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Richard M. Burns and Joe Walker
This research is motivated by two major factors: (1) the over twenty year hiatus since the last thorough review ofthe capital budgeting survey literature, and (2) past appeals to the finance academic community by researchers to explore neglected areas ofthe 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 ofthe neglected areas have infact been directly addressed. Unfortunately, the most prevalent focus of capital budgeting surveys continues to be that ofthe selection stage. As a result, many areas ofthe capital budgeting process still remain relatively unexplored, providing numerous survey research opportunities.
This research effort is motivated by two tnajor 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.
Richard M. Burns is a Professor of Finance at the University of Alabama at Birmingham, AL Joe Walker is an Associate Professor of Finance at the University of Alabama at Birmingham, AL. The authors wish to thank the Editor and the anonymous referee for their many helpful comments and suggestions. 78
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 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 I a four-stage capital budgeting process will be identified and used throughout the balance ofthe 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 II this four-stage process will also be used to describe the procedures used in performing the capital budgeting
and the informational needs to support effective decisions must be built into the firm's decision comprehensive reviews support system. is considered the least All four stages are critical to the overall process. appears on an executive's desk and all that is needed is for the manager to choose the project(s) with the highest expected payoff. Our contention is that the capital budgeting process must be viewed in its entirety. 3) balance of research among (1987) over twenty years ago. As noted in the procedures section. The selection stage other stages as well as the overall capital budgeting process. Furthermore. how the cost of capital is determined. Further. this is not the case. selection. which receives the most and methods involved. Instead. Even within the more widely-studied Stage 3. data details. All four stages have budgeting process. but difBcult ofthe three stages . if relevant. procedures.. the title of this paper derives from Mukherjee's title. likely due to publication lags. project definition and cash flow estimation is performance for both control purposes and continuous considered the "most difficult" aspect ofthe capital improvement for future decisions. it called for particularly in the area of selection techniques. This in turn has led to For example. resulting in more research into specific questions relevant for each stage.CAPITAL BUDGETING SURVEYS: THE FUTURE IS NOW 79 survey literature update over the 1984-2008 period. The three stage classification: 1) project definition and cash flow selection stage includes the detailed project analysis that estimation 2) financial analysis and project selection. Past Reviews and Appeals In the corporate finance capital budgeting survey literature the capital The last budgeting process has been were made by researchers Scott described in terms of four The two most significant stages: 1) identification. and results in acceptance or rejection of the project for funding. project selection stage. In stage 2. neglected it is usually assumed that a set of well-defined capital investment opportunities. and how. risk. has also been the most investigated by survey researchers.. how adjustments for Mukherjee (1987) agreed that there had been too much projects risks are assessed and reflected. procedural aspects. details. as most managers quickly learn. the selection stage is arguably the most involved since it includes the choices of analytical methods/techniques used. However. . The financial analysis and common areas of interest including personnel. As Gordon and Pinches (1984) organizational structure ofthe firm. Section III will continue to use this framework to present the detailed findings while Section IV will provide an overall summary. they noted that: . Finally. and the their survey research efforts.BURNS & WALKER . once projects are chosen. survey focus on the selection stage and not enough on the capital rationing affects project choice. Paraphrasing that paper's recommendations. and 4) control. date. suddenly ^ o t e that these two reviews are only three years apart based on publication 'See Gordon and Pinches (1984) and Mukherjee (1987).' these four stages were those The identification stage of Scott and Petty (1984) comprises the overall process of project idea generation and Mukherjee (1987).^ Scott and Petty provided a synthesis of earlier surveys of incentives/reward system. cannibalization. corporate Most of the literature on the subject of capital biases. the evaluation of an individual project's subsequent performance is usually either ignored or often inappropriately handled. comments. and that the latter does not cite the former. The development stage involves the initial screening process relying primarily large American firms and organized their analysis based on a upon cash flow estimation and early screening criteria. Citing Gitman and Finally. with all of the informational needs clearly specified. along with the rationale for each. 3) project implementation and review. and inflation. attempts to assess the and Petty (1984) and Mukherjee 2) development. however. Also covering surveys of large American corporations. a relative neglect ofthe other stages. strategic considerations. giving little coverage to the other phases. in stage 1. Section V will present conclusions. if any. the control stage involves the evaluation of project Forrester (1977).. this paper uses the Mukherjee format. both of which occurred well over including sources and submission procedures and the twenty years ago.. I. It is interesting to note. future surveyors were urged to appeals to future researchers to consider the other stages in investigate the reward systems. more research note: was suggested on the topics of divisional vs. Scott and Petty (1984) use a similar 3-stage process. attention in the literature. that an even earlier survey by Gitman and Forrester (1977) had used a 4-stage analysis. and insights for future survey research. cash flow estimation budgeting has emphasized the selection phase.
