................................................................7
2.3Significance of Capital Budgeting....................................................................................................8
2.4Capital budgeting Decision process.................................................................................................8
2.5Factors Affecting Capital Budgeting.............................................................................................9
2.6Capital Budgeting Techniques.....................................................................................................11
2.6.1Payback Period Method:.........................................................................................................11
2.6.2Accounting Rate of Return:.....................................................................................................11
2.6.3Net Present Value (NPV) Method:..........................................................................................12
2.6.4Profitability Index (PI):............................................................................................................12
2.6.5Internal Rate of Return (IRR):.................................................................................................12
2.7Empirical Review: Capital Budgeting Decision..........................................................................13
2.8Literature Gap..............................................................................................................................13
Chapter Three........................................................................................................................................15
3.Research Methodology.......................................................................................................................15
3.1 Research Design...........................................................................................................................15
3.2 Research approaches...................................................................................................................16
3.3 Source of data...............................................................................................................................16
3.3.1 Data collection methods........................................................................................................16
3.3.2 Sampling techniques and sampling size...............................................................................17
3.4 Data Analysis method..................................................................................................................18
3.5 Ethical Considerations.................................................................................................................19
References...............................................................................................................................................20

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Abstract
The purpose of this thesis is to validate the impact of various factors, which influence the capital
budgeting decisions taken by Ambo Mineral Water S.C. Capital budgeting decisions use the
structural equation modeling approach and case study after undergoing factor analysis, which
results in a better-developed model after various rotations with different variables for arriving at
the best-fit structural model. This paper will based on primary data with sample size of 15
managers participating in capital budgeting activities by categorizing the variables into four
factors - Size, Risk, Social Cost Benefit Analysis (SCBA) and Trait. A the researcher will
conduct regression analysis in which he will check first three factors (Size, Risk and SCBA) are
significant and influence the decision of acceptance of the Type of Capital Budgeting Technique
used in Ethiopia.

Keywords

Capital Budgeting, Trait, Size, Risk, Social Cost Benefit Analysis, DCF Techniques.

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Chapter One
1. Introduction
Capital budgeting is a company’s formal process used for evaluating potential expenditures or
investments that are significant in amount. It involves the decision to invest the current funds for
addition, disposition, modification or replacement of fixed assets. The large expenditures include
the purchase of fixed assets like land and building, new equipment, rebuilding or replacing
existing equipment, research and development, etc. The large amounts spent for these types of
projects are known as capital expenditure. Capital Budgeting is a tool for maximizing a
company’s future profits since most companies are able to manage only a limited number of
large projects at any one time. (Mid-market pulse,zzz Edu Pristine.com)

The crux of capital budgeting decision is profit maximization. There are two ways to it; either
increase the revenues or reduce the costs. If an investment proposal is accepted, the decision for
capital budgeting is that, a firm invests in it and if rejected the firm does not invest. Generally,
proposals that yield a rate of return greater than a certain required rate of return or cost of capital
are accepted and the others are rejected. All independent projects are accepted. Independent
projects are projects that do not compete with one another in such a way that acceptance gives a
fair possibility of acceptance of another. Mutually exclusive project decision compete with other
projects in such a way that the acceptance of one will exclude the acceptance of the other
projects. Only one may be chosen. Mutually exclusive investment decisions gain importance
when more than one proposal is acceptable under accept or reject decision.

The acceptance of the best alternative eliminates the other alternatives. Capital rationing
decision required in a situation where the firm has unlimited funds, capital budgeting becomes a
very simple process. In that, independent investment proposals yielding a return greater than
some predetermined level are accepted. However, actual business has a different picture. They
have fixed capital budget with large number of investment proposals competing for it. Capital
rationing refers to the situation where the firm has more acceptable investments projects
requiring a greater amount of finance, than that is available with the firm. Ranking of the
investment project employed because of some predetermined criterion as the rate of return. The
project with highest return ranked first and the acceptable projects then ranked thereafter.

