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American Finance Association

Survey and Analysis of Capital Budgeting Methods


Author(s): Lawrence D. Schall, Gary L. Sundem, William R. Geijsbeek and Jr.
Source: The Journal of Finance, Vol. 33, No. 1 (Mar., 1978), pp. 281-287
Published by: Wiley for the American Finance Association
Stable URL: https://www.jstor.org/stable/2326365
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THE JOURNAL OF FINANCE VOL. XXXIII, NO. I MARCH 1978

NOTES

SURVEY AND ANALYSIS OF CAPITAL BUDGETING METHODS

LAWRENCE D. SCHALL, GARY L. SUNDEM AND WILLIAM R. GEIJSBEEK, JR.*

I. INTRODUCTION

RECENT FINDINGS PRESENTED in the finance and accounting literature have indi-
cated that firms are using increasingly sophisticated capital budgeting techniques
(Istvan [2], Klammer [3] and Fremgen [1]. The present paper discusses the results of
a more recent survey of large U.S. firms that was conducted by the authors. The
survey (presented in the Appendix) inquired about the capital budgeting techniques
employed, the computation of the discount rate and of cash flows, and the method
of estimating and adjusting for project risk. Section II describes the sample
employed and presents the results of the survey. Section-III compares the results to
those of previous surveys and briefly examines the association between the survey
findings and a number of firm economic variables. Section IV is a summary.

II. SURVEY SAMPLE AND FINDINGS

A. Sample

A sample of 424 firms was selected. This included all firms on the COMPUS-
TAT tape with either 1) net plant assets exceeding $200 million, 2) capital
expenditures exceeding $20 million, or 3) net plant assets exceeding $150 million
and capital expenditures exceeding $10 million. Of these firms 17 were either
merged with another firm before the survey or their mailing address was unattain-
able. Therefore, questionnaires were sent to a major financial officer of each of 407
firms.
There were 189 responses, a 46.4% response rate. (This excludes responses in a
telephone follow-up). The respondents were statistically significantly larger than
nonrespondents, had smaller variances of shareholder rates of return [(dividends
plus capital gains)/share price], had lower variation of net income, and had smaller
beta values. The total sample of 424 is therefore biased toward large stable firms,
and the set of firms responding tends to be biased even more in the same direction.
Our results consequently apply only to large stable firms.
Response bias is also possible in a survey such as this. It is possible that firms
using more sophisticated capital budgeting techniques would be more likely to
respond than firms using less sophisticated capital budgeting techniques. A
telephone follow-up to 16 randomly selected nonrespondents was carried out, and
the answers to the questionnaire were obtained from 15 of them. The results of this

*Professor of Finance and Business Economics, University of Washington, Associate Professor of


Accounting, University of Washington, and Finance Manager, The Boeing Company.
281

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282 The Journal of Finance

follow-up analysis indicate that there was little response bias; the follow-up firms
were slightly (not statistically significant) more sophisticated in methods used for
capital budgeting and slightly less sophisticated in risk assessment methods. Thus,
response bias does not appear to be a major factor, although it may exist to some
extent. However, it should be noted that the same kind of response bias has existed
for previous capital budgeting surveys, so comparison of our results to previous
results to detect trends should still be valid (see Section III below for such a
comparison).

B. Results

Capital Budgeting Techniques. Firms were asked which capital budgeting tech-
nique(s) (CBT's) they use: payback (PBK), accounting rate of return (ARR),
internal rate of return (IRR) or net present value (NPV). The results are shown in
Table 1. All but two respondents indicated use of at least one of these CBT's and
almost 86% of the firms use more than one of the CBT's, with 17% using all four.
The most popular CBT is PBK (used by 74% of the respondents), but only 2% use
it as the only CBT. ARR is used by 58% (4% as the only CBT), IRR by 65% (6% as
the only CBT), and NPV by 56% (2% as the only CBT). Over 86% of the
respondents use either IRR or NPV or both, but only 16% use one or both without
also using PBK or ARR.

