Payback without apology

When interest rates are uncertain, the net‐present‐value threshold required to justify an irreversible investment is increasing in the length of a project's payback period. Therefore, slow‐payback projects should face a higher hurdle than fast‐payback projects, just as investment folklore suggests. This result suggests that the widely disparaged use of payback for capital budgeting purposes can be an intuitive response to correctly perceived costs and benefits.     

The evolution of the application of capital budgeting techniques in enterprises

This study examines the evolution of the application of capital budgeting techniques. Previous studies mostly used cross-sectional inquiries to understand the capital budgeting practices of firms. Only a few researchers have undertaken longitudinal studies to generalise the findings of the individual cross-sectional studies to the wider population and to identify the emerging trends in the use of capital budgeting techniques (CBTs). This longitudinal study surveys 83 studies of capital budgeting practices across firms in India, South Africa, the United Kingdom (UK) and the United States of America (USA) for the period from 1966 to 2016. The findings show that six capital budgeting techniques, namely, the net present value (NPV), the internal rate of return (IRR), the payback period (PBP), the accounting rate of return (ARR), the return on investment (ROI) and the real option valuation (ROV), are the most popular methods for evaluating capital investments. Of these techniques, the ROV is the least used, and a general lack of familiarity with this technique and its complexity are the most commonly cited reasons for not using it. Another method that is used less than the first four techniques is the ROI. However, this technique is of growing significance and is mainly used in the UK, followed by the USA, South Africa, and India. Firms in the USA and UK have increased their use of the IRR as a primary method for evaluating capital projects and have retained the PBP as an ancillary technique to strengthen the available information when evaluating capital projects. Firms in India and South Africa are increasingly excluding both the PBP and ARR methods and are increasingly using the NPV when evaluating capital investments. Although this development is in line with the theory, it limits the scope of the available information when evaluating capital projects.     

Management Compensation and Payback Method in Capital Budgeting: A Path Analysis

While discounted cash flow techniques, such as net present value, are the primary normative models of capital budgeting recommended by finance theory, our survey suggests that one of the so-called ‘naive methods’, the payback (PB) criterion, is widely used in practice. About 85% of the responding firms make some use of the payback criterion. Almost 50% of the responding firms indicate that the payback method plays a relatively important role in capital budgeting decisions, and the degree of the importance varies among firms. This study uses path analysis to empirically identify links between the use of payback and management compensation contracts. Controlling for uncertainty in estimating future cash flows and firm size, we find that the use of the payback method is positively related to the degree to which management compensation depends on accounting earnings. Furthermore, this study finds two indirect links between management compensation and the use of payback. The more management compensation depends on accounting earnings: the more important management perceives the earnings objective and, consequently, the greater the use of the payback method; and the less important management perceives the shareholder wealth objective and, consequently, the greater the use of the payback method. We conclude that owner-management conflict and management's self-interest behaviour induced by employment contracts are factors that promote the use of payback method.     

Factors affecting biasing of capital budgeting cash flow forecasts: evidence from the hotel industry

This study contributes to a neglected aspect of the capital budgeting process, namely, the proposal development stage, which is primarily concerned with project cash flow estimation. Given that the deployment of sophisticated selection techniques is severely undermined when directed to input data suffering from bias, it is surprising that minimal empirical research has sought to explore for antecedent factors associated with biasing of capital budgeting cash flow forecasts. This paper reports the findings of a survey concerned with determining factors associated with biasing of capital budget cash flow forecasts in hotels that are mediated by a management contract. Statistically significant support is provided for the view that higher levels of biasing of capital budget cash flow forecasts occur in the presence of: high emphasis attached to the payback investment appraisal method; deficient reserve funds for furniture, fittings, and equipment (FF&E); low operator accessibility to reserve funds for FF&E; shorter periods of time to management contract expiry; and high emphasis attached to non-financial factors in capital budgeting appraisal.     

THE EFFECTS OF BORROWING ON THE RATE OF GROWTH OF CAPITAL AND THE RISK OF RUIN OF A FIRM

The research reported in this paper used Monte Carlo simulation to study the long term effects of borrowing policy on the rate of growth of capital and the risk (probability) of ruin of hypothetical firms, operating in explicitly described, realistic capital budgeting environments. The capital rationing environment is described explicitly. The debt policies modeled were based on the results of interviews with senior financial executives in eight major firms. The results indicate that three intuitively appealing ranking procedures performed equally well and all out-performed a random selection decision procedure: yielding higher rates of capital growth with lower risks of ruin. In general, an aggressive borrowing policy resulted in a higher average capital growth rate for a firm but a conservative borrowing policy resulted in a lower risk of ruin. It is believed that the results provide some interesting insights which indicate that a computer simulation model could be used to aid management in the evaluation of their capital budgeting procedures and borrowing policies.     