encouraged to read this very thorough article in its entirety. and the reward system for performance. more research was encouraged into the details of performance evaluation. To further assess the effectiveness ofthe research appeals. Although a careful look at some of the stage categories individually indicates that several neglected areas have been researched over the period. Finally. For example. note that on Figure 4. They found that in over 80% of the responding firms that capital budgeting proposals originated bottom up 'These more specific questions are largely paraphrased from Mukherjee (1987) and are not fully exhaustive. they had to be broad-based (not focused on one particular industry).. 2009 areas were identified such as the rationale for the various methods used. the four stages are: (1) identification. As a result. how that process works when present. the category of "techniques" was divided into "techniques used" and "reasons for techniques used". of course. yielded over two hundred results. proposal development. leaving no question that it remains strongly neglected. Gilbert and Reichert (1995). and "risk adjustment". Summary comments are provided only on those surveys which provide a significant contribution to a previously neglected area of capital budgeting survey research. But in the table. how the company follows up on such evaluation. in the body of the paper. In the next section the authors describe the procedures employed to assess the effectiveness of these appeals made over twenty years ago. the findings of Bierman ( 1993). there has never been an in-depth survey focused on this stage. and the details of authorization levels. To insure against missing articles due to any limitations ofthe ABl database. and Gale (1999). the authors checked the references ofthe surviving articles. the details of expenditure control procedures. authors. and control or performance evaluation. whether the proposal process is on-going or on an "only-when-needed" basis.* Unfortunately. research method. the associated low rates of risk adjustment and assessment sophistication. II. and in addition. ••The initial search using Proquest (ABI Inform) specifying "capital budgeting surveys" in scholarly journals after January 1. (2) development. with regard to Stage 4. (3) selection. the low rate of risk recognition. 'As in footnote 3. how firms compute their cost of capital. capital budgeting process. Heath. 'In the 1987 article.ISSUES 1 & 2. conducted a manual search ofthe most cited finance journals tables of contents and the reference sections of the various survey articles found. The interested reader is. the great majority were published in the non-mainline journals. and (4) the post-audit. at what level projects are generated. the survey year (which in all cases differs from the publication year). the analysis and reported results in this section will be ordered by the four stages. Similarly. the risk category was divided into "risk recognition". "risk assessment". the following criteria were used to choose capital budgeting survey articles for inclusion in this review: the surveys had to involve large US firms. whether there is a formal process for submitting ideas. 2. However. Payne. 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. Stage 1 : Identification Suggested areas of study within this stage include how project proposals are initiated. The results of this process are reported in Figure 2 and consistent with Mukherjee's (1987) chronological ordering in a tabular form indicating areas of investigation within the four stages ofthe A. and they had to be published in mainline academic journals post-1984.80 JOURNAL OF APPLIED FINANCE . the 4 stages are idea generation.' How well these appeals have been answered with subsequent survey research is the primary focus of this paper. and 4. 1984. Findings by Stage A quick perusal of Figure 2 reveals an obvious concentration of "checks" in Stage 3 (selection) similar to the previous findings of Mukherjee. Using these criteria resulted in the selection of the nineteen capital budgeting surveys included in Figure 1. in chronological order.' It should be noted that the Figures herein were slightly altered from Mukherjee's original format to better focus on selected issues that were identified specifically as areas of neglect. the following suggested areas of study for all four stages are largely paraphrased from Mukherjee (1987). selection of projects. The only contribution of a minor nature to this topic is the incidental finding by Stanley and Block (1984). and Ryan and Ryan (2002) are not summarized. III. there is still an obvious and relative lack of research into Stages 1. the stages are described somewhat differently from the discussion in the paper itself Specifically.'' The Figure provides. capital rationing (and the low usage of linear programming). Procedures Consistent with the reviews by Scott and Petty (1984) and Mukherjee (1987). . including many strictly practitioner (trade journal) outlets and /or were focused on a particular country or industry and thus eliminated by the screening criteria. usable responses and the audience surveyed. and if there is an incentive system for rewarding good ideas.
