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Capital budgeting models: theory vs. practice.

Capital budgeting decisions are crucial to a firm's success for several reasons. First, capital expenditures typically require large outlays of funds. Second, firms must ascertain the best way to raise and repay these funds. Third, most capital budgeting decisions require a long-term commitment. Finally, the timing of capital budgeting decisions is important. When large amounts of funds are raised, firms must pay close attention to the financial markets because the cost of capital is directly related to the current interest rate.

The need for relevant information and analysis of capital budgeting alternatives has inspired the evolution of a series of models to assist firms in making the "best" allocation of resources. Among the earliest methods available were the payback model, which simply determines the length of time required for the firm to recover its cash outlay, and the return on investment model, which evaluates the project based on standard historical cost accounting estimates. The next group of models employs the concept of the time value of money to obtain a superior measure of the cost/benefit trade-off of potential projects. More current models attempt to include in the analysis non-quantifiable factors that may be highly significant in the project decision but could not be captured in the earlier models.

This article explains budgeting models currently being used by large companies, the division responsible for evaluating capital budgeting projects, the most important and most difficult stages in the capital budgeting process, the cost of capital cutoff rate, and the methods used to adjust for risk. A possible rationale is provided for the choices that firms are making among the available models. The discussion identifies difficulties inherent in the traditional discounted cash flow models and suggests that these problems may have led some firms to choose the simpler models.

Previous Research Studies

Capital budgeting decisions are extremely important and complex and have inspired many research studies. In an in-depth study of the capital budgeting projects of 12 large manufacturing firms, Marc Ross found in 1972, that although techniques that incorporated discounted cash flow were used to some extent, firms relied rather heavily on the simplistic payback model, especially for smaller projects. In addition, when discounted cash flow techniques were used, they were often simplified. For example, some firms' simplifying assumptions include the use of the same economic life for all projects even though the actual lives might be different. Further, firms often did not adjust their analysis for risk (Ross, 1986).

In 1972 Thomas P. Klammer surveyed a sample of 369 firms from the 1969 Compustat listing of manufacturing firms that appeared in significant industry groups and made at least $1 million of capital expenditures in each of the five years 1963-1967. Respondents were asked to identify the capital budgeting techniques in use in 1959, 1964, and 1970. The results indicated an increased use of techniques that incorporated the present value (Klammer, 1984).

James Fremgen surveyed a random sample of 250 business firms in 1973 that were in the 1969 edition of Dun and Bradstreet's Reference Book of Corporate Management. Questionnaires were sent to companies engaged in manufacturing, retailing, mining, transportation, land development, entertainment, public utilities and conglomerates to study the capital budgeting models used, stages of the capital budgeting process, and the methods used to adjust for risk. He found that firms considered the internal rate of return model to be the most important model for decision-making. He also found that the majority of firms increased their profitability requirements to adjust for risk and considered defining a project and determining the cash flow projections as the most important and most difficult stage of the capital budgeting process (Fremgen, 1973).

In 1965, J William Petty, David P. Scott, and Monroe M. Bird examined responses from 109 controllers of 1971 Fortune 500 (by sales dollars) firms concerning the techniques their companies used to evaluate new and existing products lines. They found that internal rate of return was the method preferred for evaluating all projects. Moreover, they found that present value techniques were used more frequently to evaluate new product lines than existing product lines (Petty, 1975)

Laurence G. Gitman and John R. Forrester Jr. analyzed the responses from 110 firms who replied to their 1977 survey of the 600 companies that Forbes reported as having the greatest stock price growth over the 1971-1979 period. The survey containing questions concerning capital budgeting techniques, the division of responsibility for capital budgeting decisions, the most important and most difficult stages of capital budgeting, the cutoff rate and the methods used to assess risk. They found that the discounted cash flow techniques were the most popular methods for evaluating projects, especially the internal rate of return. However, many firms still used the payback method as a backup or secondary approach. The majority of the companies that responded to the survey indicated that the Finance Department was responsible for analyzing capital budgeting projects. Respondents also indicted that project definition and cash flow estimation was the most difficult and most critical stage of the capital budgeting process. The majority of firms had a cost of capital or cutoff rate between 10 and 15 percent, and they most often adjusted for risk by increasing the minimum acceptable rate of return on capital projects (Gitman, 1977).