The Role of Payback in the Investment Process

This study examines the use of the payback (PB) method as a means of evaluating a proposed asset's risk and its joint application with profit-oriented capital budgeting models. Previous research studies indicating a linkage between the PB method and risk analysis are reviewed. A certainty-equivalent model is used to demonstrate this relationship and the properties of the relationship exploited by PB when used as a heuristic. Results of the analysis indicate that using a hurdle PB as a filter for identifying proposals with acceptable risk and return attributes is consistent with more quantitatively oriented investment techniques under certain conditions. The study then examines the conceptual relationship between PB and profit-oriented capital budgeting models. Results suggest that PB and profit-oriented capital budgeting techniques measure different attributes of an investment and complement one another in describing and analysing its cash flows.     

THE DETERMINATION AND USE OF INVESTMENT HURDLE RATES IN CAPITAL BUGETING: A SURVEY OF AUSTRALIAN PRACTICE*

This paper summarizes the results of a survey, conducted in 1979, which investigated Australian practice in the determination and use of investment hurdle rates, and in certain other areas of capital budgeting which impinge on hurdle rate practice. The study suggests a significant closure of the gap between theory and practice in capital budgeting in terms of the use of discounted cash flow techniques of capital project evaluation, and in terms of the use of some tools of finance such as the weighted average cost of capital. However, many developments in the determination and use of investment hurdle rates appear to have taken place at a slower rate, and it is possible that some “back-tracking” may be required in order to improve practice.     

THE CAPITAL BUDGETING BEHAVIOUR AND CORPORATE CHARACTERISTICS OF CAPITAL-CONSTRAINED FIRMS

This paper addresses (1) the nature and pervasiveness of organisational constraints, frnancial and otherwise, on investment, and (2) the corporate characteristics and capital budgeting behaviour of capital-constrained firms for a sample of 126 UK companies. The results indicate that corporate size, risk and profitability are important corporate characteristics in this regard, and that financially-constrained firms tend to adopt naive capital budgeting methods in resolving the capital rationing problem.     

THE MARGINAL-EFFICIENCY-OF-CAPITAL FUNCTION OF THE FIRM

In this paper, the author points out that over a decade ago E. Norman Bailey identified the marginal-efficiency-of-capital (MEC) function as erroneous and argued that revisions in capital budgeting theory and teaching were necessary. The author develops more fully the arguments against the function and offers the theoretically correct MEC function. The development of the correct MEC function is a straightforward application of basic price theory; however, this application requires that the capital of the firm be viewed as a collection of complementary resources, in addition to its role as an income-producing investment.     

AN ANALYSIS OF THE FINANCIAL MANAGEMENT TECHNIQUES CURRENTLY EMPLOYED BY LARGE U.S. CORPORATIONS

Economic conditions have placed increased importance upon rigorous financial analysis. In order to determine which analytical techniques are currently emp loyed by management, a questionnaire was sent to each fm on the May 1980, FORTUNE 500 list. The researchsought to establish a profile of the respondents' organizational structure and to identify the primary procedures used in risk assessment, working capital management, capital budgeting, and operations research modeling. The results do suggest a basic profile of the more active employers of analytical techniques. Relatively sophisticated capital budgeting procedures appear to be accepted across most industries, and many firms support their decision making with a "package" of formal tools.     

THE USER COST AND CAPITAL BUDGETING

This study describes the relationship between the user cost of capital and capital budgeting processes and presents a formula for computing the user cost of an investment, accommodating the existence of taxes, inflation, and a nonconstant level of production. A project acceptability criterion assigning positive net present value when cash operating income exceeds user cost is discussed and applied to several examples. The test is shown to be useful and easy to apply.     

The Theory-Practice Gap in Capital Budgeting: Evidence from the United Kingdom

We report the results of a survey of capital budgeting techniques used by United Kingdom firms. Where possible, the evidence is combined with data collected over a 22 year period to provide a basis for the discussion of causes of trends. We observe that there has been a substantial narrowing of the theory-practice gap in the use of project appraisal methods. The gap has also narrowed in other areas: the analysis of risk, inflation adjustment, capital budget preparation, WACC calculation and post-auditing. However, there are other elements of capital budgeting theory, e.g. probability and beta analysis which have been adopted by very few practising managers. We also discuss non-economic projects, capital rationing and hurdle rates.     

Corporate capital budgeting and CEO turnover

When a firm has minimal agency and informational asymmetry problems it should make efficient capital budgeting decisions. Many firms over-invest prior to CEO turnover, halt investments in the period surrounding the turnover, and then greatly increase their level of expenditures. Empirical analysis of the cross-sectional and inter-temporal variation in the quality of firms' corporate capital budgeting decision reveals that the impact of CEO turnover is asymmetric between under- and over-investing firms, and this complements the larger literature using average firm-wide performance measures. Firms are more likely to have forced turnovers when there is more over-investment prior to the turnover, and these firms make more efficient investment decisions subsequently. Board influence is largely insignificant prior to a CEO turnover but is consistently associated with higher levels of investment subsequently.     