TABLE 1

PERCENTAGE OF RESPONDENT FIRMS USING


EACH POSSIBLE COMBINATION OF CAPITAL
BUDGETING TECHNIQUES

Percentage of Firms
Models Used Using Models

PBK, ARR, IRR, NPV 17


PBK, ARR, IRR 14
PBK, ARR, NPV 9
PBK, IRR, NPV 9
ARR, IRR, NPV 2
PBK, ARR 8
PBK, IRR 8
PBK, NPV 7
IRR, NPV 7
ARR, NPV 4
ARR, IRR 2
IRR 6
ARR 4
NPV 2
PBK 2

101*

* Rounding error.

Nearly 41% of the respondents use capital budgeting techniques (CBT's) for all
investment decisions, while 59% use them for certain types of investment decisions.

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Survey and Analysis of Capital Budgeting Methods 283

The average firm uses CBT's for 82% of its investment decisions (based on dollar
value). Of the 37 firms that use CBT's only for large investments, the average
response was to restrict CBT's to investments over $100,000.
Calculation of the Discount Rate and Cash Flows. Of those responding firms
indicating that a discount rate is applied, 46% employ a weighted average cost of
capital (one-third of which use it in combination with another method or methods),
and only 8% use a risk-free rate plus a premium for their risk class. Seven of the
eleven firms using the latter also use other methods, with four of the seven firms
also using a weighted average cost of capital. The remaining 49% use a variety of
methods as indicated in Table 2.

TABLE 2

PERCENT OF THE 140 FIRMS THAT USE A DISCOUNT RATE USING EACH COST OF CAPITAL METHOD

Use Measure in
Use Measure Combination
Exclusively With Others Total % Using

Cost of Debt 7% 10% 17%

Cost of Equity Capital 1 8 9

Weighted Average Cost


of Capital 31 16 46*

A Measure Based Upon


Past Experience 14 6 20

Expectations With Respect to


Growth and Dividend Payout 8 9 17

Return From a Risk-free


Asset Plus a Premium
Associated with the Risk
Class 3 5 8

Another Rate 12 4 16

* Does not add due to ro

An after-tax discount rate applied to after-tax cash flows is used by 88% of the
firms responding to this question. The other 12% use both pre-tax cash flows and a
pre-tax discount rate. A numerical value for the discount rate was given by 76
firms. For 69 firms that use an after-tax rate, the average rate is 11.4% with a
distribution as shown in Table 3. For 7 firms that use a before-tax rate the average
rate is 14.3%.1
The most common method of predicting cash flow is to first predict net income

1. The correlation of the cost of capital rate with the firm's beta value is .10 (and with the firm's
standard deviation of market return is .03) for the 69 firms using an after tax rate. The 7 firms using a
before tax rate provide too small a sample for such a correlation to be meaningful.

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284 The Journal of Finance

TABLE 3

DISTRIBUTION OF COST OF CAPITAL FOR THE 69 FIRMs USING


AN AFTER TAX COST OF CAPITAL

Number Percentage
Percentage Cost of Capital of Firms of Firms

7.0-7.9 3 4

8.0-8.9 3 4

9.0-9.9 2 3

10.0-10.9 30 43

11.0-11.9 4 6

12.0-12.9 11 16

13.0-13.9 0 0

14.0-14.9 5 7

15.0-15.9 8 12

16.0-16.9 2 3

17.0+ 1 1

69 99*

* Rounding error.

and then adjust this for non-cash flow items such as depreciation (this method is
used by 62% of the 135 firms responding to this question). Only 7% indicated that
they used net income directly, while 18% predict cash inflows and outflows directly.
The remaining 13% use various different methods.
Risk Assessment. Over 36% of the responding firms use a quantitative assess-
ment of risk, only 4% do not assess risk, and the remaining 60% assess risk only
subjectively. Projects are assigned to risk classes by 23% of the respondent firms
and the remaining 77% of firms do not use risk class assignment. Different CBT's
are used for different classes of risk by 19% of respondent firms whereas 81% use
the same set of CBT's for all projects.
Individual project risk is assessed by means of a probability distribution of cash
flow by 25% of the respondent firms and by sensitivity analysis by an additional
10%.2 Only 4% of the respondents calculate the covariance of a project's cash flow
with the cash flows of other projects. Over 57% of the firms either ignore risk or
assess project riskiness based only on a subjective evaluation.