In 1981, Suk H. Kim and Edward J. Farragher surveyed the 1979 Fortune 100 Chief Financial officers about their 1975 and 1979 usage of techniques for evaluating capital budgeting projects. They found that in both years, the majority of the firms relied on a discounted cash flow method (either the internal rate of return or the net present value) as the primary method and the payback as the secondary method (Suk, 1981).

Capital Budgeting Techniques

Several models are commonly used to evaluate capital budgeting projects: the payback, accounting rate of return, present value, internal rate of return, profitability index models and others.

The payback model measures the amount of time required for cash income from a project to exactly equal the initial investment. The accounting rate of return is the ratio of the project's average after-tax income to its average book value.

Academicians criticize both the payback and the accounting rate of return models because they ignore the time value of money and the size of the investment.

When the net present value model is used, the firm discounts the projected income from the project at the firm's minimum acceptable rate of return (hurdle rate). The net present value is the difference between the present value of the income and the cost of the project. If the net present value of the project is positive, the project is accepted; conversely, if the net present value is negative, the project is rejected. The internal rate of the return model equates the cost of the project to the present value of the project. The net present value and the internal rate of return models overcome the time value of money deficiency; however, they fail to consider the size of a project.

Furthermore, the payback model does not consider returns from the project after the initial investment is recovered. The profitability index is a ratio of the project's value to its initial investment. The firm then selects the project with the highest profitability index and continues to select until the investment budget is exhausted. The profitability index overcomes both the time value of money and the size deficiencies.

Some decision makers have criticized the net cash flow method because they simply do not agree with the decisions indicated by the results from the models. In some cases, managers are reluctant to make important decisions based on uncertain estimates of cash flows far in the future. Thus, they consider only near-term cash flows or are distrustful of the output of the models. In others, managers may have predetermined notions about which projects to adopt and may, therefore, "massage" the numbers to achieve the result they desire. Thus, in many cases, the negative results occurred because of inappropriate input into the models, rather than from the models themselves. One area of particular concern is the choice of discount rate. For example, Robert S. Raplan and Anthony A. Atkinson suggested, in 1985, that users often employ too high a discount rate, either by choosing too high a cost of capital or by using a higher rate as an adjustment for risk. An inappropriately high discount rate yields too high a hurdle rate or too low a net present value and thus a negative signal about the project. They recommend using a discount rate that reflects the firm's true cost of capital according to sound theory of finance. Moreover, they say that risk should be analyzed by modeling multiple scenarios (best to worst cases) in a manner similar to flexible budgeting. Finally, when the discount rate incorporates inflation, the user must be careful to adjust future cash flows for inflation as well (Kaplan, 1985).

Other areas of concern in using capital budgeting models involve appropriate comparisons. Decision makers sometimes consider a new project as discrete and more independent of the rest of operations than it really is. They may assume that, without the project, conditions will remain just as they have been while, in reality, the environment will change with or without it. Careful consideration needs to be given to what conditions will exist without the project as well as with it, so that it will be compared with the appropriate benchmark. In analyzing cash flows with the project, users must consider the interaction of the project with remaining operations to appropriately capture all of the costs and benefits. Sufficient projections should be made for start up cost, including new training, and computer costs. Without planning for these items in advance, there may be a tendency to scrimp on them as a result, later net cash flows will not be as positive as planned because the project is not running efficiently.

The greatest problem with the traditional present value methods, however, is that the entire decision must rest upon quantifiable cash flows. In today's high-tech environment, many new projects involve total redesign of the manufacturing environment. Although managers know that they must develop fully computerized design and manufacturing systems to be competitive in this fast-moving world, it is difficult if not impossible to quantify all of the benefits of such systems. The whole strategy of improving customer satisfaction through innovation, higher quality and speedier delivery must be implemented with massive refitting of the entire organization including its marketing and manufacturing components. Benefits of increased flexibility, quicker times through the manufacturing process, and improved customer relations may not be immediately reducible to cash flow figures. Also, new projects are simply steps in a continual, global process, even when cash flows can be quantified, it may be virtually impossible to separate the amounts into parts attributable to individual projects.

As a result of the complex nature of today's projects, new methods, such as multiattribute decision models and the analytical hierarchy process have been developed to incorporate the "softer" measures into the decision process. These approaches weigh and rate for importance, impact, and probability all factors that can be identified as relevant, from the ones that can be measured to those that are more subjective.

The Study

What is Corporate America's current level of sophistication in making capital budgeting decisions? To assess the level of capital budgeting sophistication, a survey questionnaire was sent to the chief financial officer of the Fortune 500 companies. Replies were received from 113 companies for a response rate of 23 percent. Of the 113 received, 102 were usable.