An Empirical Study of the Adoption of Sophisticated Capital Budgeting Practices and Decision-Making Effectiveness

This paper examines the trend towards greater sophistication in investment selection techniques and control processes, and their impact on capital budgeting decision effectiveness. Based on a sample of 100 large UK firms, the study examines the capital budgeting practices employed over an 11-year period. Very significant increases in the uptake of sophisticated investment methods are reported, particularly in the analysis of project risk. These developments are partly explained by the rapid developments in computing within capital budgeting. Clear evidence is found to suggest that senior finance executives believe that the adoption of sophisticated investment practices gives rise to improved effectiveness in the evaluation and control of large capital projects.     

Intertemporal capital budgeting

This paper analyzes the optimal capital budgeting mechanism when divisional managers are privately informed about the arrival of future investment projects. Consistent with field study evidence, an optimal allocation mechanism can include a stipulation that a capital request for discretionary investment will be declined with positive probability in the period after a significant investment was made even though this is ex post suboptimal. The model derives a number of empirical predictions regarding capital budgeting and the investment of financially constrained firms.     

CAPITAL BUDGETING DECISIONS WHEN CASH FLOWS AND PROJECT LIVES ARE STOCHASTIC AND DEPENDENT

The purpose of this study is twofold: (1) to develop an operational economic state and simulation capital budgeting procedure for allowing cash flows and project lives to be dependent and (2) to provide empirical evidence of the impact of stochastic project lives on mean-variance and mean-semivariance capital budgeting decisions. The required number of input estimates for the proposed model is small. For individual projects, incorrectly assuming deterministic project lives when project lives are stochastic often results in large overestimates of expected net present values and large underestimates of the variance of the net present value. Similar results occur for the mean-variance and mean-semivariance portfolio models. The primary managerial implication of this study is that the inclusion of stochastic project lives in capital budgeting decisions is critical to obtain appropriate risk-return estimates.     

The practice of investment valuation in emerging markets: Evidence from Argentina

This paper discusses the challenges of applying traditional valuation techniques to emerging markets, and reports on how CFOs, financial advisors and private equity funds meet those challenges in Argentina, a major Latin American emerging economy. On many fronts, our findings show that there is substantial alignment with U.S. valuation practices. We find that: (a) discounted cashflow techniques like NPV, IRR and payback are very popular among corporations and financial advisors; (b) the CAPM is the most popular asset pricing model, yet it is frequently modified to account for country-specific risk; (c) capital budgeting analyses are performed in U.S. dollars by non-dollar companies; (d) financial advisors tend to apply U.S. betas to the emerging market, yet they rarely adjust betas for cross-border asymmetries; and (e) corporations tend to disregard the effects of small size and illiquidity. We provide tentative explanations for our findings.     

THE RELUCTANT MANAGERS: CLINICIANS AND BUDGETS IN THE NHS

A review of the literature on management budgeting, combined with recent fieldwork in a number of health authorities, points to major weaknesses in both the theory and practices of management budgeting. The lack of major incentives to clinician participation and of significant penalties for non-participation are seen as central to the failure of management budgeting to achieve either rapid or widespread adoption. In addition, it has been insufficiently appreciated that many managers themselves are less than enthusiastic about the prospects for workload-related budgeting. Finally, it is suggested that, though novel in some important aspects, resource management may often suffer similar difficulties.     

CANBERRA TO PORT MORESBY: GOVERNMENT ACCOUNTING AND BUDGETING FOR THE EARLY STAGES OF DEVOLUTION

This paper examines changes which have occurred in government accounting and budgeting from the antecedent system of Treasury control in the colonial era of The Territory of Papua and New Guinea to the contemporary system of Finance control in the Independent State of Papua New Guinea. An exposition is provided of existing and proposed governmental accounting and budgeting issues during the early stages of devolution for indigenous control. Although self-government provided new legislation for government accounting and budgeting, the critical event in the formation of the present system was the Constitution which highlighted indigenous responsibility against a backdrop of national attainment criteria. The development of indigenous responsibility for the government accounting and budgeting system has been limited by: (i) overreliance on an expatriate model, and (ii) a fundamental dearth of qualified accountants at the professional level in the public sector. In the longer term, however, cultural rather than administrative issues will tend to influence and guide policy in this area.     

Do organizations adopt sophisticated capital budgeting practices to deal with uncertainty in the investment decision?: A research note

This study examines the impact of uncertainty on the sophistication of capital budgeting practices. While the theoretical applications of sophisticated capital budgeting practices (defined as the use of real option reasoning and/or game theory decision rules) have been well documented, empirical evidence on the factors that affect the importance and use of these sophisticated capital budgeting practices is scarce. I investigate the relation between specific uncertainties and sophisticated capital budgeting practices in 189 Dutch organizations. The empirical results show that sophisticated capital budgeting involves the use of multiple tools and procedures (such as Monte Carlo simulations, certainty equivalents, Game Theory decision rules and Real Option Reasoning). An increase in financial uncertainty is associated with the use and importance of sophisticated capital budgeting practices. Finally, size and industry are also related to the use and importance of sophisticated capital budgeting practices.