& Hamer(1991) Bierman (1993) Porterba & Summers (1995) Gilbert & Reichert (1995) Trahan & Gitman (1995) Shao & Shao (1996) Burns & Walker (1997) Method questionnaire questionnaire Number of Usable Responses 121 121 Sample CFO's of Fortune 1000 multinationals VP Finance or Treasurer of largest industrials in Fortune 500 CFO's of Fortune 500 Executives and capital budgeting directors of large US industrials except utilities and transportation Large public firms from FASB Data Bank 100 largest of Fortune 500 CEO's of Fortune 1000 Fortune Magazine Directory CFO's CFO's of Fortune 500 + Forbes 200 Managers of foreign manufacturing subsidiaries of US industrials Fortune 500 7 best-sellling texts. Surveys of Capital Budgeting of Large US Firms Surveyed Year(s) 1982 1986 Survey Author(s) Stanley & Block (1984) Pruitt & Gitman (1987) Pohlman.CAPITAL BUDGETING SURVEYS: THE FUTURE IS NOW 81 Figure 1. 10 leading financial advisors Fortune 500 CFO's USA and Canadian based companies from S&P Compustat database CFO's from Fortune 1000 CFO's from FEI corporations executives of large companies CFO's of Fortune 1000 top-ranking officers of Fortune 1000 1986 questionnaire 232 1988 questionnaire 282 1988 1992 1990 1991 1992 1992 1992 questionnaire questionnaire questionnaire questionnaire questionnaire questionnaire questionnaire 282 74 160-228 151 84 188 180 7.10 102 155 1996-97 Bruneretal(1998) telephone survey 1992-93 1994 Mukherjee & Hingorani(1999) Payne.27. Heath.BURNS & WALKER . Santiago. & Gale (1999) Gitman & Vandenberg (2000) Graham & Harvey (2001) Triantis & Borison (2001) Ryan & Ryan (2002) Block (2007) questionnaire questionnaire 1997 1999 1999 1999 2005 questionnaire questionnaire interviews questionnaire questionnaire 111 392 39 205 40 . & Markel(1988) Gordon & Myers (1991) Myers. Gordon. 27 prestigious CFO's.
Screening Process ¡C. Personnel Involved/Procedure C.)weM0!ay's. Control (or Perfonnance Evaluation) A.) uBUjJio 'S UBUBJi (1.ISSUES 1 & 2. Process of Origination & Submission |D. a> a> i2 i2 I (O O) O) •o 3 OQ |L Idea Generation |A. Classification of Projects for Economic Analysis B. -7-?• a re U (0 O) 3 D) z •^ II O) (¿ooz) >iooia (0002) (866l. Risk assessment D3. Capital Rationing Rationale E3. Reasons for Idea Origination |C.)ueaJi!O'SH!n.) sjaÄ|/\l'8uopjoo (W6l)>|00ia'8'^8|UBis (6660 9|B0 'S 'MIB9H 'auÄBd (666 O !UBJo6u!H 'S aa[jaLj>|ni^ CM o -y -y -y -y -y -?• -?• ~7- -?• -?• -?• -?• -?• -7- -y -y -y -y -y ~y -y ~y -y -y ~y -y -y -y 'y -y -y -y -y -y -y -?• -?• -?• -y -y CO t ^ ~y ~y -y •y JOURNAL OF APPLIED FINANCE . Responsibility for Budget Preparation (personnel) |lll. Personnel (Department) Responsible for Analysis C1. Capital Rationing Methods Used F.661.id 6jaquapueA 'S UBLUIJO < 'O6B!)UB9 'UBLU|L|Od S o o o o -?• (1. Cost of Capital G. n O •o (0 82 m •a o u. Reasons for Techniques Used Dl. Capital Rationing: How Extensive? E2.002)'^SWBH S lUBMBJO (S66l.) ueuuaig (8861. Extent of Use of Post Audit B.)|Bía. Use of Evaluation (Punishment/Reward/Etc.jaqi!9 (1. Time Pattern of Origination 1II. Project Approval |IV.002) uosuog pue suueui (1-661-) jaoiBH 'S 'uopjoo 'sjaA|/\| (9661. Risk recognition D2. Source of Origination |B. 2009 -y -y -y -y -y -y -y -y -y -y -y -y -y -y -y -y to CM CM CM CO -y -y -y -y CM CO CM .o 00 <N (0 "5 'a. Level at Which screening Takes Place |B.iaunjg (966l•)oeL^S'8OB^s (¿66l)J8>lieM'8SUjng (9661-) sjauiujns 's eqjapod (2002) ueAy "? uBAy (£661.) 1* Surveys in this exhibit appear in chronological order of their publication. Risk adjustment El.) |S>tJeiM (Z86l. Listing Techniques Used |C2. ProposalDevelopment |A. Performance Measurement D. Selection of Projects |A. Cashflow Estimates (and forecasting) |D.
