Research Proposal on Capital Budgeting in Crude Oil Companies

This report is a literature review section of a research proposal on capital budgeting, specifically addressing the challenges faced by crude oil companies due to price volatility. It explores the existing research on capital budgeting techniques, highlighting the limitations of various models when dealing with fluctuating crude oil prices. The review covers historical developments in the field, relevant theories such as the importance of maximizing shareholder wealth, and the complexities of capital budgeting processes including the use of Net Present Value (NPV) and Internal Rate of Return (IRR). It also examines recent research on the impact of demand shifts, market timing, and the Capital Asset Pricing Model (CAPM) on capital budgeting decisions. The report emphasizes the need for accurate investment appraisals in the face of uncertainty and the importance of considering future cash flows for informed financial decisions. It concludes with a discussion of various capital budgeting methods and their applicability in the context of crude oil price volatility.

Literature Review
Introduction
In this section, the literature related to the study question will be analyzed to find out
what other researchers have done in the past and how they concluded their researches. The topic
on the capital budgeting has been researched by many researchers because many industries
usually have a problem in choosing the most capital budgeting techniques because all the
developed model have limitations (Abor,2017). the case becomes more difficult especially when
the company is dealing with the volatility of the price. The crude oil companies are the most
affected by the price volatility because there are very many factors which comes into play and
which determines the price of the crude oil. These factors are not fixed and the change quacking
making the capital budgeting of the crude oil companies to be difficult. Some researchers who
will be reviewed this section have conducted the research on the best capital budgeting
techniques which the crude oil companies can use taking the price volatility of the crude oil into
account. However, the problem persists because even after companies applying those techniques,
the crude oil companies still venture into projects which prove unprofitable and, in some cases,
put the companies in the risk of been bankruptcy (Aldaarmi et al, 2015). This section will focus
on the theories of capital budgeting as well as review different capital budgeting model and
where they have been used. This will enable us to discover the strength and the weakness of
those model and then hence find the gap which exists in the body of knowledge.
Research Background
Capital budgeting is important to managers because it helps them to make the informed
and proper decision so that they can venture into certain investment. The process has to take into
consideration the future cash inflow and outflow of the business for the technique to be

considered as reliable and quite accurate. The main problem arises where the volatility of the
price experiences to the extent that it becomes impossible to predict the future price of the
product. The price volatility makes it had for the company accountants to determine the future
cash inflow of the business (Ahmad,2017). The worst case occurs when the company
accountants assume that the price of the product will increase and the end up predicting the
future cash inflow which is higher that which will be generated. this cause the company to be
unprofitable to the extent which the investors fail to get the equity returns. The investors are the
most important stakeholders in the company and hence the managers have to ensure that their
wishes and expectations are met. most of the managers use the payback period capital budgeting
technique because it is the easiest method (Al Hudithi,2017). However, this method is never
accurate because it is based on many assumptions which can be applied in the crude oil
companies like Armco Saudi where the price is highly volatile. The throughput analysis has been
used in a few companies and has proven to be the best technique of capital budgeting.
Nevertheless, most of the companies do not use this technique because it is complex and
considers every aspect of the company. This method is very accurate because all it considers the
cost as the operating cost and the profit has to be maximized to pay for these expenses (Su et al.,
2018). The Armco Saudi has vision 2020 which is aiming at ensuring that the shareholders are
satisfied by the performance of the company and how the management of the company id
managing resources. This vision might fail to be achieved considering the danger which Armco
company in the aspect of the crude oil price volatility (Alkhamis et al., 2017). The sad part of the
story is that the price of crude oil in most cases is fluctuating downward meaning that there is a
probability that the price of crude oil will go down.

Historical Development of Research in the Area
The research on capital budgeting has been conducted for the last 80 years (1940-2019)
through various methods. In most of the studies, the empirical method was used to analyze the
data. Some of the researchers were conducted by the government researcher while most of them
were done by the scholar. In more than 50% of the researcher were case studies where only the
secondary data was used in the study without having primary data to confirm the secondary data.
The government researchers used the companies’ financial data of about 20 years to study the
capital budgeting techniques which those companies have been using.
Most of the scholar-researchers were carrying out primary data collection to find out
whether the secondary data is consistent with the reality on the ground. However, the studies
concerning the impact which the volatility in price has on capital budgeting have a history of
about 20 years because most of the researches in the past have not been so keen on the effect
which price volatility has. Since the start of the 21st century, the volatility of the prices of good
has been experienced in many countries because of globalization which has expanded
international trade (AlMotairy, 2016). It is no longer the case where the price of good was
determined by the market forces within countries but with the advancement of technology, an
action happening in one country can affect the price of products in far distance country ibn short
period of time. This has brought a difficult time for the managers and hence a few researchers
have conducted studies on the impact of volatility on the capital budgeting. The study on the
volatility of the price of crude oil impacting the capital budget is scarce and has only been done
for the last 10 years (Al-Maamary et al., 2017). This is because the price of crude oil had for a
long period of the time constant until there was great economic depression in the year 2008 (Al
Hudithi,2017). After many countries recovered from the great depression, the price of crude oil

