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Capital-Budgeting Surveys: The Future Is Now

Richard M. Burns, Professor of Finance Joe Walker, Associate Professor of Finance UAB School of Business Birmingham, Al 35294

The authors wish to thank the editor and the anonymous referee for their many helpful comments and suggestions.

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Capital-Budgeting Surveys: The Future Is Now

Abstract This research is motivated by two major factors: (1) the over twenty year hiatus since the last thorough review of the capital budgeting survey literature, and (2) past appeals to the finance academic community by researchers to explore neglected areas of the capital budgeting process. In response, and using a four-stage capital budgeting process as a guide, the authors review the capital budgeting survey literature from 1984 through 2008 and find that some of the neglected areas have in fact been directly addressed. Unfortunately, the most prevalent focus of capital budgeting surveys continues to be that of the selection stage. As a result, many areas of the capital budgeting process still remain relatively unexplored, providing numerous survey research opportunities.

Page 3 of 38 I. Introduction This research effort is motivated by two major factors: (1) the twenty year hiatus since the last thorough review of the capital budgeting survey literature, and (2) past observations and appeals made to the finance academic community by fellow researchers to explore neglected areas of the capital budgeting process through more focused and directed survey research. The first factor stands on its own as justification for an update of the capital budgeting survey literature. The last comprehensive reviews were made by researchers Scott and Petty (1984) and Mukherjee (1987) over twenty years ago. Regarding the second factor, almost three decades ago, Kim (1979) noted that too much emphasis was being placed on methods of ranking and selecting capital budgeting proposals. Scott and Petty (1984) also noted the disproportionate (unjustified) amount of time [spent] on a particular stage (financial analysis and project selection) Further, Gordon and Pinches (1984) generalized this complaint by arguing that the capital budgeting process must be viewed in its entirety. Mukherjee (1987) agreed that further survey efforts need to be devoted to understanding the entire process. To address these two factors, the authors have provided a current review of the capital budgeting survey studies over the past twenty-four years. The results are reported in a four-stage capital budgeting framework that allows a more detailed and clear assessment of the appeals by past researchers. As a

Page 4 of 38 result, fertile areas for future applied research in the area of capital budgeting survey work are more easily identified and summarized. The organization of this paper is as follows. In Section II a four-stage capital budgeting process will be identified and used throughout the balance of the paper. It provides a useful framework to evaluate in more detail the most prominent capital budgeting survey literature reviews of the past, to highlight neglected areas of capital budgeting research, and to organize past appeals for future research in this area. In Section III this four-stage process will also be used to describe the procedures used in performing the capital budgeting survey literature update over the 1984-2008 period. Section IV will continue to use this framework to present the detailed findings while Section V will provide an overall summary. Finally, Section VI will present conclusions, comments, and insights for future survey research.


Past Reviews and Appeals In the corporate finance capital budgeting survey literature the capital

budgeting process has been described in terms of four stages: (1) identification, (2) development, (3) selection, and (4) control.1 The identification stage comprises the overall process of project idea generation including sources and submission procedures and the incentives/reward system, if any. The development stage involves the initial screening process relying primarily upon cash flow estimation and early screening criteria. The selection stage includes the detailed project analysis that results in acceptance or rejection of the project

Page 5 of 38 for funding. Finally, the control stage involves the evaluation of project performance for both control purposes and continuous improvement for future decisions. All four stages have common areas of interest including personnel, procedures, and methods involved, along with the rationale for each. All four stages are critical to the overall process, but the selection stage is arguably the most involved since it includes the choices of analytical methods/techniques used, how the cost of capital is determined, how adjustments for projects risks are assessed and reflected, and how, if relevant, capital rationing affects project choice. The selection stage has also been the most investigated by survey researchers, particularly in the area of selection techniques, resulting in a relative neglect of the other stages. This in turn has led to appeals to future researchers to consider the other stages in their survey research efforts. As Gordon and Pinches (1984) note: Most of the literature on the subject of capital budgeting has emphasized the selection phase, giving little coverage to the other phases. Instead, it is usually assumed that a set of well-defined capital investment opportunities, with all of the informational needs clearly specified, suddenly appears on an executives desk and all that is needed is for the manager to choose the project (s) with the highest expected payoff. However, as most managers quickly learn, this is not the case. Further, once projects are chosen, the evaluation of an individual projects subsequent performance is usually either ignored or often inappropriately handled. Our contention is that the capital budgeting process must be viewed in its entirety, and the informational needs to support effective decisions must be built into the firms decision support system (p.3).

Page 6 of 38 The two most significant attempts to assess the balance of research among these four stages were those of Scott and Petty (1984) and Mukherjee (1987), both of which occurred well over twenty years ago.2 Scott and Petty provided a synthesis of earlier surveys of large American firms and organized their analysis based on a three stage classification: (1) project definition and cash flow estimation (2) financial analysis and project selection, and (3) project implementation and review. Citing Gitman and Forrester (1977), they noted that: project definition and cash flow estimation is considered the most difficult aspect of the capital budgeting process. The financial analysis and project selection stage, which receives the most attention in the literature, is considered the least difficult of the three stages Also covering surveys of large American corporations, Mukherjee (1987) agreed that there had been too much survey focus on the selection stage and not enough on the other stages as well as the overall capital budgeting process. Paraphrasing that papers recommendations, it called for more research into specific questions relevant for each stage. For example, in stage 1, future

surveyors were urged to investigate the reward systems, procedural aspects, and the organizational structure of the firm. In stage 2, more research was suggested on the topics of divisional vs. corporate biases, strategic considerations, cash flow estimation details, data details, cannibalization, risk, and inflation. Even within the more widely-studied Stage 3, neglected areas were identified such as the rationale for the various methods used, how firms compute their cost of capital, the low rate of risk recognition, the associated low rates of risk