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. they provided a deeper understanding of capital budgeting forecast biases and cash flow estimation. and project approval. 1.. although specifically how this adjustment was made was not addressed. how ideas get turned into proposals.g. Since. Among other important findings. the responsihle personnel. good progress has been made in stage 2 research. were even more likely to have such a specialized person. how many people are involved in the process. Highlights of their findings include: • The rationale for the continued use of simple payback was its ease of computation and also its usefulness as . In so doing. the results are provided in the subheadings below. cash flow data. • 85% of their respondent companies used systematic. myopic euphoria. stage 3: Selection Suggested areas of study within this stage include: the personnel involved. As emphasis. standard procedures in estimating cash flows (which were used even more in higher risk firms). had earlier emphasized that the decision support system or information system was the key to development and other stages of capital budgeting. No research in this area was noted over the last two decades as well as previously. mass psychology. and who makes the final decision. • 78% had standard forms and worksheets for their cash flow forecasts.CAPITAL BUDGETING SURVEYS: T H E FUTURE IS NOW 83 (vs. marketing. Gordon and Pinches (1984). B. in a direct response to the appeal by Scott and Petty (1984). this stage also focuses on firm data-gathering efforts. and the role of project size and organizational structure. capital rationing. company-wide." Bums 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 5 0 0 firms on the detailed reasons for their choice of techniques and the reasons for any changes in the emphasis of those techniques over time. past surveys did not directly take up the matter of rationale behind these practices with surveyed firms. or 2) erroneous information emanating from upper level management and provided to forecasting personnel. risk analysis. both of which compounded the profitability forecast error. top down).. • Among the other third of officers who did not attribute bias to these two main reasons (and who provided their identity). and the origination of biases in those processes. Stage 2: Development Suggested areas of study within this stage include the extent of screening of project ideas. and salesmen optimism). the extent to which companies use accounting vs. and the decision support system. in fact. Santiago and Markel (1988).BURNS & W A L K E R . Pruitt and Gitman (1987) specifically identified and investigated Stage 2. Pohlman. the techniques used . the level of review. and economic factors such as inflation. Overall. especially in the areas of 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. For example. firms combined judgment with their quantitative forecasts. this stage is arguably the most involved. Perhaps more importantly. and that the decision-making process was centralized.. among other topics. follow-up telephone calls revealed 1) psychological explanations (e. • Over two-thirds of the oflicers felt these biases arose due to intentional overstatement or lack of experience. Mukherjee (1987) said. the details of how the data is estimated. ".the rationale and conflict priority and the details of WACC and hurdle rate determination. viz. as stated earlier. provided the first indepth look at the cash flow estimation practices by surveying the Fortune 500. group polarization. they discovered that: • About 67% of their survey respondents employed a person to specifically supervise their cash flow estimation. 2.. forecasting. financial. Rationale for Selection Techniques Suggested topics for study in this area include determining why some techniques are preferred over others by practitioners. Personnel Suggested areas of study on personnel issues include determining who or which department analyzes capital expenditures. and 65% had a standard model. the screening criteria. • Firms with more leverage and higher capital intensities C. • In addition to considering production. • The officers said they handled such biases by adjusting the cash flow estimates downward on an informal basis.
and in capital rationing situations. Bruner. • DCF was the dominant investment-evaluation technique. • Project size and payback were the main factors in assessing project risk. including the post audit phase. whether or not firms use the same hurdle rate to evaluate all projects. Gitman and Vandenberg (2000) did an update on an earlier cost of capital survey (Gitman and Mercurio. but In an oft-cited article on this topic. In particular. 3. but none directly asked practitioners "why". sophistication of techniques used. 32% used the project cost of capital. they found that: budgeting techniques was through formal education. and some used both. Eades. such as size of firm vs. 1982) and found that: • 93% of firms used the capital asset pricing model to find their cost of equity.ISSUES 1 & 2. measure seemed easier to understand and compute. 2009 an adjunct to discounted cash flow measures as both a measure of liquidity and risk. • Firms used target weights vs. . in fact. WACC Suggested areas of research in this category include the extent to which firms use hurdle rates to make project selections. They found that: • Hurdle rates were higher than standard analysis would suggest. and Higgins (1998) answered the research call by examining • The profitability index and the modified internal rate of how firms computed their cost of capital (WACC).84 JOURNAL OF APPLIED FINANCE . • The Internal rate of return • Most firms had more and net present value were than one hurdle rate. not average rates • CAPM was the dominant equity model. of money considerations • Some managers made a and not enough on the other and also because of their distinction between the cost use of cash flow measures stages as well as the overall of capital and hurdle rates (as opposed to accounting as a way of adjusting for capital budgeting process. • One counter-intuitive result was that fewer firms in the follow-up survey seemed to be using formal procedures than previously. and how firms arrive at the particular numbers they calculate. income measures). • WACC was the dominant discount rate. the authors found rate of return's attractiveness was its more realistic evidence of a general alignment among the three groups reinvestment rate assumption. • The after-tax debt cost was based on marginal tax rates. 