Empirical evidence on capital budgeting practices

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Previous empirical evidence on capital budgeting practices

Rapidly changing technology, innovations and globalization are lead to make more competition in modern businesses context. The business that can compete with this competition be able to survive in the market and earn profits. Organizations which are having more flexible structure and strong financial position be able to compete with the market changes. Making capital nature expenses for unforeseen future may not be best solution to the organizations. On the other hand having zero investment also may not be the best scenario. Therefore organizations should undertake the projects which may give sustainable competitive advantage to the businesses.

Capital investment decisions normally represent the most important decisions that an organization makes, since they commit a substantial proportion of a firms resources to actions that are irreversible. Expansion of business operations, acquisitions, modernization and replacement of long term assets and sale of a division or business can be identified as investment. Normally such investment will take more than one year period and those includes investments in plant and machinery, research and development, advertising and warehousing facilities.

These types of investments carry huge cash inflows and outflows as well as risk associated with; therefore managers are evaluating the project before it is accepted. In this case, managers apply different criterion to evaluate investment decisions in which maximize the wealth of the shareholder's. In general, there are four main capital budgeting techniques the manager may use when evaluating an investment project.

The Net Present Value (NPV) and Internal Rate of Return (IRR) methods are considered to be discounted cash flow (DCF) methods. The Payback Period (PB) and Average Accounting Rate of Return (ARR) methods are so-called non-DCF methods. From a pure theoretical approach the NPV is considered to be the most precise technique to evaluate projects. Yet, it is also the most complicated of the four, followed by the IRR method. Both non-DCF methods are thought to be less accurate, of which the PB method is the least complex.

In the past, several surveys on capital budgeting techniques have been carried out. Analysis results of capital appraisal practices have been published in the literature since the late 1950s. Most surveys focus on companies in the U.S. This is particularly true for surveys carried out prior to the 1980s. Some future studies are based on available data from Canadian, Australian and European companies. Three studies look at capital budgeting techniques in some countries in East-Asian countries, but in these studies China is not included. 

Comparing survey results of investment practices in the U.S over time generally seems to show that the analytical techniques used by executives have improved in terms of complexity. For example, in one of the earliest studies publishing the results of questionnaires on capital budgeting practices, Klammer (1972) shows that in 1959, based on a model of 184 large U.S companies, 19 per cent indicated that they used DCF methods as their main process to evaluate projects. The majority of firms used either PB (34 per cent of the total sample) or ARR methods (34 per cent) as their primary method of appraisal. In 1970, the image had changed dramatically: DCF methods were now used by 57 per cent of the firms; 26 per cent used ARR and only 12 per cent used PB as their primary method of evaluation.

In a later study, Hendricks (1983) reports in that 1981 76 per cent of the firms in his model reported they used DCF methods as their primary instrument. Only 11 per cent confirmed they used the PB method as their primary tool. Pandey (1989) study of 14 Indian companies in 1984 finds that payback period method is most widely used followed by IRR as a capital budgeting technique. There is a lack of familiarity with the discounted cash flow methodology amongst the executives. The cost of equity is taken as 25% based on value judgment. The project risk is assessed through sensitivity analysis and conservative forecasts.

Bierman (1993) finds that 73 of 74 Fortune 100 firms use discounted cash flow analysis, with IRR being preferred over NPV. The payback period method also remains a very popular method in practice, though not as a primary technique. Trahan and Gitman (1995) confirm that, based on a 1992 survey of 58 of the Fortune 500 large firms and 26 of the Forbes 200 best small firms, most companies used DCF methods as their primary evaluation instrument, although these methods were more essential for the large (88 per cent for NPV and 91 per cent for IRR) than for the small firms (65 and 54 per cent).

A recent analysis by Graham and Harvey (2001), which is the most comprehensive survey published on capital budgeting practices to date (using answers from a 1999 survey among 392 Chief Financial Officers (CFOs) of companies in the U.S and Canada) shows that the NPV and IRR techniques are the most commonly used capital budgeting techniques. This survey reports that 75 per cent of the CFOs always use NPV and 76 per cent frequently or almost always use the IRR method.

Surveys of capital budgeting practices in the UK and USA expose a trend towards the increased use of additional complicated investment appraisals requiring the purpose of DCF techniques. Another survey carried out by Pike (1996) on capital budgeting practices of large UK companies between 1975 and 1992 reported a substantial increase in the usage of discounted cash flow. According to survey he has identified 75% and 81% UK firms are applying NPV and IRR respectively.

Several writers, however, have claimed that companies are under investing because they misuse or misunderstand DCF techniques. These claims were derived on the basis of observations in only a few firms, without any supporting statistical substantiation. Reports on a recent survey conducted by the Drury C & Tayles M (1997) suggest that many UK firms are responsible of misapplying DCF techniques.

In theory would suggest that DCF method is more superior to the traditional method, on that NPV is superior to IRR. Even though in theoretically NPV technique of investment appraisal is superior in pragmatic ground its rivals are over. It is proved that survey conducted by Arnold & Hatzopoulos (2000) and Graham & Harvey (2001). These surveys done in UK and more generally and they have revealed that techniques less behind for its rivals.