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This research will be organized with First section starting with introduction, the second section
will outline the literature review, third section will describe the sample, methodology, analysis &
discussion and finally, section four will draw the conclusions and recommendation of the study.

1.1 Statement of the Problem

The evidence from Swedish companies studied by Daunfeldt O. and F. Hart wig indicates that
larger companies tend to use capital budgeting methods more often when deciding on
investments. The choice of capital budgeting methods influenced by Size, Risk, Social Cost
Benefit Analysis (SCBA) and Trait and other individual characteristics of the CEOs. As outlined
in introduction section, most studies explored only use or non-use, or the frequency of use, of
capital budgeting methods, and did not mentioned/studied the factors affecting capital budgeting
decision.

Therefore, the motivation for this study emanates from the lack of methodological research on
capital budgeting decision and factors affecting/influencing it. Hence, this study serves two
purposes, the first is to survey capital budgeting methods applied by Ambo Mineral Water S.C
and the second is to validate the impact of various factors, which influence the capital budgeting
decisions taken by Ambo Mineral Water S.C.
1.2 Objectives of the study
1.2.1 General objective
The main objective of this research is to assess that Factors Affecting Capital Budgeting
Decision (CBD) in the case of Ambo Mineral Water S.C (AMW SC.
1.2.2 Specific Objectives
The specific objectives of this research will be:
 To assess the capital budgeting decision and factors affecting it in AMW S.C one by one
 To investigate capital budgeting decision trend analysis AMW S.C for during 2018 & 2019
 To assess the challenges of current capital budgeting decision and process of AMW S.C’s
 To check which capital budgeting method adopted by AMW SC for decision-making.

1.2.3 Research questions

The following research question will addressed to fulfill the requirement of specific objectives of
the thesis depicted above.

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1. What are factors affecting capital budgeting decision at Ambo Mineral water SC
2. What CBD trends are there at AMW SC to make things smooth with lower cost and higher
return in the last two years?
3. What are the challenges at AMW SC that hinder their CBD process during the last two years
4. What are method of capital budgeting techniques is/are maintained at AMW SC for long-
term investment decision?

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Chapter Two
Review of literature
2. Review of Related literature
This part of the researcher’s proposal presented in detail theoretical, conceptual framework
and/or empirical related to the subject matter under the study. Theories concerning capital
budgeting decisions will reviewed and addressed in detail topics. Empirical literatures will
reviewed and presented to show the studies done on the theme and literature gap.

2.1 Theoretical Reviews

The effectiveness of capital investment theoretically associated with the disciplines of capital
budgeting practices. Therefore, in order to capture the theoretical framework, the researcher will
present capital budgeting overviews and detail theories found from different theoretical sources.

2.2 Over views of Capital budgeting decision

According to Chandra (2004) the first and perhaps the most important decision that any firm has
to make is to define the business or businesses that it wants to be. According to Bhalla (2004),
the field of capital budgeting is both comprehensive and challenging. It clearly plays a rite role in
assisting most business firms to achieve their various goals. Herman, Edwards & Ivancevich
(2011), defined capital budgeting as the planning, evaluation, and selection of capital
expenditure proposals.Herman, Edwards & Ivanccevich (2011), states that Poor capital
budgeting decisions can be costly because of the large sums of money and relatively long period
involved.

For Quirin (1967) capital budgeting is a process for analyzing and selecting long-term
investment projects. Concerning the need for capital budgeting analysis need Gilman (2008)
states that long term investments represent sizable out lays of funds that commit a firm to some
course of action. Consequently, the firm needs procedures to analyze and properly select its long-
term investments.

Hagos (2007) described investing is incurring costs in order to gain benefit during the estimated
life of the plant assets or current assets in the future. Therefore, investment activities should
evaluated with its factors affecting its decision very carefully. According to Kolb (1968), the
theory of capital budgeting calls for;

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 1. Estimating in terms of a rate of return the benefits expected to result from carrying out a
capital investment project,
2. Estimating the overall cost of capital to the firm (also in terms of a rate)
3. Basing approval of the project up on whether or not the benefits exceed the cost of
capital.