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. how the hurdle rate is defined and why. For example. Other studies did look at inferential types of rationales for selection techniques. and the modified internal examining seven best selling textbooks. occurred. 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. Using return were not used as much as finance textbooks would a telephone survey to target twenty seven highly regarded imply. not book weights. The biased estimates of projects' internal rate of return profitability. Stanley and Block (1984) looked at a variety of capital budgeting topics involving US firms within a multinational context. • Firms used after-tax debt costs. • There was wide variation in the inputs to the models and major disagreements with respect to how to apply CAPM. and in the area involving the cost of capital they found that: • 49% of respondents used the parent company's cost of capital. The profitability index's attractiveness was its use corporations and ten leading financial advisers. Some very important work on the why and how of the cost of capital and hurdle rates has. • 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. • Market weights were used. and they There had been too much survey used primarily because varied their hurdle rates with focus on the selection stage of their use of time value the projects being considered. Harris net present value was seen as more reliable. on the use of common theoretical frameworks and basic • The most common way of learning about capital methods of estimation. book weights.
• 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. Thus. • Capital rationing occurred only about 40% of the time. notable progress has been made on the nature of and rationale for capital rationing. in response to a unique inquiry into what risk analysis subjects firms would like to know more about. reported mixed results in this regard. why the application of management science tools has remained low. than those in the 1980 study (Gitman and . Shao and Shao (1996) found that sensitivity analysis was the dominant assessment technique. and computer simulation. size. scenario. 5. For the most part.g. especially for large outlays. Then. 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. and Monte Carlo analyses. as well as explaining the low usage of sophisticated methods. Risk Analysis Suggested areas of study within the risk analysis category include how risk is actually defined in a capital budgeting context. decision trees. Note again the desirability of more research on the decision support system which was commented upon at the end ofthe section on Stage 2. and 77% differentiated project risk. 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. how risk is recognized. inflation. For example. Gitman and Vandenberg (2000) found that 39% of firms also adjusted their rates vs. and 4) difficult to apply. Graham and Harvey found that more than half of the firms did not adjust WACC (average firm risk) to reflect specific project risk. and adjustment of risk. assessment. in reference to how risk is characterized or identified. they found that 23% wanted to learn more about sensitivity analysis. the respondents recognized market risk. and there was a conspicuous absence of tools (e. • Capital rationing was seen as "soft" in nature. the interface between strategies. 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.. • The dominant cause of capital rationing among 60% of the respondents was a debt limit imposed by management. and how improvements could be made in obtaining the necessary input from management for improving existing risk models or building new ones. and the role of divisional manager in each of those categories. to correct project proposal biases). comprised of firms wanting to learn more about management subjective estimates.CAPITAL BUDGETING SURVEYS: THE FUTURE IS NOW 85 4. Further. in the last two decades little research has been done on the topic of project approval. Stanley and Block (1984) and Shao and Shao (1996) found that firms were using risk-adjusted cash flows more often than risk-adjusted discount rates. less than the 60% occurrence found in earlier studies. 3) difficult to explain to top management. adjusting their cash flows to adjust for risk while 21% do both. Several of their important findings in this regard included: • The main reason for capital rationing was a reluctance to issue external financing. whether capital rationing is "soft" or "hard". however. Also. regarding the low usage of sophisticated risk analysis methods. Capitai Rationing Suggested areas of recommended research in this area include the financial environment in which the decisions are made. the role of divisional managers. and reflected. but they also identified other risk factors such as interest rate. 2) relying upon unrealistic assumptions. capital investment and operating decisions. in Graham and Harvey's (2001) survey. 6. especially when evaluating international projects. assessed. The next highest response category was only 5%. Trahan and Gitman (1995). they found that 16% ofthe firms grouped projects into risk classes. Project Approvai Suggested areas of study within this subheading include the extent ofthe autonomy of divisional managers (since project acceptance does not mean implementation. constrained maximization) used when capital rationing was present. and the upward bias in cash flow estimates. even though few projects are rejected at this stage of formal analysis). and foreign exchange rate risk. why there is such low usage of sophisticated risk analysis methods such as the sensitivity. and the specific reasons behind capital rationing (e.BURNS & WALKER .. In adjusting for risk. 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. Finally. Although some progress has been made in the identification. a noticeable change fi-om previous survey findings.g. 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. 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.