has been fluctuating greatly making it very difficult for the managers to determine which is the
best method they can use for capital budgeting.
Relevant Theories in the Research
When it comes to the capital budgeting there are many theories which are developed by
the researchers. The most important of them is that the main aim of the company is to make a
profit so that to create as much wealth as possible for the shareholders. For the company to make
profit then project which will be profitable to the company have to be selected (Al-Mutairi et al.,
2018). For this reason, the capital budget has to be used to select the appropriate project which
the company has to invest in so as to meet the expectation of the shareholder who is the owners
of the company. The capital budgeting process is quite complex because the managers have to
ensure that the future uncertainties are covered in the capital budgeting techniques. In case the
managers ignore future uncertainty, then the investment appraisal is unreliable and will not be a
true reflection of indicating the profitability of the company (Adam et al., 2017).
There are many techniques which the managers have been utilizing in capital budgeting
which include, throughput analysis, discounted cash flow method, net present value (NPV),
internal rate of return and payback period. These techniques have different complexities and the
more complex certain techniques are, the more it is likely to be accurate. In most cases, the net
present value and the internal rate of return (IRR) are used together but the NPV is considered
paramount even which the IRR seems to give contradicting conclusion (Araujo et al., 2016).
When the net present value of the project is found to be positive then it means that the company
will be profitable. However, this model cannot be fit in cases where the price is volatile since the
model is not flexible. Basically, the capital budgeting models are not fully capable of appraising
the investment for the managers to make the most informed decisions (Aregbeyen&

Fasanyan,2017). Despite which method is used in capital budgeting the crude oil price volatility
has to affect it because the volatility in the prices affect the revenue which the company is
expecting in the future and which is subject to price fluctuations (Benramdane, 2017). The
capital budgeting of the company is usually governed by the budgetary policy which governs the
allocation of the resources in the company.
Review of Recent Research in the Area
Capital budgeting
Capital budgeting can be affected by changes in demands over the time horizon. Capital
budgeting using issuing new equity as a source of finance, Implies that industries anticipating
positive shifts in demand in the near future, as a result issuing more equity is the appropriate
financing method to cater for such demand shift (Buller& McEvoy,2016). Market timing implies
that industries anticipating positive demand shifts in the distant future should issue less equity, to
avoid exposure to undervaluation (Chittenden& Derregia,2015). The relationship between
demand shifts and stock issuance has been found to be: new listings and equity issuance respond
positively to demand shifts up to 5 years ahead, and negatively to demand shifts 5 to 10 years
ahead.(DellaVigna & Pollet, 2007)
In the context of project appraisal, Ross et al. demonstrate a generic discount rate should
be discouraged in practice. In theory, however, a generic discount rate is justified through M&M
proposition III. Dayala (2010) has investigated the discrepancy and finds that consistently
selecting positive NPV projects with individual risk-adjusted discount rates will always result in
an excess return over the generic hurdle rate, hence value creation. Yet, a generic discount rate
for individual project appraisal can only be justified if and when the generic discount rate is
identical to the individual discount rate; that is in a context of projects being perfectly correlated

and of an identical risk class only (Araujo et al., 2016). In all other cases, a generic discount rate
could lead to value destruction. M&M Proposition III is misguided (Dayala, 2010).
Budgeting is considered to be one of the most important management tools to steer the
organization, evaluate its performance and motivate its people. Capital budgeting decisions
affect the profitability of a business organization. The paper focused on the efficiency of capital
budgeting. Over-investment or under-investment is inefficiency (Crossman & Fischer, 2016).
Using Chinese listed company's data, when the majority stockholder has more stock, the more
inefficiency of capital budgeting has been concluded. Also, the negative relationship between
leverage and the inefficiency of capital budgeting has been established (Davoudi, 2018). The
inefficiency of capital budgeting decreases as the number of independent director increases (Wu,
2011).
Capital asset pricing model (CAPM)
The empirical evidence presented by Da, Guo, & Jagannathan (2012) against the capital
asset pricing model (CAPM) based on stock returns, proposed that using CAPM for estimating
the cost of capital does not invalidate its use as capital budgeting model for projects in the
making. It can be attributed to the fact that stocks are backed not only by projects in place
(Decisions,2015). The presence of options to modify current projects and undertake new ones,
the expected returns on stocks does not have to satisfy the CAPM even when expected returns of
projects pass CAPM criteria for financing the specific project. Our findings justify the continued
use of the CAPM by firms in spite of the mounting evidence against it based on the cross-section
of stock returns. (Da et al., 2012)

