Empirical Evidence of the Adoption of Sophisticated Capital Budgeting TechniquesAuthor(s): Thomas KlammerSource: The Journal of Business, Vol. 45, No. 3 (Jul., 1972), pp. 387-397Published by: The University of Chicago PressStable URL: http://www.jstor.org/stable/2351494Accessed: 05/11/2009 08:57

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Thomas Klammer*

Empirical Evidence of the Adoption of Sophisticated Capital Budgeting Techniques

Previous research into capital budgeting procedures has usually shown the following picture. At any one time, at least some theorists and schol- ars are advocating relatively sophisticated capital budgeting methods. These methods are being used or seriously considered by a small number of firms, mostly large and in industries with high investment rates and rapid changes. Most remaining firms are relying on methods which are simpler and theoretically less satisfactory, although there may be con- siderable sophistication in the way in which individual practitioners apply formally simple capital budgeting methods.' For example, in the late 1950s theorists were advocating rate of return as a measure of an in- vestment's worth, but this method tended to be in actual use only in some of the larger oil, chemical, and automotive products companies, while the majority of firms used relatively simple and formally unsatis- factory methods, such as payback.

In recent years, leading theorists have gone beyond rate of return, have attempted to deal more explicitly with the existence of risk, and have suggested a variety of applications of management science or op- erations research techniques to capital budgeting problems. Have there been similar changes in the practices of business firms? This paper re- ports on a survey aimed at answering this and related questions for large manufacturing firms in 1970.

SURVEY PROCEDURE

Sample The sample was drawn from the 1969 Compustat listing of manufactur- ing firms.2 Firms in this list were omitted if they did not meet the follow- ing requirements: (a) The Compustat listing contained at least fifteen firms in the same major Standard Industrial Classification grouping (e.g., SIC no. 20, Food and Kindred Products). (b) The Compustat listing showed at least five firms in the same SIC subclassification (e.g., SIC no. 2082, Malt Liquors). (c) The firm made at least $1 million of capi-

* Assistant professor of business administration, North Texas State Univer- sity.

1. See, for example, George A. Christy, Capital Budgeting-Current Prac- tices and Their Efficiency (Eugene: Bureau of Business and Economic Research, University of Oregon, 1966).

2. Compustat is a magnetic tape library containing financial information for over 1,000 companies, including 678 manufacturing firms in 1969. These represent the major New York, American, over-the-counter, and regional stock exchange companies. Compustat is a service of Standard Statistics Company of New York.

387

388 The Journal of Business

tal expenditures in each of the five years 1963-67 as determined from the Compustat breakdown of capital expenditures.

These selection rules produced a sample of 369 rather large firms with sizable and continuing capital expenditure programs. Such firms would be expected to make relatively heavy use of the more sophisticated capital budgeting techniques covered in the survey questionnaire, as compared will all firms on the Compustat list.

Response Rates The 369 firms were surveyed by mail in the first part of 1970. One hundred eighty-four firms, about half of those surveyed, returned ques- tionnaires with some usable data. Table 1 shows the two-digit SIC classification of firms in the sample and of firms responding.

Table 1 Sample Size and Response Rates by Industry

Response SIC No. and Firms in Responses Rate

Industry Sample Received (%)

20. Food and Kindred Products .4 5 .. 45 21 46.7 22. Textile Mill Products . 1 6 .. 16 4 25.0 26. Paper and Allied Products .2 0 .. 20 9 45.0 27. Printing, Publishing, and Allied

Products .......................... 8 2 25.0 28. Chemicals and Allied Products ..... .... 72 40 55.6 29. Petroleum Refining and Related

Industries ........... .............. 31 21 67.7 32. Stone, Clay, Glass, and Concrete

Products ............ .............. 17 6 35.3 33. Primary Metal Industries ...... ........ 20 10 50.0 34. Fabricated Metal Products, except

Ordinance, Machinery, and Transportation Equipment ..... ...... 17 7 41.1

35. Machinery, except Electrical ..... ...... 45 23 51.1 36. Electrical Machinery, Equipment,

and Supplies .......... ............. 43 20 46.5 37. Transportation Equipment ...... ....... 35 21 60.0

Total ................................. 369 184 49.9

Measures of size and capital intensity were calculated for both re- sponding and nonresponding firms. The response rate was higher for larger and more capital-intense firms.3 Also, the response rate seemed to be higher for those industries that are subject to more rapid changes in technology and/or capital needs, such as chemicals, petroleum, and transportation equipment. Overall, it appears that firms that have found the greatest need for capital budgeting and therefore have the greatest

3. Size is based on the average operating assets for an eight-year period, 1961-68. Capital intensity is the yearly depreciation divided by the yearly oper- ating assets for each of the eight years 1961-68. The larger this ratio, the higher the capital intensity of the firm.

389 Empirical Evidence of Budgeting Techniques

interest in the practices of other firms were most likely to respond. The bias which this introduces in the results appears to be in the same direc- tion as that already inherent in the sample: toward more use of sophis- ticated methods.

Questionnaire All but one of the questions asked for yes-no or multiple-choice re- sponses. Respondents were asked whether they used each of five specific administrative procedures, four specific methods of appraising risk (with an additional open-end question to cover any other method used), and eight management science techniques. Additional questions covered the proportion of projects for which profitability estimates were made and the use and nature of minimum profitability standards, both primary and secondary. The questions and summaries of the numerical responses appear in the Appendix.

Respondents were asked to answer each question for each of three time periods: the present, 1964, and 1959. There was a clear tendency for respondents to give less information for the earlier periods.