at the time the appeals were made.g. "In the mid-1980's academics began [emphasis added] building option-based models to value investments in real assets. • They also found that the use ofthe post audit varied highly according to the use or non-use of established procedures by asset base . 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.." In particular.. also looked at the post-audit process to find an upward bias that management suspects. real options analysis is prominent among decision method considerations today in the academic arena. real options survey contributions were checked under the categories of "listing techniques used" and "risk assessment." Block (2007). whether there is an expenditure control procedure.. energy and utilities. Myers. 2 0 0 9 Mercurio. 1 on page 8. • However. and 3) documented policies and procedures. particularly in the early part of the review period.3%) used real options in the capital budgeting process. For example.. Gordon and Hamer ( 1991 ) compared (sophisticated) experimental groups vs.that strategic assets (e.5% ofthe non-users said that there was a good chance they would consider the use of real options in the fiiture. 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. whether management is rewarded or punished for such discrepancies.g. Stage 4: Control (Post-audit and Performance Appraisal) Suggested areas of study within this stage include research into: how project performance is evaluated. and this spurred two surveys dedicated to real options usage. ".' Clearly. Thus.g. However. 2) the use of risk-adjusted discount rate cash flow techniques. The users were primarily in industries where sophisticated analysis is generally more common such as technology. Bums 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. the category of real options was not included separately in Figure 2 since it was not a part ofthe original appeals.. minor office equipment) received the fewest.. Instead. laying the foundation for an extensive academic literature in this area. how it is done. Reasons cited by the respondents for non-use included a lack of top management support. Note that Pruitt and Gitman (1987). and the excessive risk-taking encouraged by the use of real options. the requirement of too much sophistication. how? The control stage received some significant attention. and operating assets (e. in Figures 2 and 3. 1982). none of the surveys before 2001 focused on real options analysis.]. what happens when expected and actual results differ.ISSUES 1 & 2. the survey found that the use of real options was limited. They found a relatively infrequent use of such options... 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. administrative assets (e. • They confirmed the "bad news" that post-auditing is far from being a standard part of the capital budgeting process. a much smaller percentage of those audits were not effective according to criteria which involved 1) the need to be regular and periodic. and if so. But overall. They found that firms increased their performance when using sophisticated (discounted cash flow based) audit procedures. motivated by the predictions of Copeland and Antikarov (2001). unanimous feeling . Before leaving this discussion on Stage 3 (selection). see their footnote no. (naïve) control groups.real options will serve . Using the data from this same study. A more positive 'As noted by Triantis and Borison (2001). finding was that 43... Copeland and Antikarov (2001) suggested that real options would dominate the capital budgeting process within the next decade. was the increasing awareness and use ofthe need for post-auditing.86 JOURNAL OF APPLIED FINANCE . [that real options help managers make better investment decisions. D. polled the Fortune 1000 to determine the extent to which these companies had adopted real options analysis as a complement to traditional analysis. The interested reader is encouraged to read this article and the cited references.. and mostly for reasons of maintaining market share or allowing for operating and managerial flexibility. Triantis and Borison (2001) interviewed 39 individuals from 34 companies in 7 different industries and concluded that. • Their "good news.. Especially pertinent in this regard was their finding that optimistic ." however." Two earlier surveys over the review period asked about real options incidentally.. replacement projects) received the next most. Gordon and Myers (1991) surveyed executives and capital budgeting directors of large US industrial firms and found that: • 76% of their survey respondents had performed postaudits over the previous 10 years. Out of 279 respondents only 40 (14. although somewhat higher than that found in prior studies.as a general way of thinking" [and that] "there is an overwhelming . expansion projects) received the most post-audits. 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. Interestingly. mentioned above in the Stage 2 review. by whom.