As displayed in the Table 1, the most commonly used primary capital budgeting evaluation technique is the internal rate of return. It is interesting to note that the second most popular technique is the payback method. These results agree with the findings of previous studies and show a continual shift toward models that incorporate present value techniques. The most popular backup technique is the payback method, which is slightly more popular than the internal rate of return and the net present value. Approximately 23 percent of the respondents did not indicate a secondary technique, possibly either because they misunderstood the question or because the firms do not use one.

The majority of firms are using capital budgeting techniques that incorporate the time value of money; however, there still is widespread use of the payback method. Possibly, the popularity of the payback model is enhanced because it is easy to understand and it provides important information to management about the recovery of the initial investment.

Capital Budgeting Procedures

Table 2 displays the functional segments responsible for making capital budgeting decisions. More than half of the firms use a team that consists of accounting, management and marketing personnel to make capital budgeting decisions. Approximately 21 percent of the respondents chose the "other" category. An analysis of their written responses indicates that those who chose the "other category also used a team approach. The composition of the team varied across firms. The majority of the firms used teams that at least, included accounting, manufacturing, and/or operational personnel. In some firms, finance and technical services personnel were included in the team. Thus, approximately 73 percent of the respondents use some type of team to make capital budgeting decisions. Apparently, the great majority of the respondents believe that it is necessary to draw on the diverse expertise of the many functional areas to make sound capital budgeting decisions.

The results show a change in the capital budgeting philosophy since the Gitman and Forrester study in which the researchers found that 60 percent of the firms utilized only the finance department in making capital budgeting decisions.

Stages of the Capital Budgeting Process

Table 3 contains a summary of the respondents' perceptions of the most important stage of the capital budgeting process. For purposes of this study, the capital budgeting process was broken down into the following four stages:

* Project definition and cash flow estimation

* Project analysis and project selection

* Project implementation

* Project review

The largest number of respondents believes that project definition and cash flow estimation is the most important stage of the capital budgeting process. The first stage is considered the most important because of the difficulty and importance of defining the project and estimating cash flows.

These results confirm the findings of the Fremgen and the Gitman and Forrester studies that more firms perceived project definition and cash flow estimation as the most important and difficult stage.

Cost of Capital

Table 4 displays the cost of capital or hurdle rate used. Both the Gitman and Forrester study and this study found that a majority of firms used a cost of capital cutoff rate of between 10 and 15 percent. The written responses were more interesting than the cutoff rate used by the firms. The cutoff or hurdle rate varied from the cost the firm had to pay to borrow funds to a combination method that incorporates both the cost of debt and equity into a weighted average cost of capital.

The cost of debt and equity were obtained in several ways. Some firms used their own in-house estimates, some obtained rates from their bankers, while others used the capital asset pricing model to determine their cost of capital. Additionally, many firms disclosed that they have been using the same cost of capital for five years. This is a not surprising considering the instability of interest rates.


The survey asked two general questions concerning the method of handling risk in the capital budgeting process. The questions were:

(1) Does your firm use subjective techniques to consider risk and/or uncertainty (i.e. non-quantitative)?

(2) Does your firm use quantitative techniques to consider risk and/or uncertainty?

Eighty-seven percent responded that they use subjective techniques and sixty-five percent affirmed that they used quantitative techniques.

Firms that responded yes to using quantitative techniques were asked to identify the techniques used. The results are summarized in table 5.

The most popular method identified by thirty-three percent of the respondents was to increase the required rate of return or cost of capital to compensate for risk considerations. This method of compensating for risk is supported by the academic literature. Somewhat surprising is the largest number who did not answer the question. It is unclear why firms did not respond to this question. Possible they ignore risk in their formal analysis, but subjectively evaluate risk.


The results of this study are both encouraging and thought provoking. Encouraging in the sense that the most popular method of evaluating capital budgeting projects, the internal rate of return, is one of the discounted cash flow methods.

The results are thought provoking, if for no other reason than the popularity of the payback method in evaluating capital budgeting projects. The payback method ignores the time value of money, which is considered a serious flaw. Further, the payback method measures the length of time it takes to recover the initial investment and ignores cash flows beyond the recovery period. Given the serious flaws, why does the payback method enjoy such popularity?