2.3 Significance of Capital Budgeting

According to Ballad (2004), there are several practical reasons for placing greater emphasis on
capital expenditure decisions. The investment involves long period and substantial expenditures.
In addition, the irreversibility nature of long-term investments without paramount loss and the
effect of over and under capacity of the business bring additional cost to the business. Khan &
Jain (2007) states that the rationale underlying the capital budgeting decision is efficiency. Thus,
a firm must replace worn and obsolete plants and machinery, acquire fixed assets for current and
new products and make strategic investment decisions.

2.4 Capital budgeting Decision process

According to Noreen, Brewer & Garrison (2011) any decision that involves an outlay now in
order to obtain a future return is a capital budgeting decision. Typical capital budgeting decisions
include cost reduction decision, expansion decision, equipment selection decision, and lease or
buy decisions and equipment replacement decisions.Capital budgeting, as we know, is a decision
making process. It involves the following six steps:

Figure 1 Noreen capital budgeting decision- process

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a. Identifying Potential Investment Opportunities: The Company has various options for
capital employment on a long-term basis. In the initial stage, the management needs to
analyze the strengths and weaknesses of every project for foreseeing the potential of each
option.
b. Evaluating and Assembling Investment Proposals: In the next step, the management
assembles and compiles all the investment proposals on the grounds of cost, risk
involvement, future profits, return on investment, etc.
c. Decision Making: Now, the company needs to decide as to which investment option it may
select to suit its pocket and yield a high profit for the company in the end.
d. Capital Budgeting and Apportionment: The next step is to classify the investment as per
its duration. The long-term investment is generally considered under capital budgeting. This
step helps in monitoring the performance of an individual investment.
e. Implementation: After the apportioning of the long-term investment, the company comes
into action for the execution of its decision. To avoid complications and excess time-
consumption, the management should lay out a detailed plan of the project in advance.
f. Performance Review: The last but the most crucial step is the follow-up and analysis of the
project’s performance. While the company’s operations are steady, the management needs to
measure and correlate the actual performance with that of the estimated one to figure out the
deviation and take corrective actions for the same.

2.5 Factors Affecting Capital Budgeting

The capital budgeting decisions influenced by various elements present in the internal and
external business environment. Following are some of the significant factors affecting investment
decisions:

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Fig, 1 (https://theinvestorsbook.com/wp-content/uploads/2019/03/FACBD.jpg)

Capital Structure: The Company’s capital structure, i.e., the composition of shareholder’s funds
and borrowed funds, determines its capital budgeting decisions.

Working Capital: The availability of capital required by the company to carry out day-to-day
business operations influences its long-term decisions.

Capital Return: The management estimates the expected return from the prospective capital
investment while planning the company’s capital budget.

Availability of Funds: The company’s potential for capital budgeting is dependent on

its dividend policy, availability of funds and the ability to acquire funds from the other sources.

Earnings: If the company has a stable earning, it may plan for massive investment projects on
leveraged funds, but the same is not suitable in case of irregular earnings.

Lending Policies of Financial Institutions: The terms on which financial institutions provide
loans such as interest rates, collateral, duration, etc. contributes to capital budgeting decisions.

Management Decisions: The decision of the management to take a risk and invest funds in
high-value assets or holding some other plan, also determines the capital budgeting of the
company.

Project Needs: The Company needs to consider all the essentials of a new project. In addition,
the means to fulfil the requirements along with the estimate of the related expenses should be
clear.

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Accounting Methods: The accounting rules, principles and methods of the company is another
factor considered while capital budgeting to frame the reporting of such expenses and revenue to
be generated in the future.

Government Policy: The restrictions imposed and the exemptions allowed by the government
to the companies while investing in capital nature, affects the company’s capital budgeting
decisions.

Taxation Policy: The taxation procedure and policy of the country also influences the long-term
investment decision of the firm since additional capital will be required for such expenses.

Project is Economic Value: The total cost estimated for the long-term investment and the
capacity of the company determines the capital budgeting decisions.