2. Sensitivity analysis was not one of the listed responses for the questions. These firms checked the
response "other (please explain)" and indicated that they use sensitivity analysis. Therefore, use of
sensitivity analysis may be understated here.

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Survey and Analysis of Capital Budgeting Methods 285

Most firms (78% of the respondents), even those that assess individual project
risk subjectively, have an explicit adjustment in their capital budgeting techniques
to account for risk. Of the 143 firms responding to the question about how they
take risk into account, 90% raise the required rate of return or the discount rate.
Just over 10% of the 143 firms use a shortened payback period as their only risk
adjustment, while 31% combine shortening of the payback period with an adjust-
ment of the required rate of return. Of the 120 firms that use PBK together with
either IRR or NPV (or both) as CBT's, 8% adjust only the required payback
period, 42% adjust only the required rate of return, 32% adjust both, and 18%
adjust neither.

III. ANALYSIS OF RESULTS

The results of this survey indicate the increasing sophistication in capital budgeting
techniques pointed out by Klammer [3] and confirmed by Fremgren [1]. While
Klammer found only 57% of the firms using discounting methods (IRR or NPV) in
1970, we found that in our sample (of possibly slightly larger firms) 86% use IRR or
NPV. Our results are quite similar to those of Fremgren, but his paper does not
disclose enough data for a direct comparison.3
Risk analysis is also becoming more sophisticated. Klammer [3, p. 391] reported
that 39% of the firms "were using some specific formal method" for dealing with
risk. Fremgren [1, p. 22] reported that "sixty-seven percent... considered risk and
uncertainty explicitly in the analysis of capital investment proposals." We found
that 78% of the firms adjust the capital budgeting techniques for risk by shortening
the payback period, raising the required rate of return, or raising the discount rate
in computing present value. Further, we find more firms raising the required rate of
return or discount rate than did Fremgren.
Despite the increase in sophistication in capital budgeting techniques employed,
there remains a wide variation in sophistication among firms. As a final analysis,
we attempted to identify some firm characteristics that might be associated with
added sophistication in capital budgeting techniques. We selected size and risk as
the characteristics to be examined, and we used several surrogates of each.4 Results
indicated that larger firms use more sophisticated techniques, but correlation of
size and each of several measures of sophistication never exceeded .19. Therefore,
the association is statistically significant but of only minor explanatory signifi-
cance. There is also a slight tendency for market assessed risk (beta value) to be
negatively associated with sophistication, especially sophistication in risk assess-
ment techniques. Measures of total risk (standard deviation of market return,

3. Fremgren [1] indicates that 78% of the firms use IRR and 34% use NPV (compared to 64% and
56%, respectively, in our survey), but he does not indicate how many firms use both methods.
4. Size was represented by net plant and average capital expenditure over five years; risk surrogates
were beta value, standard deviation of quarterly market return, standard deviation of quarterly
accounting return, and standard deviation of normalized quarterly net income around a trend line;
sophistication variables were percent of capital investments for which capital budgeting techniques are
used, capital budgeting technique used, whether risk is explicitly assessed, whether risk classes are used,
method of risk class assignment, and method of determining cost of capital. For more details see Schall
and Sundem [4].

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286 The Journal of Finance

accounting return, or net income) were generally less stable than the beta value in
their association with sophistication variables, with some negative and some
positive associations, none of which were very large. In general, the firm economic
variables were not highly associated with capital budgeting sophistication.