First, the payback method is simple to calculate and understand. Many firms use a team approach to evaluate capital projects. These teams are composed of individuals with varied backgrounds and training. When persons of varied backgrounds come together as a team, it is important that everyone understand the evaluation techniques used. The measurement of the time it takes to recover the initial investment is something that is easily understood.

Second, the payback period focuses on short-term profitability. Managers who use the payback can readily identify projects that have the earliest prospect of profitability. American managers have the reputation for being most interested in short term profitability, while foreign companies appear to be more concerned with long-term profitability. This fixation of short-term profitability has been and continues to be a major criticism of American managers.

At this time, the application by industry of the most sophisticated models that incorporate "soft" factors is still in its infancy. Without these newer models, some decision makers may simply feel that the cost of dealing with the complexity of the traditional discounted cash flow models is simply not justified by the less than complete decision analysis that is provided.
Table 1
Capital Budgeting Studies



Internal Rate of Return 10% 18% 22%
Payback 38% 32% 26%
Net Present Value 7% 15% 21%
Average Rate of Return 36% 30% 29%
Profitability Index * * *
Other 9% 5% 2%
Missing * * *


Internal Rate of Return 4% 5% 11%
Payback 60% 52% 47%
Net Present Value 8% 9% 12%
Average Rate of Return 15% 25% 19%
Profitability Index * * *
Other 13% 9% 11%
Missing * * *

 Fremgen Existing New


Internal Rate of Return 38% 38% 41%
Payback 14% 12% 11%
Net Present Value 4% 11% 15%
Average Rate of Return 22% 35% 31%
Profitability Index 1% 1% 2%
Other 5% 4% 0%
Missing 16% * *


Internal Rate of Return * 21% 19%
Payback * 44% 37%
Net Present Value * 10% 14%
Average Rate of Return * 17% 24%
Profitability Index * 5% 4%
Other * 2% 2%
Missing * * *

 Gitman/ Cooper/
 Kim/Farragher Forr- Morgan/
 ester Redmon/

PRIMARY BUDGETING METHOD 1975 1979 1977 1990

Internal Rate of Return 37% 49% 53% 57%
Payback 15% 12% 9% 20%
Net Present Value 26% 19% 10% 13%
Average Rate of Return 10% 8% 25% 4%
Profitability Index * * 3% 2%
Other * * * 2%
Missing 12% 12% * 2%


Internal Rate of Return 7% 8% 14% 21%
Payback 33% 39% 44% 23%
Net Present Value 7% 8% 28% 21%
Average Rate of Return 3% 3% 14% 7%
Profitability Index * * 2% 4%
Other * * * 1%
Missing 50% 42% * 23%

Table 2

 Gitman/Forrester Cooper/Morgan/
 1977 Redmon/Smith 1990

Accounting * 2%
Finance 60% 6%
Operations 13% 19%
Team * 52%
Other 27% 21%

Table 3

 Gitman/ Morgan
 Fremgen Forrester Redmon/
 1971 1977 Smith 1990

Definition, cash flow projection 51% 52% 46%
Analysis and selection 27% 33% 28%
Implementation * 9% 20%
Review 23% (1) 6% 2%
Other 2% * 4%

Definition, cash flow projection 44% 64% 50%
Analysis and selection 12% 15% 23%
Implementation * 7% 11%
Review 44% (1) 14% 11%
Other 1% * 5%

(1) Fremgen combined the implementation and review stages

Table 4

 Gitman/ Cooper/Morgan/
 Forrester 1977 Redmon/ Smith 1990

Less than 10% 10% 5%
10 up to 15% 60% 53%
15 up to 20% 23% 27%
20% or more 7% 15%

Table 5
 Gitman/ Morgan/
 Fremger (1) Forrester Redmon/
 1971 1977 Smith 1990

Increase the minimum rate of
 return of cost of capital 32% 43% 33%
Shorten minimum payback period 40% 13% 10%
Use expected values of cash
 flows (certainty-equivalents) * 26% 10%
Increase profitability
 requirement 54% * 5%
Other 37% 19% 7%
Missing * * 35%

(1) Some companies listed more than one method.

(1.) Bavishi, Vinrod B. "Capital Budgeting Practices at Multinationals," Management Accounting, August 1981, 32 35

(2.) Berliner, Callie and James A. Brimson, eds., Cost Management For Today's Advanced Manufacturing, Harvard Business School Press, 1988. Chapter 7.