Page 7 of 38 adjustment and assessment sophistication, capital rationing (and the low usage of linear programming), and the details of authorization levels. Finally, with

regard to Stage 4, more research was encouraged into the details of performance evaluation, how the company follows up on such evaluation, the details of expenditure control procedures, and the reward system for performance.3 How well these appeals have been answered with subsequent survey research is the primary focus of this paper. In the next section the authors

describe the procedures employed to assess the effectiveness of these appeals made over twenty years ago. III. Procedures Consistent with the reviews by Scott and Petty (1984) and Mukherjee (1987), the following criteria were used to choose capital budgeting survey articles for inclusion in this review: the surveys had to involve large U.S. firms, they had to be broad-based (not focused on one particular industry), and they had to be published in mainline academic journals post-1984. Using these criteria resulted in the selection of the nineteen capital budgeting surveys included in Exhibit 1 below 4. The exhibit provides, in chronological order, the survey year (which in all cases differs from the publication year), authors, research method, usable responses and the audience surveyed. [ Insert Exhibit 1 about here]

Page 8 of 38 Each of these 19 survey articles was then thoroughly examined in an effort to identify the stages and areas within each stage that the survey covered. The results of this process are reported in Exhibit 2 and consistent with Mukherjees (1987) chronological ordering in a tabular form indicating areas of investigation within the four stages of the capital budgeting process.5 It should be noted that the exhibits herein were slightly altered from Mukherjees original format to better focus on selected issues that were identified specifically as areas of neglect. For example, the category of techniques was divided into techniques used and reasons for techniques used. Similarly, the risk category was divided into risk recognition, risk assessment, and risk adjustment. IV. Findings by Stage A quick perusal of Exhibit 2 reveals an obvious concentration of checks in Stage 3 (selection) similar to the previous findings of Mukherjee. Although a careful look at some of the stage categories individually indicates that several neglected areas have been researched over the period, there is still an obvious and relative lack of research into Stages 1, 2, and 4. [Insert Exhibit 2 about here] To further assess the effectiveness of the research appeals, the analysis and reported results in this section will be ordered by the four stages. Summary comments are provided only on those surveys which provide a significant contribution to a previously neglected area of capital budgeting survey research.

Page 9 of 38 As a result, the findings of Bierman (1993), Gilbert and Reichert (1995), Payne, Heath, and Gale (1999), and Ryan and Ryan (2002) are not summarized. A. Stage 1: Identification Suggested areas of study 6 within this stage include how project proposals are initiated, whether the proposal process is on-going or on an only-whenneeded basis, at what level projects are generated, whether there is a formal process for submitting ideas, how that process works when present, and if there is an incentive system for rewarding good ideas. Unfortunately, there has never been an in-depth survey focused on this stage, leaving no question that it remains strongly neglected. The only contribution of a minor nature to this topic is the incidental finding by Stanley and Block (1984). They found that in over 80% of the responding firms that capital budgeting proposals originated bottom up (vs. top down), and that the decisionmaking process was centralized. B. Stage 2: Development Suggested areas of study within this stage include the extent of screening of project ideas, how ideas get turned into proposals, the level of review, the screening criteria, and the role of project size and organizational structure. Perhaps more importantly, this stage also focuses on firm data-gathering efforts, viz., the extent to which companies use accounting vs. cash flow data, the details of how the data is estimated, the responsible personnel, and the decision support system.

Page 10 of 38 Overall, good progress has been made in stage 2 research, especially in the areas of cash flow estimation, forecasting, and the origination of biases in those processes. For example, Pruitt and Gitman (1987) specifically identified and investigated Stage 2. In so doing, they provided a deeper understanding of capital budgeting forecast biases and cash flow estimation. They specifically found that: 80% of high-ranking financial officers perceived both a pronounced upward bias in the revenue forecasts and a less-pronounced downward bias in the cost forecasts, both of which compounded the profitability forecast error. Over two-thirds of the officers felt these biases arose due to intentional overstatement or lack of experience. Among the other third of officers who did not attribute bias to these two main reasons (and who provided their identity), follow-up telephone calls revealed (1) psychological explanations (e.g., myopic euphoria, mass psychology, group polarization, and salesmen optimism) or (2) erroneous information emanating from upper level management and provided to forecasting personnel. The officers said they handled such biases by adjusting the cash flow estimates downward on an informal basis, although specifically how this adjustment was made was not addressed. Pohlman, Santiago and Markel (1988), in a direct response to the appeal by Scott and Petty (1984), provided the first in-depth look at the cash flow estimation

Page 11 of 38 practices by surveying the Fortune 500. Among other important findings, they discovered that: About 67% of their survey respondents employed a person to specifically supervise their cash flow estimation. Firms with more leverage and higher capital intensities were even more likely to have such a specialized person. 85% of their respondent companies used systematic, company-wide, standard procedures in estimating cash flows (which were used even more in higher risk firms). 78% had standard forms and worksheets for their cash flow forecasts, and 65% had a standard model. In addition to considering production, marketing, financial, and economic factors such as inflation, firms combined judgment with their quantitative forecasts. One of the more noteworthy points of their research was the emphasis on the importance of information systems processes and their role in forecast accuracy. Gordon and Pinches (1984), in fact, had earlier emphasized that the decision support system or information system was the key to development and other stages of capital budgeting. C. Stage 3: Selection Suggested areas of study within this stage include: the personnel involved, the techniques used the rationale and conflict priority and the details of WACC and hurdle rate determination, risk analysis, capital rationing, and