2.6 Capital Budgeting Techniques

Capital budgeting is a complicated and tedious process. It involves a lot of financial
expertise and calculations. According to Keown, Martin, Petty & Scott (2003) and Herman,
Edwards & Ivanccevich (2011), the following methods techniques identified for analysis of
CBD in today’s business environment.

Figure.2 Capital Budgeting Techniques (https://www.cbt.com/search?tbs)

2.6.1Payback Period Method:

The payback period method is the simplest of all. It defines the period in which the
company can recover its investment value.
The formula for calculating the payback period of a project is:

The shorter is the payback period of the project, the more suitable it is for the company.

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2.6.2Accounting Rate of Return:
The accounting rate of return depicts the future profitability of a project with the help of
accounting information mentioned in financial statements.

The formula for calculating the accounting rate of return is:

The higher is the ARR of the investment proposal, the more preferable it is for the company.
2.6.3Net Present Value (NPV) Method:
Net present value is the discounted cash flow method. It functions on the principle that the
cash inflow from the project will be acquired in a future period when the value of money
will change. Hence, the future cash flow needs to be discounted at present value to compare
the estimate performance with the actual one.

The Net Present Value (NPV) formula is:

i.e.,

Where, A1, A2, A3 are the cash inflows in consecutive years; k is the cost of capital of the
project; we assume that all the cash outflows are done in the first year (t) and therefore, t=1.

2.6.4Profitability Index (PI):

Profitability index is the ratio, which relates the present value of earnings with the
investment value. The formula of the Profitability Index (PI) is:

Or,
To denote the Profitability Index in percentage, Profitability Ratio of a new project is
calculated. Its formula is:

2.6.5Internal Rate of Return (IRR):

The internal rate of return determines the rate at which the investment amount is recovered
by the cash inflows. The net present value of the project is zero in this method. In addition,
the discounted cash inflow and outflow are the same.Initially, the Present Value of Cash
Outflow (Co) calculated as follows:
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Where Co is the present value of cash outflow;C1, C2, C3 are the cash inflows in the
consecutive years;n is the number of years;r is the expected rate of return.
This is the cutoff rate of the project.
The Internal Rate of Return (IRR) formula is:

Where NPV (LR) is the net present value at a lower rate,NPV (HR) is the net present value
at a higher rate.Analysis: If the IRR≥Co, the project is accepted; but if IRR<Co, the project
is rejected.
2.7 Empirical Review: Capital Budgeting Decision
As indicated in the over view of the chapter of the study section the main point to address in this
study is to assess how capital budgeting decision was practiced in Ambo Mineral water SC
Capital budgeting process involves many activities that ensure the existence of good business
practice in organization. Therefore, the study tried to review and presented empirical research
conducted in capital budgeting practices worldwide and presented as follows:
Lazaridis (2004) argue that companies mostly use capital budgeting techniques for evaluating
projects intended to be launched that leads for companies operation to be profitable. This ensures
the management to commit resources on profitable projects that meet the minimum threshold. In
addition Hornstein & Zhao (2011) indicates that a significant relationship exist between value
enhancing capital budgeting decisions and stronger internal linkage. Moreover, Batra & Verma
(2017) found that corporate practitioners largely follow the capital budgeting practices using
discounted cash flow techniques of net present value and internal rate of return. Non-financial
criteria are also given due consideration in capital budgeting decision.
2.8 Literature Gap
Lazardis (2004) clearly showed the importance of capital budgeting techniques for profitable
operation thereby ensuring the management commits resources on profitable projects only. In capital
budgeting practices, Slagmulder et al. (1995) found that pre-established criterion governs capital
budgeting practices and strategic considerations receive attention in decision-making processes.
Verbeeten (2005) found that firms use advanced capital budgeting practices in case of financial
uncertainties. Concerning efficient utilization of resources Hornstein & Zaho (2011) found that

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corporate over investment significantly reduced with better information sharing across units. In case
of capital budgeting techniques used Chittenden and Derregia (2013) found that payback period is
the most widely used technique in capital budgeting practices. Contrary to this, finding Anand and
Monoj (2002), Jain, and Yadev (2002) found that the discounted cash flow techniques are more
popular.
As we can see from the above summary, there are serious issues considered in capital budgeting
practices to bring efficient utilization of resources. There is also a contradiction in findings of
different researchers. In addition, these researches done in developed economies and no previous
study is there concerning the subject matter in Ethiopian context. Therefore, this gap derives the
attention of the researcher to engage in assessing the capital budgeting decision of Ambo Mineral
Water SC.