(3.) Brick, Ivan E. and Daniel G. Weaver, "A Comparison of Capital Budgeting Techniques in Identifying Profitable Investments," Financial Management, winter 1984 29-39.

(4.) Canada, John R. and William G. Sullivan, Economic and Multiattribute Evaluation of Advanced Manufacturing Systems, Prentice Hall, 1989. Chapters 8-11.

(5.) Carter, William K., "Two Invest in New Technology or Not? New Tools For Making the Decision," Journal of Accountancy, May 1992, 58-61, 64.

(6.) Cooley, Philip L. and Roden, Peyton F., Business Financial Management, first edition, Dryden Press, 1988

(7.) Fremgen, James, "Capital Budgeting Practices: A Survey," Management Accounting, May 1973, 19-25.

(8.) Gitman, Lawrence G. and Forrester, John R. Jr., "A survey of Capital Budgeting Techniques Used by Major U.S. Firms", Financial Management, fall 1977, 66-71.

(9.) Hays, Robert H. and David A. Garvin, "Managing as if Tomorrow Mattered," Harvard Business Review, May-June 1982, 70-79.

(10.) Istvan, Donald F. "The Economic Analysis of Capital Expenditure," The Journal of Business, January 1961, 45-51.

(11.) Kaplan, Robert S. and Anthony A. Atkinson, Advanced Management Accounting, 2nd ed., Prentice Hall, 1985.

(12.) Kim, Suk H. and Edward J. Farragher, "Current Capital Budgeting Practices," Management Accounting June 1981, 26-30.

(13.) Klammer, Thomas P. "Empirical Evidence of the Adoption of Sophisticated Capital Budgeting Techniques," The Journal of Business, July 1972, 387-397.

(14.) Klammer, Thomas P. and Michael C. Walker, "The Continuing Increase in the Use of Sophisticated Capital Budgeting Techniques," California Management Review, fall 1984, 137-148.

(15.) Klammer, Thomas P. and Michael C. Walker, "Capital Budgeting Questionnaires: A New Perspective," Quarterly Journal of Business and Economics, Summer 1987, 87-96.

(16.) Mukherjee, Tarum K. "Capital Budgeting Surveys: the Past and spring 1987, 37-56.

(17.) Neuhauser, J.J. and J.A. Viscione, "How Managers Feel About Advanced Capital Budgeting Methods," Management Review, November 1973, 16-22.

(18.) Petry, Glenn H. "Effective Use of Capital Budgeting Tools," Business Horizons, October 1975, 57-65.

(19.) Petty, J. William, David F. Scott, Jr. and Monroe M. Bird, "The Capital Expenditure Decision-Making Process of Large Corporations," The Engineering Economist, Spring 1975, 159-171.

(20.) Petty, J. William and Oswald D. Bowlin, "The Financial Manager and Quantitative Decision Models," Financial Management, winter 1976, 32-41.

(21.) Polakoff, Joel C., "Computer Integrated Manufacturing: A New Look at Cost Justifications," Journal of Accountancy, March 1990, 24-29.

(22.) Resenblat, Meir J. and James Junker, "Capital Expenditure Decision Making: Some Tools and Trends," Interfaces, February 1979, 63-69.

(23.) Ross, Marc, "Capital Budgeting Practices of Twelve Large Manufactures," Financial Management, Winter 1986, 15-22.

(24.) Saaty, Thomas L., Decision Making for Leaders, Lifetime Leaning Publications, 1982.

(25.) Schall, L. D., G. L. Sundern and W. R. Geisjbect, "Survey and Analysis of Capital Budgeting Methods," Journal of Finance, March 1978, 281, 287.

(26.) Van Horne, James C., Fundamentals of Financial Management, Seventh Edition, Prentice Hall, 1989.

William D. Cooper is a Professor in the Department of Accounting in the School of Business and Economics at North Carolina A&T State University, Greensboro, NC.

Robert G. Morgan is a Professor in the Department of Accounting in the College of Business at East Tennessee State University, Johnson City, TN.

Alonzo Redman is an Associate Professor in the Department of Business Administration in the School of Business and Economics at North Carolina A&T State University, Greensboro, NC.

Margart Smith is an Assistant Professor in the Department of Accounting in the School of Business and Economics at North Carolina A&T State University, Greensboro, NC.
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Author:Cooper, William D.; Morgan, Robert G.; Redman, Alonzo; Smith, Margart
Publication:Business Forum
Geographic Code:1USA
Date:Jan 1, 2001
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