Page 12 of 38 project approval. Since, as stated earlier, this stage is arguably the most involved, the results are provided in the subheadings below. 1. Personnel Suggested areas of study on personnel issues include determining who or which department analyzes capital expenditures, how many people are involved in the process, and who makes the final decision, among other topics. No research in this area was noted over the last two decades as well as previously. 2. Rationale for Selection Techniques Suggested topics for study in this area include determining why some techniques are preferred over others by practitioners. As emphasis, Mukherjee (1987, p. 44) said, past surveys did not directly take up the matter of rationale behind these practices with surveyed firms. Burns and Walker (1997) directly cited the 1987 Mukherjee article as the catalyst for their research effort and focused on the why of capital budgeting practices by surveying the Fortune 5OO firms on the detailed reasons for their choice of techniques and the reasons for any changes in the emphasis of those techniques over time. Highlights of their findings include: The rationale for the continued use of simple payback was its ease of computation and also its usefulness as an adjunct to discounted cash flow measures as both a measure of liquidity and risk. The accounting rate of return was used primarily for reconciliation for financial statement reporting and because it was often the basis for performance appraisal and bonus incentives.

Page 13 of 38 The Internal rate of return and net present value were used primarily because of their use of time value of money considerations and also because of their use of cash flow measures (as opposed to accounting income measures). The internal rate of return measure seemed easier to understand and compute, but net present value was seen as more reliable. The profitability index and the modified internal rate of return were not used as much as finance textbooks would imply. The profitability indexs attractiveness was its use in capital rationing situations, and the modified internal rate of returns attractiveness was its more realistic reinvestment rate assumption. The most common way of learning about capital budgeting techniques was through formal education. Other studies did look at inferential types of rationales for selection techniques, such as size of firm vs. sophistication of techniques used, but none directly asked practitioners why. 3. WACC Suggested areas of research in this category include the extent to which firms use hurdle rates to make project selections, whether or not firms use the same hurdle rate to evaluate all projects, how the hurdle rate is defined and why, and how firms arrive at the particular numbers they calculate. Some very important work on the why and how of the cost of capital and hurdle rates has, in fact, occurred. For example, Stanley and Block (1984) looked at a variety of

Page 14 of 38 capital budgeting topics involving U.S. firms within a multinational context, and in the area involving the cost of capital they found that: 49% of respondents used the parent companys cost of capital, 32% used the project cost of capital, and some used both. The cost of capital was adjusted for expected changes in foreign exchange rates by 34% of firms in order to adjust their foreign currency debt. Porterba and Summers (1995) directly surveyed the chief executive officers of the Fortune 1000 to provide a deeper understanding of how hurdle rates were measured and used. They found that: Hurdle rates were higher than standard analysis would suggest. Most firms had more than one hurdle rate, and they varied their hurdle rates with the projects being considered. Some managers made a distinction between the cost of capital and hurdle rates as a way of adjusting for biased estimates of projects profitability. In an oft-cited article on this topic, Bruner, Eades, Harris and Higgins (1998) answered the research call by examining how firms computed their cost of capital (WACC). Using a telephone survey to target twenty seven highly regarded corporations and ten leading financial advisers, and examining seven best selling textbooks, the authors found evidence of a general alignment among the three groups on the use of common theoretical frameworks and basic methods of estimation. In particular, they found that: DCF was the dominant investment-evaluation technique

Page 15 of 38 WACC was the dominant discount rate Market weights were used, not book weights The after-tax debt cost was based on marginal tax rates, not average rates CAPM was the dominant equity model There was wide variation in the inputs to the models and major disagreements with respect to how to apply CAPM Gitman and Vandenberg (2000) did an update on an earlier cost of capital survey (Gitman and Mercurio, 1982) and found that: 93% of firms used the capital asset pricing model to find their cost of equity. Project size and payback were the main factors in assessing project risk. Firms used target weights vs. book weights. Firms used after-tax debt costs. One counter-intuitive result was that fewer firms in the follow-up survey seemed to be using formal procedures than previously, including the post audit phase. 4. Risk Analysis Suggested areas of study within the risk analysis category include how risk is actually defined in a capital budgeting context; how risk is recognized, assessed, and reflected; why there is such low usage of sophisticated risk analysis methods such as the sensitivity, scenario, and Monte Carlo analyses;

Page 16 of 38 and how improvements could be made in obtaining the necessary input from management for improving existing risk models or building new ones. For example, in reference to how risk is characterized or identified, in Graham and Harveys (2001) survey, the respondents recognized market risk, but they also identified other risk factors such as interest rate, size, inflation, and foreign exchange rate risk. In adjusting for risk, Graham and Harvey found that more than half of the firms did not adjust WACC (average firm risk) to reflect specific project risk, especially when evaluating international projects. Stanley and Block (1984) and Shao and Shao (1996) found that firms were using riskadjusted cash flows more often than risk-adjusted discount rates, a noticeable change from previous survey findings. Trahan and Gitman (1995), however, reported mixed results in this regard. Gitman and Vandenberg (2000) found that 39% of firms also adjusted their rates vs. adjusting their cash flows to adjust for risk while 21% do both. Finally, they found that 16% of the firms grouped projects into risk classes, and 77% differentiated project risk. Shao and Shao (1996) found that sensitivity analysis was the dominant assessment technique. Then, regarding the low usage of sophisticated risk analysis methods, Trahan and Gitman (1995) looked at barriers to the use of sophisticated financial decision-making techniques to find that they were perceived as: (1) not practical, (2) relying upon unrealistic assumptions, (3) difficult to explain to top management, and (4) difficult to apply. Also, in response to a unique inquiry into what risk analysis subjects firms would like to know more about, they found that 23% wanted to learn more about sensitivity analysis, decision trees, and

Page 17 of 38 computer simulation, and the upward bias in cash flow estimates. The next highest response category was only 5%, comprised of firms wanting to learn more about management subjective estimates. Although some progress has been made in the identification, assessment, and adjustment of risk, as well as explaining the low usage of sophisticated methods, none of the studies looked at the details of the actual process of obtaining the necessary input from management to improve existing risk assessment and adjustment models or to build new ones. Note again the desirability of more research on the decision support system which was commented upon at the end of the section on Stage 2. 5. Capital Rationing Suggested areas of recommended research in this area include the financial environment in which the decisions are made, why the application of management science tools has remained low, whether capital rationing is soft or hard, and the specific reasons behind capital rationing (e.g., to correct project proposal biases). Mukherjee and Hingorani (1999) referred to the 1987 Mukherjee article as the motivation for their research effort in surveying the Fortune 500 concerning the why of capital rationing. They found that capital rationing is not simply the irrational manifestation that textbooks frequently imply but was instead a reaction to real problems that managers face. Several of their important findings in this regard included: The main reason for capital rationing was a reluctance to issue external financing.