% 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. Methods used F. 95% did it for initial investment outlays. Classification of projects for economic analysis B. and a fiill 100% for operating cash flows. Listing Techniques Used C2. • Only 68% of firms compared actual and forecasted cash flows for salvage values due to the increased difficulty of that estimation.BURNS & WALKER . and a way to eliminate the psychological biases on future capital budgeting proposals (e. Use of evaluation (rewards / punishment) N forecasts were sometimes based on psychological factors such as myopic euphoria. found in the Stage 4 area that: • 75% of their firms compared actual and forecasted cash flows. though mentioned earlier above in reference to their Stage 2 contributions. Why capital rationing? E3. Extent of use of post audit B.. Gordon and Hamer (1991) analyses above which both argued for a post-audit system with four objectives .g. . Risk adjustment El. Screening Process C. but only 43% claimed a 90% accuracy level for operating cash flows. Risk recognition D2. Risk assessment D3. and group polarization effects. Pohlman. Responsibility for budget preparation (personnel) Stage 3: Selection of Proposals A. In short. Project Approval Stage 4: Control (Performance Evaluation) A. Capital rationing: how extensive? E2. Cost of capital G. a means to remove psychological and/or political impediments to effective capital budgeting (e. Cashflow estimates (and forecasting) Il-D.CAPITAL BUDGETING SURVEYS: THE FUTURE IS NOW 87 Figure 3. Source of origination B. Time pattern of origination Stage 2: Proposal Development A. • 66% of their firms achieved a 90% accuracy level on salvage values. This ties in with the Gordon and Myers (1991) and Myers. abandoning an on-going project).. "pet" proposals). • 68% of their firms achieved a 90% accuracy level of initial investment outlays. Santiago and Markel (1988). Performance measurement D. Reasons for Techniques Used D1. 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 i : Idea generation A. Level at which screening takes place B. Personnel involved / procedures C.a financial control mechanism. Reasons for idea origination C. mass psychology. the post-audit should provide objective information on which to base potentially unpopular decisions. Personnel (department) responsible for analysis C1. Process of origination and submission D. This important research into the control stage has resulted in a deeper understanding of this previously neglected area. a means to provide future information for capital budgeting. Comparison of iVIukherjee's 1987 Results and 2008 Update Results Mukherjee (1984) No.g. • Of these.
however. Thus. areas of cost of capital and hurdle rates. . Pike (1996) made a therefore only one occurred in the last seven years. Brounen. they specifically called for more survey work on international studies are in order. Although not all ofthe cited of large European firms with some noteworthy contributions studies can be directly attributed to the specific appeals. early screening to match with strategy and culture.other stages in the process which includes in absolute number of studies. note that Pike. but they 'Three of the current survey papers directly cite the appeals: Pohlman. although in percentage terms there is even more for ideas. They obtained 313 responses out of 6. and France. and Mukherjee and found little difference in US and European capital budgeting IV. to include. capital budgeting surveys in this review were limited to those Finally. four research etîorts were neglected stages of the capital budgeting process over the found that could be classified as mainline academic surveys 1984-2008 period of review. All studies based on international and Koedijk (2004) used the Graham and Harvey (2001) firms were screened from the list to facilitate comparisons questions in their survey of firms in the U. Looking back at Figures 1 but contrary to the earlier and 2.this will provide a better understanding of but again. Pinches (1984). Bums and Walker ( 1997). in turn. and the In addition. Overall Summary of Findings Hingorani(1999).1992 this review.. They too appealed for future research with Stages 4 and 2 close behind.88 JOURNAL OF APPLIED FINANCE . and Mukherjee (1987). performance. Most of the international studies identified in the initial search would have been eliminated anyway due to their narrow focus In summary ofthe overall findings of this literature review. Figure 1 shows and use ofthe usual selection made in the neglected stages of that over the review period techniques and found that the capital budgeting process over the frequency of use of of this paper (using the actual survey year) all but one of the 1984-2008 period of review. the the firms' use of real options. The notable contribution by answering Sangster's call for timeaverage age of the studies. called for more real options research followed by a virtual shutdown after 2002. capital rationing.. showing that the greatest changes over are over twenty years old. the development of proposals into projects. and which therefore received conclusions reached by Scott and Petty (1984). series studies by arguably performing the first extensive is approximately 16 years from the 2008 ending point of longitudinal study survey of U. and time. have remained concentrated on the selection stage. as well as for more risk analysis investigation. the focus on the listing of techniques than before (18% > 14%). the results show a steady that period had occurred in the increasing sophistication of stream of research (about one study per year) into some risk analysis and post-completion audits.K. As stated earlier. it too has less research now identification of investment opportunities. appeals have arguably had an important effect. Figure 3 summarizes and compares the current study's Arnold and Hatzopoulos (2000) cited Pike (1996) in their results with the Mukherjee (1987) results for easier survey of the Times 1000 and delved into the neglected comparison. he merely Significant contributions have been troublesome aspects of these focused on the cataloging findings. Pike said. It is interesting to of the neglected areas beginning shortly after the appeals.* the to a few neglected areas. [and the] control and review of percent). a few comments on research. three ofthe 19 studies just mentioned at five-year intervals. the entire process." an echo of the earlier American any neglected area specifically. This includes the four studies that did not address of empirical knowledge." Among other suggestions for future Before leaving this section. It can be seen that Stage 1 remains the most neglected and risk assessment.ISSUES 1 & 2. Santiago.ftirther general capital budgeting listing of techniques used continues to preoccupy surveyors' status surveys would contribute little to the existing body efforts. based on the actual survey year.K. 2009 and consistency with the earlier reviews and appeals. ". and much more on the cost of capital (12% > 7%. only in percentage terms).. Germany.500 mailouts of both public and private firms.. the more sophisticated these studies occurred in methods had increased over the first eighteen years. However.... the search than before. and Markel (1988). and he also Second. ". reveals two American appeals. In fact. Even for Stage 3 research. First. Sangster (1993) surveyed the largest 500 Scottish firms. Gordon and no comments in the results section. firms from 1975 . the slightly more on risk recognition and assessment (about a implementation stage. and to facilitate comparison. de Jong involving only US firms. Netherlands. a perusal of Figure 2 shows that over the past appealed for more focused surveys in capital budgeting since twenty years the majority of the capital budgeting surveys the so-called theory/practice gap was seen to be narrowing. on a particular industry and/or publication in specialized it is clear that significant contributions have been made in the practitioner outlets.