Net Present Value
Net present value: is defined as the sum of the present values (PVs) of the individual cash
flows. In the case when all future cash flows are incoming (such as coupons and principal of a
bond) and the only outflow of cash is the purchase price, the NPV is simply the PV of future
cash flows minus the purchase price (which is its own PV) (de Andrés et al., 2015). NPV is a
central tool in discounted cash flow analysis and is a standard method for using the time value of
money to appraise long-term projects (Domanski et al., 2015). Used for capital budgeting, and
widely throughout economics, finance, and accounting, it measures the excess or shortfall of
cash flows, in present value terms, once financing charges are met. ( Lin et al., 2000).
Advantages: the time value of money, easy to calculate, and Shows the risk associated with all
future cash flows. Disadvantage: it assumes that interim payments received during the life of the
project can be invested at the discount rate used in the calculation (Donovan & Corbishley,
2016). For determining expected annual cash flows and the expected period of benefit, subjective
data is used. The outcome is shown as a rand value and not as a percentage; which are usually
easier to understand (Feibel, 2003).
Net Present value for Foreign Investment
The usage of the theoretically correct net present value method decreases with the
political risk in the host country, and that the use of the Payback method increases with the
political risk (Chittenden& Derregia,2015). also in the presence of capital market imperfections,
unsystematic and country-specific political risks are important (Ghenimi et al., 2018). Due to the
fact that these risks are difficult to estimate (rendering high deliberation costs) managers are
inclined to use simple rules of thumb for their capital budgeting decisions (Araujo et al., 2016).

Research results partly explain why surveys find that alternative methods such as the Payback
method are frequently used despite their theoretical drawbacks (Holmén & Pramborg, 2009).
The traditional methodology for determining whether or not such an investment should
be made is known as the discounted cash flow method (Al Hudithi,2017). This method,
unfortunately, does not capture efficiently the benefits of flexibility that often accompany capital
budgeting decisions (Graham & Harvey,2002). Using the framework of financial theory,
employing real options modeling in public sector capital decision-making has been found to
improve the efficacy of capital budgeting decisions.(Schubert & Barenbaum, 2007b)
The standard textbook formula for computing the present value of future random cash
flow - the discounted expected value – has been found to be formally incorrect and can generate
significant errors when used to compute present values. The standard error found in the standard
text PV formula has been theorized to be more severe for projects that run beyond 5 years
(Jarrow, 2014).
Including real options for decision makers for capital budgeting, empowered the decision
makers to eliminate projects that didn’t perform up to standards at an early stage (Guerrero-
Baenaet al., 2015). The study by Denison (2009) Using experimental methods to explore whether
incorporating real options into net present value analysis can reduce escalation of commitment,
or the tendency of decision makers to continue to commit resources to a project after receiving
negative feedback (Jahfer & Mulafara,2016). Findings indicated that users of real options display
less escalation of commitment than do users of net present value analysis alone. The main result
demonstrates that the use of real options in capital budgeting can affect the behavior and

decisions of the user even in an experimental setting that controls for the informational
advantage of using real options(Denison, 2009).
Budgetary policies
The impact of the institutionalization of governance and budgetary policies on the
accountability of organizational actors from an institutional and critical realism perspective has
been studied by Mutiganda (2013). The study has been based on the framework developed by
Burns and Scapens (2000) to critical realism. Accountability practices have been reported to be
dependent on whether the institutionalized policies have reduced or increased the gaps between
the real, the actual, and the empirical domains of the reality of the organizational actors involved
(Kengatharan,2016). The governance policy that prevails at a given domain of reality, has been
reported to be a factor to affect the accountability practices (Araujo et al., 2016). The application
of budgetary information as a tool of governance and accountability in the empirical field of the
study, cannot be taken for granted (Mutiganda, 2013).
The nature of the prescreening process has not been thoroughly investigated. However,
evidence suggests that some screening takes place during proposal budget development.
Researchers have identified departments responsible for the budget, 39 percent of the budgets
were prepared by engineering, 33 percent by accounting, 17 percent by finance or budget
committees, while 11 percent were considered divisional responsibilities (Kristjanpoller &
Concha,2016). It may be inferred from this finding that engineers and accountants are more
involved in the prescreening process than personnel in the finance department (Araujo et al.,
2016). An important analytical issue is the estimation of cost-benefit data. It has been found that
firms typically classified projects, and user acceptance and selection criteria that depended upon
these classifications (Lee et al., 2017). Generally, the finance department is not responsible for