Page 18 of 38 Firms senior management was highly risk averse and therefore used capital rationing to avoid accepting projects with high downside risk and to correct for middle managers optimistic forecast biases. Capital rationing was seen as soft in nature, and there was a conspicuous absence of tools (e.g., constrained maximization) used when capital rationing was present. Further, Gitman and Vandenberg (2000) found yet other considerations in the use of capital rationing: 23% engaged in capital rationing in order to maintain a target earnings per share or price to earnings ratio Capital rationing occurred only about 40% of the time, less than the 60% occurrence found in earlier studies. The dominant cause of capital rationing among 60% of the respondents was a debt limit imposed by management. Thus, notable progress has been made on the nature of and rationale for capital rationing. 6. Project Approval Suggested areas of study within this subheading include the extent of the autonomy of divisional managers (since project acceptance does not mean implementation, even though few projects are rejected at this stage of formal analysis), the role of divisional managers, the interface between strategies, capital investment and operating decisions, and the role of divisional manager in each of those categories.

Page 19 of 38 For the most part, in the last two decades little research has been done on the topic of project approval. The one exception to this is the Gitman and Vandenberg (2000) study showing that firms in the 1997 follow-up survey employed more formal processes for project approval, especially for large outlays, than those in the 1980 study (Gitman and Mercurio, 1982). Before leaving this discussion on Stage 3 (selection), it is important to mention the more recent survey work on real options as an important enhancement to the NPV selection technique through its contribution to risk assessment. Interestingly, at the time the appeals were made, real options analysis had not yet even been considered as an addition to capital budgeting methods in practice and certainly not in survey research efforts.7 Clearly, real options analysis is prominent among decision method considerations today in the academic arena, and one could argue that any survey research done in the area of real options usage in the capital budgeting process during this period of review should be noted. However, the category of real options was not included separately in Exhibit 2 since it was not a part of the original appeals. Instead, in Exhibits 2 and 3, real options survey contributions were checked under the categories of listing techniques used and risk assessment. Two earlier surveys over the review period asked about real options incidentally. Burns and Walker (1997) included two questions on the frequency and kinds of strategic options in the context of discovering reasons for accepting a negative NPV project. They found a relatively infrequent use of such options, and mostly for reasons of maintaining market share or allowing for operating and

Page 20 of 38 managerial flexibility. Ryan & Ryan (2002) found in their survey of selection techniques that almost 90% of firms rarely or never used real options as a capital budgeting tool. But overall, none of the surveys before 2001 focused on real options analysis. Copeland and Antikarov (2001) suggested that real options would dominate the capital budgeting process within the next decade, and this spurred two surveys dedicated to real options usage. Triantis and Borison (2001) interviewed 39 individuals from 34 companies in 7 different industries and concluded that, real options will serve as a general way of thinking [and that] there is an overwhelming unanimous feeling [that real options help managers make better investment decisions]. Block (2007), motivated by the predictions of Copeland and Antikarov (2001), polled the Fortune 1000 to determine the extent to which these companies had adopted real options analysis as a complement to traditional analysis. Out of 279 respondents only 40 (14.3%) used real options in the capital budgeting process. The users were primarily in industries where sophisticated analysis is generally more common such as technology, energy and utilities. Thus, the survey found that the use of real options was limited, although somewhat higher than that found in prior studies. A more positive finding was that 43.5% of the non-users said that there was a good chance they would consider the use of real options in the future. Reasons cited by the respondents for non-use included a lack of top management support, the requirement of too much sophistication, and the

Page 21 of 38 excessive risk-taking encouraged by the use of real options. The interested reader is encouraged to read this article and the cited references.


Stage 4: Control (Post-audit and Performance Appraisal) Suggested areas of study within this stage include research into: how

project performance is evaluated, by whom, how it is done, what happens when expected and actual results differ, whether there is an expenditure control procedure, whether management is rewarded or punished for such discrepancies, and if so, how? The control stage received some significant attention, particularly in the early part of the review period. For example, Gordon and Myers (1991) surveyed executives and capital budgeting directors of large U.S. industrial firms and found that: 76% of their survey respondents had performed post-audits over the previous 10 years However, a much smaller percentage of those audits were not effective according to criteria which involved (1) the need to be regular and periodic, (2) the use of risk-adjusted discount rate cash flow techniques, and (3) documented policies and procedures. They also found that the use of the post audit varied highly according to the use or non-use of established procedures by asset base - that strategic assets (e.g., expansion projects) received the most post-audits, administrative assets (e.g., replacement projects) received the next most, and operating assets (e.g., minor office equipment) received the fewest.