IV. CONCLUSIONS

The trend toward use of more sophisticated capital budgeting techniques continues,
with this survey indicating that 86% of the sample firms use discounted cash flow
methods, most of them combining this with a payback or accounting rate of return
analysis. The most common method of determining a required rate of return is to
use an after-tax weighted average cost of capital. Project risk is usually assessed
subjectively, and most firms require a higher rate of return for more risky projects.
There is slight evidence within this sample that the level of sophistication in capital
budgeting methods is positively related to the size of the firm's capital budget and
negatively related to the firm's beta value.

APPENDIX: SURVEY QUESTIONNAIRE AND RESPONSES5

1. For what investment decisions do you use capital budgeting techniques:


77 All
74 For certain types
37 For investments over $100,2976
1 None
2. For what percentage of total corporate capital investment expenditures are
capital budgeting techniques applied (based on dollar values)?
82.3%6
3. What form do these capital budgeting techniques take? Check all applicable.
138 Payback
109 Average accounting rate of return (either before or after taxes)
121 Minimum rate of discounted cash flow (internal rate of return)
105 Discounted present value of cash flow
1 Ignored the question
4. If you use a method requiring discounted cash flows, what do you use as
your cost of capital rate (discount rate)?
47 Not applicable
24 Cost of debt
12 Cost of equity capital
65 Weighted average cost of capital
28 A measure based upon past experience
24 Expectations with respect to growth and dividend payout

5. In many cases, a respondent checked more than one answer to a question or completely ignored a
question. For those questions for which more than one answer could be given by a respondent, the
number of respondents ignoring the question entirely is indicated; otherwise, it is not indicated.
Questions requiring an explanation rather than merely checking a box are omitted here.
6. Average for respondents providing a figure.

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Survey and Analysis of Capital Budgeting Methods 287

11 Return from a risk-free asset plus a premium associated with your risk
class
23 Another rate
2 Ignored the question
5. What is the numerical value of your cost of capital rate?
If after-tax rate 11.4%76 If pre-tax rate 14.3%o6
6. Is your required rate of return or cost of capital a: 20 pre-tax or 147 post-tax
return on investment?
7. How do you compute the cash flow that you analyze using your required
rate (or cost of capital) on investment (i.e., how do you define cash flow)? Is
this cash flow a 19 pre-tax or a 144 post-tax flow?
8. How do you assess risk in investment decisions?
66 Risk is quantified on an individual project basis
128 Risk is assessed subjectively
8 Risk is not assessed
8 Ignored this question
9. Do you assign projects to risk categories that are treated differently in the
capital budgeting process? 42 Yes 138 No
If yes, what categories?
10. Do you use different types of capital budgeting techniques for different
classes of risk? 33 Yes 143 No
11. What do you use as the basis for determining the risk of a project
11 Ignore risk and use single standard for all projects
138 Assessment of project riskiness based on subjective evaluation
43 Probability distribution of project's cash flow
7 Covariance of project's cash flow with cash flows of other projects
20 Probability of loss
27 Other, please explain
9 Ignored the question
12. How do you take risk into account in capital budgeting techniques?
59 Shortening the required payback period
118 Raising the required rate of return
30 Raising the discount rate in computing present value
40 None of the above
6 Ignored the question

REFERENCES

1. J. A. Fremgren. "Capital Budgeting Practices: A Survey," Management Accountin


19-25.
2. D. F. Istvan. "The Economic Evaluation of Capital Expenditures," Journal of Business, (January
1961), pp. 45-51.
3. T. Klammer. "Empirical Evidence of the Adoption of Sophisticated Capital Budgeting Techniques,"
Journal of Business, (October 1972), pp. 387-397.
4. Lawrence D. Schall and Gary L. Sundem. "Capital Budgeting Techniques and Firm Economic
Variables." Unpublished paper, University of Washington, 1977.

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