budget development during the screening process. Finance, however, appears to control selection
(Muksherjee & Henderson, 1987).
Uncertainty is defined as the gap between the information currently available and the
information required to make the decision (Galbraith, 1973). A condition of uncertainty usually
exists in capital budgeting because investment decisions, by definition, involve uncertain
outcomes that in the long run are important to firm survival and about which complete
information is unavailable (Zhu and Weyant, 2003; Simerly and Li, 2000; Smit and Ankum,
1993). Also consistent with previous research is that industry has an impact on capital budgeting
practices. More specifically, firms in the financial services industry and, to a lesser extent, the
building, construction, and utility industries appear to find sophisticated capital budgeting
practices (SCBP) more important and useful than the extraction, manufacturing and non-
financial services industries (Masri & Abdulla,2018). The results indicate that it is more than the
sole uncertainty that affects the importance and use of sophisticated capital budgeting practices
(SCBP). One reason may be that some industries have characteristics (that make administrative
innovations like GT and/or ROR more suitable to implement (Mukherjee et al., 2016). Another
reason may be that these industries are used to dealing with uncertainty through option-like
analyses (Verbeeten, 2006).
Participative budgeting
The process by which managers have an influence on the setting of their budget goals,
participative budgeting (PB), has been researched extensively since the 1960s. The empirical PB
studies identified (1) the antecedents or determinants of PB, (2) the impact PB has on mental
states and performance and (3) PB's effects on the existence of budgetary slack (Myers,1974).
Summing up the findings, it has to be noted that while the informational role of PB in enhancing

subordinate performance is generally established, the results relating to reductions in information
asymmetry as well as PB's motivational effects remain ambiguous (Prümmer, Frey, Schentler,
Williams, & Motwani, 2011).
Beyond budgeting
Beyond Budgeting has been proposed as an influential idea that will reinvigorate
management accounting contribution in business operation and performance. It is claimed that
the traditional system has lost relevance with the modern business environment and is no longer
satisfying the needs of managers (Nobanee,2017). Budgets have been ingrained in the culture of
business since their inception in the 1920s and managers will find it extremely difficult to
radically shift to a system without budgets. The implications of a Beyond Budgeting system are;
performance measures relative to competitors and a decentralized organization structure
(Nurullah& Kengatharan,2015). Alternatives such as the Better Budgeting techniques may be
more favorable to management who desires a formal planning and control system. The Beyond
Budgeting concept is still in its infancy and requires further development and practical
implementation. (Goode & Malik, 2011)
Capital budgeting forlong-terminfrastructures projects
A new empirical insight on the capital structure of project-financed Liquefied Natural
Gas (LNG) infrastructures and gas pipeline projects has been provided, by using data relating to
projects whose financial close occurred between June 2004 and March 2011. Most results are
consistent with the basic view of risk-averse funds suppliers (Prasad,2018). Especially, the
projects located in risky countries and larger projects tend to exhibit lower debt ratios and less-

concentrated equity ownership. In addition, regasification projects appear to have more diluted
equity ownership. Methodological issues raised by the financing of these projects are also
examined from a capital-budgeting perspective (Rahma et al., 2016). In particular, the equity
residual method, usually used by industrial practitioners to value these projects, should be
adjusted (Pierru, Roussanaly, & Sabathier, 2013). Liquefied Natural Gas projects are the current
new strategic venture by Aramco (Aramco,2014). Understanding the applied method for LNG
projects capital budgeting is important because Natural Gas considered to the more efficient
alternative source of energy for crude oil.
Risk budgeting
The impacts of risk budgeting on managers' optimal effort decision and on investors'
contract design has been studied by Zhong &Jiang( 2011 ). The results indicate that managers
spend a low level of effort when they are constrained than when they are unconstrained
regardless of whether the effort is observable or not, and the effort managers spend decreases as
the constraint becomes tighter (Riley et al., 2017). However, active risk budgeting has negligible
impacts on investors' contract design. In addition, the contract sharing coefficient without risk
budgeting restrictions is still optimal in the scenario where the active risk budgeting is present
and the effort is observable (Rossi, 2015).
Throughput analysis
Throughput analysis is one of the methods that is used in capital budgeting. The
technique is so complex that many managers prefer not to use it but many economics have
proposed it as the best capital budgeting technique( Ruiz & Zuniga-Jara, 2018). Unlike many
other techniques like the net present value the technique does not consider the cash flow of each
separate project but it analysis the total throughput of the company. throughput is a word which