Page 22 of 38 They confirmed the bad news that post-auditing is far from being a standard part of the capital budgeting process. Their good news, however, was the increasing awareness and use of the need for post-auditing. Using the data from this same study, Myers, Gordon and Hamer (1991) compared (sophisticated) experimental groups vs. (nave) control groups. They found that firms increased their performance when using sophisticated (discounted cash flow based) audit procedures. Note that Pruitt and Gitman (1987), mentioned above in the Stage 2 review, also looked at the post-audit process to find an upward bias that management suspects. Especially pertinent in this regard was their finding that optimistic forecasts were sometimes based on psychological factors such as myopic euphoria, mass psychology, and group polarization effects. This ties in with the Gordon and Myers (1991) and Myers, Gordon and Hamer (1991) analyses above which both argued for a post-audit system with 4 objectives a financial control mechanism, a means to provide future information for capital budgeting, a means to remove psychological and/or political impediments to effective capital budgeting (e.g., abandoning an on-going project), and a way to eliminate the psychological biases on future capital budgeting proposals (e.g., pet proposals). In short, the post-audit should provide objective information on which to base potentially unpopular decisions. Pohlman, Santiago and Markel (1988), though mentioned earlier above in reference to their Stage 2 contributions, found in the Stage 4 area that:

Page 23 of 38 75% of their firms compared actual and forecasted cash flows. Of these, 95% did it for initial investment outlays, and a full 100% for operating cash flows. Only 68% of firms compared actual and forecasted cash flows for salvage values due to the increased difficulty of that estimation. 68% of their firms achieved a 90% accuracy level of initial investment outlays, but only 43% claimed a 90% accuracy level for operating cash flows. 66% of their firms achieved a 90% accuracy level on salvage values.

This important research into the control stage has resulted in a deeper understanding of this previously neglected area. V. Overall Summary of Findings In summary of the overall findings of this literature review, it is clear that significant contributions have been made in the neglected stages of the capital budgeting process over the 1984-2008 period of review. Although not all of the cited studies can be directly attributed to the specific appeals,8 the appeals have arguably had an important effect. Looking back at Exhibits 1 and 2, however, reveals two troublesome aspects of these findings. First, Exhibit 1 shows that over the review period of this paper (using the actual survey year) all but one of these studies occurred in the first eighteen years, and therefore only one occurred in the last seven years. The average age of the studies, based on the actual survey year, is approximately 16 years from the 2008 ending point of this review. In fact, three

Page 24 of 38 of the 19 studies just mentioned are over twenty years old. Thus, the results show a steady stream of research (about one study per year) into some of the neglected areas beginning shortly after the appeals, followed by a virtual shutdown after 2002. Second, a perusal of Exhibit 2 shows that over the past twenty years the majority of the capital budgeting surveys have remained concentrated on the selection stage, and the listing of techniques used continues to preoccupy surveyors efforts. This includes the four studies that did not address any neglected area specifically, and which therefore received no comments in the results section. Exhibit 3 below summarizes and compares the current studys results with the Mukherjee (1987) results for easier comparison. [Insert Exhibit 3 about here It can be seen that Stage 1 remains the most neglected with Stages 4 and 2 close behind. Even for Stage 3 research, in absolute number of studies, it too has less research now than before, although in percentage terms there is even more focus on the listing of techniques than before (18% > 14%), slightly more on risk recognition and assessment (about a percent), and much more on the cost of capital (12% > 7%, but again, only in percentage terms). Before leaving this section, a few comments on international studies are in order. As stated earlier, the capital budgeting surveys in this review were limited to those involving only U.S. firms. All studies based on international firms were screened from the list to facilitate comparisons and consistency with the earlier

Page 25 of 38 reviews and appeals. Most of the international studies identified in the initial search would have been eliminated anyway due to their narrow focus on a particular industry and/or publication in specialized practitioner outlets. However, four research efforts were found that could be classified as mainline academic surveys of large European firms with some noteworthy contributions to a few neglected areas. Sangster (1993) surveyed the largest 500 Scottish firms, but contrary to the earlier American appeals, he merely focused on the cataloging and use of the usual selection techniques and found that the frequency of use of the more sophisticated methods had increased over time. Pike (1996) made a notable contribution by answering Sangsters call for time-series studies by arguably performing the first extensive longitudinal study survey of U.K. firms from 1975 1992 at five-year intervals, showing that the greatest changes over that period had occurred in the increasing sophistication of risk analysis and post-completion audits. It is interesting to note that Pike, in turn, called for more real options research as well as for more risk analysis investigation, and he also appealed for more focused surveys in capital budgeting since the so-called theory/practice gap was seen to be narrowing. In addition, Pike said, further general capital budgeting status surveys would contribute little to the existing body of empirical knowledge, an echo of the earlier American conclusions reached by Scott and Petty (1984), Gordon and Pinches (1984), and Mukherjee (1987). Arnold and Hatzopoulos (2000) cited Pike (1996) in their survey of the Times 1000 and delved into the neglected areas of cost of capital and hurdle

Page 26 of 38 rates, capital rationing, and risk assessment. They too appealed for future research to include, other stages in the process which includes identification of investment opportunities, the search for ideas, the development of proposals into projects, the early screening to match with strategy and culture, the implementation stage, [and the] control and review of performancethis will provide a better understanding of the entire process. Among other suggestions for future research, they specifically called for more survey work on the firms use of real options. Finally, and to facilitate comparison, Brounen, de Jong and Koedijk (2004) used the Graham and Harvey (2001) questions in their survey of firms in the U.K., Netherlands, Germany, and France. They obtained 313 responses out of 6,500 mailouts of both public and private firms, but they found little difference in U.S. and European capital budgeting practices. Furthermore, as in the original U.S. study, there was no investigation into the neglected stages except for how risk was characterized or identified. Although these European surveys did make some minor contributions to the neglected areas, more interestingly and importantly, they made independent appeals to their readership similar to the earlier American survey studies serving as the basis of this review. It seems that the European investigators realized that they also were too focused on the selection stage to the detriment of learning more about the neglected stages and the entire capital budgeting process.