' Secondly. and the in-depth studies of the control (post-audit) stage by Gordon and Myers (1991) and Myers. that a set of well-defined capital investment opportunities. 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.. Scott and Petty (1984). the selection stage. V. 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. For example. The more recent work in the area of real options offers a rich opportunity to track the rationale and use of this selection technique.CAPITAL BUDGETING SURVEYS: THE FUTURE IS NOW 89 practices. 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 aitematives over time. in spite of notable progress cited in earlier years of this review. or otherwise discover research opportunities in the neglected areas ofthe capital budgeting process? The results of this study provide both good news and bad news. 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. the decision support system should make a particularly interesting. the relatively unexplored identification stage). Finally. there has been a virtual hiatus in capital budgeting survey research of US firms generally over the most recent seven years. among others. with all of the informational needs clearly specified.g. they urged future researchers to devote more resources to studying Stage I (identification). Santiago. Opportunities include focusing on a particular stage (e. a topic suggested by several authors but emphatically advocated by Gordon and Pinches (1984). see Baker and Mukherjee (2007) on the views of journal editors regarding survey research in finance. Conclusion Over two decades ago. most notably those discussed in Section III of this paper. they made independent appeals to their readership similar to the earlier American survey studies serving as the basis of this review. suddenly appears on an executive's desk and all that is needed is for the manager to [select] the project (s) with the highest expected payoff. (1998) and by Gitman and Vandenberg (2000). still dominated the survey topics over the entire review period. As a result. The highlights include the inquiries into cash flow estimation by Pruitt and Gitman (1987) and by Pohlman. that more progress in capital budgeting survey research can be made in the ftiture than has been seen in the past twenty four years. the investigation of risk analysis practices by Trahan and Gitman (1995) and by Graham and Harvey (2001). The good news is that some researchers indeed directly answered the calls (see footnote 8) and others apparently saw the need independently. 2008). it would seem that with the blessings of the primary business school accrediting agency for an increased volume of applied research (AACSB Intemational. al.g. and Hamer (1991). risk analysis within the selection stage). with its emphasis on particular project evaluation techniques. First. there was no investigation into the neglected stages except for how risk was characterized or identified.* 'For an interesting discussion of possible contributing factors to this hiatus. Furthermore. and Mukherjee (1987). Although these European surveys did make some minor contributions to the neglected areas. Further. as in the original US study. Gordon. fmitful and challenging area of survey research. Instead." Given the tremendous advances in technology since 1984. Stage 2 (development). As a result.. more interestingly and importantly. The bad news is two-dimensional. and Markel (1988). and specific neglected areas in Stage 3 (selection) since these were the most unexplored areas of capital budgeting. . the detailed evidence on cost of capital practices by Bruner et. researching a phase within a stage (e. One especially promising area of survey research is that of the decision support system. there have in fact been several quality survey research efforts into the neglected areas. or contributing detail to the overall four-stage process. But did fellow researchers in the field of capital budgeting hear the calls by Gordon and Pinches (1984). the "why" of evaluation techniques by Bums and Walker (1997). the why and how of capital rationing by Mukherjee and Hingorani (1999). also see the AACSB Intemational (2008) report's recognition of how applied research generally counts for less among tenure review committees and for annual compensation purposes. Stage 4 (control).BURNS & WALKER . As quoted earlier. future researchers should clearly avoid what Gordon and Pinches say many past surveyors have done by assuming ". Using a "best practices" perspective similar to that of Bruner et al (1998) could potentially provide a fertile approach. due to its impact on all four stages.
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