Chapter Three
3. Research Methodology
The research tend to determine check those factors affecting capital budgeting decision in Ambo
Mineral Water SC and will preceded by an extensive literature review. The review embraced
literature on investment appraisal methods and the organization of the investment process. In
particular, it included research into the diffusion of capital budgeting methods and factors
influencing budgeting decision (e.g. Klammer et al., 1991; Graham and Harvey, 2001; Sandahl
and Sjögren, 2003; Brounen et al., 2004; Verbeeten, 2006; Bennouna et al., 2010; Daunfeldt and
Hartwig, 2011).

As previous studies show companies in North America, Asia and Pacific countries most
commonly use DCF methods. DCF methods are less common among companies from Western
Europe and they are not commonly used in the countries of Central and Eastern Europe and
Africa.

3.1 Research Design

This research is going to assess the capital budgeting practice of Ambo Mineral water SC with
the case study research design using mixed research approach. The use of case study research
design will help to perform in depth analysis of the responses collected from multiple sources to
get answers to the research questions. An emphasis on detail provides valuable insight for

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problem solving, evaluation, and strategy. This detail secured from multiple sources of
information. It allows evidence in order to verify and avoid missing of the data.

In order to get answer to the research questions the researcher used descriptive research design.
Descriptive research includes surveys and fact-finding enquires of different kinds in addition to
case study. The main purpose of descriptive research is description of the state of affairs as it
exists at present and it helps to portray accurately the characteristics of a particular individual,
situation or group. Descriptive research design is appropriate for this study since it is useful
when the problem has been defined specially and where the researcher has certain issue to be
described by respondents about the problem.

3.2 Research approaches

Creswell (2003 & 2014) noted that in an investigative study there are three familiar types of
research approaches to business and social research namely, quantitative, qualitative and mixed
approach. However, each approach has its own strengths and limitations, Creswell (2003 &
2014), advocates that certain types of social research problems call for specific approach. Hence,
in selecting an approach one should take in to account the nature of the research problem, the
personal experience of the researcher, and the audience for whom the report will checked. The
researcher used mixed research approach, which tends to give better insight to the study. This
approach is appropriate for the research work based on data, which will collected through, closed
ended and likert scaled questions. The research looked for pattern of meaning because of the data
that that to be collected through structured questions. In addition, the research work used
interview and document review to gather some important information concerning the study,
which helps to triangulate and clarify points that may need further investigation.
3.3 Source of data
3.3.1 Data collection methods
Data for this study will collected from primary and secondary sources. The Primary sources are
questionnaire and interviews feedback. The secondary data source is document review. Data
from interview and document review help to triangulate findings from the questionnaire data
source.

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3.3.1.1 Questionnaire instruments
Data that will collected through questionnaire will be from senior experts who extensively
involve in the preparation of capital budgeting decision as well as from senior managers who
supervises the operation. The questionnaire will developed and refined based on field interviews
with some senior managers in the company. The questionnaire will compose 52 closed ended
questions, which will grouped in to 9-sub sections. The first sub section designed to provide
general information about respondents and the other eight sub sections designed to provide basic
information that can help the researcher to assess how capital budgeting decision conducted at
the company. The questionnaire feedback will also be collected using 5-point likert scale and the
data will analyzed and interpreted using frequency, mean score and standard deviation. Because
of the sensitivity nature of some of the questions that will asked, the level of detail sought, and
the anonymity of the respondents may be occurred in cover letter explaining the purpose of the
study.