Page 27 of 38 VI. Conclusions Over two decades ago, several prominent capital budgeting surveyors urged the finance profession to rebalance and redirect its capital budgeting research efforts away from merely cataloging what techniques firms used in their Stage 3 (selection) processes. Instead, they urged future researchers to devote more resources to studying Stage I (identification), Stage 2 (development), Stage 4 (control), and specific neglected areas in Stage 3 (selection) since these were the most unexplored areas of capital budgeting. But did fellow researchers in the field of capital budgeting hear the calls by Gordon and Pinches (1984), Scott and Petty (1984), and Mukherjee (1987), among others, or otherwise discover research opportunities in the neglected areas of the capital budgeting process? The results of this study provide both good news and bad news. The good news is that some researchers indeed directly answered the calls (see footnote 8) and others apparently saw the need independently. As a result, there have in fact been several quality survey research efforts into the neglected areas, most notably those discussed in Section IV of this paper. The highlights include the inquiries into cash flow estimation by Pruitt and Gitman (1987) and by Pohlman, Santiago, and Markel (1988), the why of evaluation techniques by Burns and Walker (1997), the why and how of capital rationing by Mukherjee and Hingorani (1999), the detailed evidence on cost of capital practices by Bruner et. al. (1998) and by Gitman and Vandenberg (2000), the investigation of risk analysis practices by Trahan and Gitman (1995) and by Graham and Harvey

Page 28 of 38 (2001), and the in-depth studies of the control (post-audit) stage by Gordon and Myers (1991) and Myers, Gordon, and Hamer (1991). The bad news is two-dimensional. First, in spite of notable progress cited in earlier years of this review, there has been a virtual hiatus in capital budgeting survey research of U.S. firms generally over the most recent seven years.9 Secondly, the selection stage, with its emphasis on particular project evaluation techniques, still dominated the survey topics over the entire review period. As a result, there are many opportunities that still await surveyors to deeply delve into the capital budgeting process by re-focusing their efforts towards the neglected stages. Opportunities include focusing on a particular stage (e.g. the relatively unexplored identification stage), researching a phase within a stage (e.g. risk analysis within the selection stage), or contributing detail to the overall four-stage process. Using a best practices perspective similar to that of Bruner et al

(1998) could potentially provide a fertile approach. The more recent work in the area of real options offers a rich opportunity to track the rationale and use of this selection technique. For example, it is interesting to think about the

interrelationship between the control (post-audit) stage and the use of real options at the selection stage because of the implied use of a post audit to monitor the outcomes and alternatives over time. One especially promising area of survey research is that of the decision support system, a topic suggested by several authors but emphatically advocated by Gordon and Pinches (1984), due to its impact on all four stages.

Page 29 of 38 As quoted earlier, future researchers should clearly avoid what Gordon and Pinches say many past surveyors have done by assuming that a set of welldefined capital investment opportunities, with all of the informational needs clearly specified, suddenly appears on an executives desk and all that is needed is for the manager to [select] the project (s) with the highest expected payoff. Given the tremendous advances in technology since 1984, the decision support system should make a particularly interesting, fruitful and challenging area of survey research. Finally, it would seem that with the blessings of the primary business school accrediting agency for an increased volume of applied research (AACSB International, 2008), that more progress in capital budgeting survey research can be made in the future than has been seen in the past twenty four years.

Page 30 of 38 Endnotes:

See Gordon and Pinches (1984) and Mukherjee (1987). Scott and Petty (1984) use a similar 3-stage process. It is interesting to note, however, that an even earlier survey by Gitman and Forrester (1977) had used a 4stage analysis.

Note that these two reviews are only three years apart based on publication date, and that the latter does not cite the former, likely due to publication lags. As noted in the procedures section, this paper uses the Mukherjee format. Furthermore, the title of this paper derives from Mukherjees title.

These more specific questions are largely paraphrased from Mukherjee (1987) and are not fully exhaustive. The interested reader is, of course, encouraged to read this very thorough article in its entirety.

The initial search using Proquest (ABI Inform) specifying capital budgeting surveys in scholarly journals after January 1, 1984, yielded over two hundred results. However, the great majority were published in the non-mainline journals, including many strictly practitioner (trade journal) outlets and /or were focused on a particular country or industry and thus eliminated by the screening criteria. To insure against missing

articles due to any limitations of the ABI database, the authors checked the references of the surviving articles, and in addition, conducted a

Page 31 of 38 manual search of the most cited finance journals tables of contents and the reference sections of the various survey articles found. 5 In the 1987 article, note that on Exhibit 4, the stages are described somewhat differently from the discussion in the paper itself. Specifically, in the body of the paper, the four stages are: (1) identification, (2) development, (3) selection, and (4) the post-audit. But in the table, the 4 stages are idea generation, proposal development, selection of projects, and control or performance evaluation. 6 As in footnote 3 above, the following suggested areas of study for all four stages are largely paraphrased from Mukherjee (1987), pp. 38 48. 7 As noted by Triantis and Borison (2001), In the mid-1980s academics began [emphasis added] building option-based models to value investments in real assets, laying the foundation for an extensive academic literature in this area. In particular, see their footnote no. 1 on page 8. 8 Three of the current survey papers directly cite the appeals: Pohlman, Santiago, and Markel (1988), Burns and Walker (1997), and Mukherjee and Hingorani (1999). 9 For an interesting discussion of possible contributing factors to this hiatus, see Baker and Mukherjee (2007) on the views of journal editors regarding survey research in finance. Further, also see the AACSB International (2008) reports recognition of how applied research generally counts for

Page 32 of 38 less among tenure review committees and for annual compensation purposes.

Page 33 of 38 References AACSB International, 2008, Final Report of the AACSB International Impact of Research Task Force, Tampa. Arnold, Glen C. and Panos D. Hatzopoulos, 2000, The Theory-Practice Gap in Capital Budgeting: Evidence from the United Kingdom, Journal of Business Finance and Accounting, 27 (5 and 6, June/July) 603-626. Baker, H. Kent and Tarun K. Mukherjee, 2007, Survey Research in Finance: Views from Journal Editors, International Journal of Managerial Finance, 3 (No. 1) p. 11 25. Bierman, Harold, Jr., 1993, Capital Budgeting in 1992: A Survey, Financial Management Letters, 22 (No. 3, Autumn), p. 24. Block, Stanley, 2007, Are Real Options Actually Used in the Real World?, The Engineering Economist, 52 (No. 3) 255-268. Brounen, Dirk, Abe de Jong and Kees Koedijk, 2004, Corporate Finance in Europe: Confronting Theory with Practice, Financial Management, 33 (No. 4, Winter) 71-101. Bruner, Robert F., Kenneth M. Eades, Robert S. Harris and Robert C. Higgins, 1998, Best Practices in Estimating the Cost of Capital: Survey and Synthesis, Financial Practice and Education, 8 (No. 1, Spring/Summer), 13-28. Burns, Richard M. and Joe Walker, 1997, Capital Budgeting Techniques Among the Fortune 500: A Rationale Approach, Managerial Finance, 23 (No. 9) 3-15. Copeland, T and V. Antikarov, 2001, Real Options: A Practitioners Guide, New York, Texere, LLC. Gilbert, Erika and Alan Reichart, 1995, The Practice of Financial Management among Large US Corporations, Financial Practice and Education, 5 (No. 1, Spring/Summer) 16-23. Gitman, Lawrence J. and J. R. Forrester, Jr., 1977, A Survey of Capital Budgeting Techniques Used by Major U.S. Firms, Financial Management, 6 (No. 3, Fall), 66-71. Gitman, Lawrence J. and V. A. Mercurio, 1982, Cost of Capital Techniques Used by Major U. S. Firms: Survey and Analysis of Fortunes 1000, Financial Management, 11 (No. 4, Winter), 21-29.

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Gitman, Lawrence J. and Pieter A. Vandenberg, 2000, Cost of Capital Techniques Used by Major U.S. Firms: 1997 vs. 1980, Financial Practice and Education, 10 (No. 2, Fall / Winter) 53-68. Gordon, Lawrence A. and Mary D. Myers, 1991, Post-auditing Capital Projects: Are You in Step with the Competition? , Management Accounting, 72 (No. 7 January) , 39-42. Gordon, Lawrence A. and George E. Pinches, 1984, Improving Capital Budgeting: A Decision Support System Approach, Reading Massachusetts, Addison-Wesley Publishing Company. Graham, John .R. and Campbell R. Harvey, 2001, The Theory and Practice of Corporate Finance: Evidence from the Field, Journal of Financial Economics, 60 (No. 2-3, May/June), 187- 243. Kim, S. H., 1979, Making the Long Term Investment Decision, Management Accounting, 60 (No. 9, March), 41-49. Mukherjee, Tarun K., 1987, Capital-Budgeting Surveys: The Past and the Future, Review of Business and Economic Research, 22 (No.2, Spring), 37-56. Mukherjee, Tarun K. and Vineeta L. Hingorani, 1999, Capital-Rationing Decisions of Fortune 500 Firms: A Survey, Financial Practice and Education, 9 (No. 1, Spring / Summer), 7-15. Myers, Mary D, Lawrence A. Gordon, and Michelle M. Hamer, 1991, PostAuditing Capital Assets and Firm Performance: An Empirical Investigation, Managerial and Decision Economics, 12 (No. 4, August ), 317-327. Payne, Janet D., Will Carrington Heath and Lewis R. Gale, 1999, Comparative Financial Practice in the US and Canada: Capital Budgeting and Risk Assessment Techniques, Financial Practice and Education, 9 (No. 1, Spring / Summer), 16-24. Pike, Richard, 1996, A Longitudinal Survey on Capital Budgeting Practices, The Journal of Business Finance and Accounting, 23 (No. 1, January) 79-92. Pohlman, Randolph A., Emmanuel S. Santiago, and F. Lynn Markel, 1988, Cash Flow Estimation Practices of Large Firms, Financial Management, 17 (No. 2, Summer), 71-79.

Page 35 of 38 Porterba, James M. and Lawrence H. Summers, 1995, A CEO Survey of U.S. Companies Time Horizons and Hurdle Rates, Sloan Management Review, 37 (No. 1, Fall), 43-53. Pruitt, Stephen W. and Lawrence J. Gitman, 1987, Capital Budgeting Forecast Biases: Evidence from the Fortune 500, Financial Management, 16 (No. 1, Spring 1987), 46-51. Ryan, Patricia A. and Glenn P. Ryan, 2002, Capital Budgeting Practices of the Fortune 1000: How Have Things Changed?, Journal of Business and Management, 8 (No. 4, Fall ), 355-364. Sangster, Alan, 1993, Capital Investment Appraisal Techniques: A Survey of Current Usage, Journal of Business Finance and Accounting, 20 (3, April) 307-332. Scott, David F., Jr. and J. William Petty, II, 1984, Capital Budgeting Practices in Large American Firms: A Retrospective Analysis and Synthesis, The Financial Review, 19 (No. 1, May), 111-123. Shao, Lawrence Peter and Alan T. Shao, 1996, Risk Analysis and Capital Budgeting Techniques of US Multinational Enterprises, Managerial Finance, 22 ( No. 1), 41-57. Stanley, Marjorie T. and Stanley B. Block, 1984, A Survey of Multinational Capital Budgeting, The Financial Review, 19 (No. 1, March), 36-54. Trahan, Emery A. and Lawrence J. Gitman, 1995, Bridging the Theory-Practice Gap in Corporate Finance: A Survey of Chief Financial Officers, The Quarterly Review of Economics and Finance, 35 ( No. 1, Spring), 73-84. Triantis, A. and A. Borison, 2001, Real Options: State of the Practice, Journal of Applied Corporate Finance, 14 (No. 2, Summer), 8-24.