In the questioners, five-point Likert scale ranging from strongly disagree (1) to - strongly agree
(5) will be used. The main advantage of likert scale questions is that they use a scale,
respondents will not be forced to express an extreme opinion allowing them to be neutral should
they so choose. The researcher will prefers to use a likert- type scale because it is very easy to
analyze statistically (Jackson, 2009). The questionnaire will also include open-ended questions to
collect other additional relevant data that will be there for the respondents that cannot be
included in the closed ended questionnaires.

3.3.1.2 Interview instruments

Interview will conducted to get clarification for some questionnaire feedbacks, which require
triangulation since interviews are an excellent way to gather detailed information about the
study. It will provide an opportunity for face-to-face interaction between two persons; hence,
they reduce conflicts. Unlike questionnaire, the interviewer has the opportunity to probe or ask
follow up questions. The corporation’s plan and program executive officer will interviewed to
get answer for items that need clarification. The interview feedback is included in chapter four of
the study report.

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3.3.1.3 Document sources
Document sources like Capital budget activities documents, policy and procedure guide lines of
capital budget process and strategic plan of the AMW SC for the period covered 2018 to
2019G.C. will used for this analysis purposes. The review will help to gather background
information about the corporation’s capital budgeting work process guideline and how actual
work will conducted. The results of the review work will help the researcher to triangulate results
from questionnaire analysis and it will include in chapter four of the study report.

3.3.2 Sampling techniques and sampling size

The research work will designed to find out answers to the research questions mentioned in the
research question section. Data related to these activities are associated with experts working on
the activities and senior managers who supervise the operation. Therefore, to get relevant
information to the study non-probability sampling specifically purposive sampling technique will
used. As the research design is case study, this method of sampling allows data collection from
those experts and senior managers who has the professional capacity to give the required
information about capital budgeting practices. The company possesses multidisciplinary
professionals with extensive and proven experience in the engineering consultancy services as
well as in other support services. According to strategic planning and management document for
the period 2018-2019GC and the company possesses 178 work force with different qualification
level as presented below in the pie chart.

Figure 3. work force of management staff of Ambo Mineral Water SC

According to the information obtained from Resource management service of the company
(2019G.C.), the total number of senior managers and experts who directly engaged in the capital
budgeting activities are 27. From the total population of 27 the researcher chooses 15

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professionals who have extensive work experience on capital budgeting practices. The work
experience level provides advantage in providing relevant and reliable information to the study.
As the study focuses in assessing the capital budget practices of the AMW SC, using purposive
sampling provided chance of getting better information from employees who judged to do so.
The sampled employees were selected based on their regular engagement on preparation of
annual plan (Budget proposal), evaluation of annual plan (Budget proposal), and approval of
annual plan (Budget proposal).

3.4 Data Analysis method

The questionnaire results will analyzed quantitatively by using descriptive statistics, namely
mean, frequency and standard deviation. Descriptive results summarize a given data set that can
be either a representation of the entire population or a sample of it. They provide descriptive
statistic results summarized to measure frequency, spread and central tendency. SPSS software
will used to run the data. The results will interpreted to draw appropriate conclusion concerning
the problem statement. In addition, data that will collected through interview and document
review will used as a source of additional information and to triangulate results of questionnaire.

3.5 Ethical Considerations

This study is will be conducted with self-sponsorship by the researcher himself. In addition, the
management may show interest to get clear information about its capital budgeting practices. To
achieve the management’s expectation it is necessary to exercise some ethical issues. This will
protect the interests of the researcher as well as the company. The people who may involve in the
study as data provider also will be ethically be protected for the information they shared during
data collection.

The researcher will exercise due diligence in designing the research work which can provide a
platform on which to conduct the study. In addition, secret of the company must be protected and
the concerned authority acknowledges all data used in the study. The privacy of the people that
will be engaged in providing data will protected securely. Data that will collected through
interview will be included in the report with consent of the interviewee.

Scope of the study

Expected outcome of your study/significance of your study

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 Work plan/time schedule

Budget

References/Bibliography

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