Page 36 of 38
Exhibit 1: Surveys of Capital Budgeting of Large US Firms Number of Survey Author(s) Method Usable Sample Responses Stanley & Block CFOs of Fortune 1000 questionnaire 121 (1984) multinationals VP Finance or Treasurer of Pruitt & Gitman questionnaire 121 largest industrials in Fortune (1987) 500 Pohlman, Santiago, & questionnaire 232 CFOs of Fortune 500 Markel (1988) Executives and capital budgeting directors of large US Gordon & Myers questionnaire 282 industrials except utilities and (1991) transportation Myers, Gordon, & Large public firms from FASB questionnaire 282 Hamer (1991) Data Bank Bierman (1993) questionnaire 74 100 largest of Fortune 500 Porterba & questionnaire 160-228 CEOs of Fortune 1000 Summers (1995) Gilbert & Reichert Fortune Magazine Directory questionnaire 151 (1995) CFO's Trahan & Gitman CFOs of Fortune 500 + Forbes questionnaire 84 (1995) 200 Managers of foreign Shao & Shao questionnaire 188 manufacturing subsidiaries of (1996) US industrials Burns & Walker questionnaire 180 Fortune 500 (1997) 7 best-sellling texts, 27 Bruner et al (1998) telephone survey 7,27,10 prestigious CFO's, 10 leading financial advisors Mukherjee & questionnaire 102 Fortune 500 CFO's Hingorani (1999) USA and Canadian based Payne, Heath, & questionnaire 155 companies from S&P Gale (1999) Compustat database Gitman & Vandenberg questionnaire 111 CFOs from Fortune 1000 (2000) Graham & Harvey questionnaire 392 CFOs from FEI corporations (2001) Triantis & Borison interviews 39 executives of large companies (2001) Ryan & Ryan questionnaire 205 CFOs of Fortune 1000 (2002) top-ranking officers of Fortune Block (2007) questionnaire 40 1000

Surveyed Year(s) 1982 1986



1988 1992 1990 1991 1992 1992 1992 1996-97 1992-93 1994

1997 1999 1999 1999 2005

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Triantis and Borison (2001)

Graham & Harvey (2001)

Myers, Gordon, & Hamer (1991)

Gilbert & Reichert (1995)

Trahan & Gitman (1995)

Gordon & Myers (1991)

Stanley & Block (1984)

Mukherjee & Hingorani (1999) Payne, Heath, & Gale (1999) Gitman & Vandenberg (2000)

Burns & Walker (1997)

Pruitt & Gitman (1987)

Pohlman, Santiago, & Markel (1988)

Porterba & Summers (1995)

Shao & Shao (1996)

Ryan & Ryan (2002)

Bruner et al (1998)

Bierman (1993)

Exhibit 2: Capital Budgeting Surveys* and the Four Stages of Capital Budgeting as of 2008

Block (2007)

N= 19

I. Idea Generation A. Source of Origination B. Reasons for Idea Origination C. Process of Origination & Submission D. Time Pattern of Origination II. Proposal Development A. Level at Which screening Takes Place B. Screening Process C. Cashflow Estimates (and forecasting) D. Responsibility for Budget Preparation (personnel) III. Selection of Projects A. Classification of Projects for Economic Analysis B. Personnel (Department) Responsible for Analysis C1. Listing Techniques Used C2. Reasons for Techniques Used D1. Risk recognition D2. Risk assessment D3. Risk adjustment E1. Capital Rationing: How Extensive? E2. Capital Rationing Rationale E3. Capital Rationing Methods Used F. Cost of Capital G. Project Approval IV. Control (or Performance Evaluation) A. Extent of Use of Post Audit B. Personnel Involved/Procedure C. Performance Measurement D. Use of Evaluation (Punishment/Reward/Etc.) * Surveys in this exhibit appear in chronological order of their publication.

1 0 0 0 0 1 2 2 1 0 14 2 8 7 6 2 2 2 8 1 4 2 3 2

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Exhibit 3: Comparison of Mukherjee's 1987 results and 2008 update results Mukherjee (1984) No. % 3 1 1 1 2 2 3 2 4 3 15 12 9 11 5 4 3 7 3 6 2 4 2 105 3% 1% 1% 1% 2% 2% 3% 2% 4% 3% 14% 0% 11% 9% 10% 5% 4% 3% 7% 3% 6% 2% 4% 2% 100% update (2008) No. 1 0 0 0 0 1 2 2 1 0 12 4 8 7 6 2 2 2 8 1 4 2 3 2 70 Stages of Capital Budgeting Process % 1% 0% 0% 0% 0% 1% 3% 3% 1% 0% 17% 6% 11% 10% 9% 3% 3% 3% 11% 1% 6% 3% 4% 3% 100% Stage 1: Idea generation A. Source of origination B. Reasons for idea origination C. Process of origination and submission D. Time pattern of origination Stage 2: Proposal Development A. Level at which screening takes place B. Screening Process C. Cashflow estimates (and forecasting) II-D. Responsibility for budget preparation (personnel) Stage 3: Selection of Proposals A. Classification of projects for economic analysis B. Personnel (department) responsible for analysis C1. Listing Techniques Used C2. Reasons for Techniques Used D1. Risk recognition D2. Risk assessment D3. Risk adjustment E1. Capital rationing: how extensive? E2. Why capital rationing? E3. Methods used F. Cost of capital G. Project Approval Stage 4: Control (Performance Evaluation) A. Extent of use of post audit B. Personnel involved / procedures C. Performance measurement D. Use of evaluation (rewards / punishment) N