ANALYSIS OF RESULTS

In analyzing the results, I found that a major question is how to make use of the industry detail available. One might speculate that the sam- ple design and the pattern of nonresponses would act to eliminate most of the potential interindustry differences, and this appears to be the case. In the absence of strong hypotheses about the nature of industry dif- ferences, x2 tests were performed on the responses to individual ques- tions by industry. The mixed results, shown in table 2, do not provide strong justification for more elaborate analysis by industry. Accordingly, the analysis which follows will present and comment on the industry detail only where it seemed especially appropriate.

Table 2 Significance of Differences in the Use of Capital Budgeting Techniques By Industry

Significance Industry and the Use of: * Levelt

Long-range capital budgeting ....... .......... 5.74 .45 Postauditing ................ ............... 5.46 .45 Full-time capital budgeting staff ...... ......... 9.38 .15 Formal method of considering risk ..... ....... 12.84 .05 Management science techniques ...... ......... 10.96 .10 Required profit rate-percentage of investments

meeting . ................................ 11.74 .08 Payback ................................... 4.76 .60 Accounting rate of return ....... ............. 7.51 .30 Discounting ................................ 5.27 .50

* The number of firms using and not using a technique was broken down for each in- dustry with ten or more responses and a X2 calculated. The results of each of these X2s are reported in this table.

t Significance at this level or greater based on six degrees of freedom.

390 The Journal of Business

Administrative Techniques Five questions covered techniques which the literature frequently em- phasizes in discussions of desirable capital budgeting systems. The per- centage responses are summarized in table 3.

Table 3 Administrative Techniques Used

Percentage Using In: *

Technique 1970 1964 1959

Search for alternative investments ...... 94 87 82 Formal long-range capital budget ...... 69 57 43 Postaudits of major projects .88...... 61 50 Standard forms for expenditure requests 97..... 90 84 Full-time capital budgeting staff .56...... 51 45

* Percentages shown are yes divided by yes + no multiplied by 100, disregarding non- responses. Nonresponse rates were higher for earlier years. For these five questions, yes + no answers ranged from 181 to 184 for 1970. For 1964 the corresponding range was 150-55 re- spondents, and for 1959 it was 137-48.

Usage of all of these techniques has been growing and is now high for most of them. Departures from 100 percent usage might be best ex- plained as a result of careful reading of the question. It is hard to imagine a respondent making no effort to search for alternative investments at some point in the evaluation procedure, or having no long-range capital budgeting plan, but the questions may have put such emphasis on the formality with which these activities were conducted that some respon- dents answered negatively. The low reported usage of a full-time capital budgeting staff, reported as used by only a little more than half of the respondents, can only mean that some amount of financial, engineering, or other duties are often performed by even the most specialized indi- viduals performing the capital budgeting function. This type of organi- zation may well be consistent with a large and well-conducted capital budgeting activity. It does not, however seem to give unqualified sup- port to Terborgh's 1967 statement that most firms had specialized staffs.4

In general, the usage rates reported here for earlier periods are consistent with the findings of Istvan,5 Pflomn,6 and Terborgh7 on the use of standard forms and postaudits.

4. George Terborgh, Business Investment Management (Washington, D.C.: Machinery and Allied Products Institute and Council for Technological Advance- ment, 1967), p. xx.

5. Donald F. Istvan, Capital Expenditure Decisions: How They Are Made in Large Corporations (Bloomington: Bureau of Business Research, Indiana Uni- versity, 1961), p. 29.

6. Norman P. Pflomn, Managing Capital Expenditures, Studies in Business Policy 107 (New York: National Industrial Conference Board, 1963), p. 30.

7. Terborgh, p. xx.

391 Empirical Evidence of Budgeting Techniques

A relationship appears to exist between the presence of a full-time staff and the use of a formal long-range capital budget. A x2 test showed less than a 5 percent chance of this relationship occurring by chance.8 One might explain this association by pointing out that a full-time staff is more likely to have the time, opportunity, ability, and interest to main- tain a long-range capital budget.

Risk Analysis It is likely that nearly every firm has some method of dealing with risk, but only 39 percent of the respondents said they were using some spe- cific formal method. Table 4 summarizes the percentage responses to

Table 4 Risk Analysis Techniques

Percentage Using In: *

Technique 1970 1964 1959

Raising required return ........ ............ 21 16 12 Shortening payback period ....... .......... 10 9 9 Determining probability distribution ......... 13 7 7 Measuring covariance of projects ..... ...... 3 2 1 Other ............... ................... 7 2 1 At least one of above ........ ............. 39 24 19 Two or more of above ........ ............ 14 7 5 Three or more of above ....... ............ 5 3 1

* Percentages shown are yes divided by yes + no multiplied by 100.

the questions on risk analysis. Many firms which did report using a formal method tended to use more than one. In addition, some of the management science techniques covered in the next section undoubtedly included risk appraisal features, although the questions were not asked in such a way as to permit determination of a nonduplicating total of firms using at least one management science or other formal method of risk analysis. If we make the relatively conservative assumption that all firms reporting the use of probability theory are making formal risk analyses, ignoring the possibility that some of the other management science techniques are being used for the same purpose, the nondupli- cating total of table 4 becomes 45 percent of respondents using some formal risk analysis method.9

Industry groups responded differently to the risk questions. Over 70 percent of firms in Petroleum Refining and over 50 percent of those in Chemicals reported using at least one method. In the remaining indus- try groups, less than 40 percent of the firms did so.

8. A series of X2 tests was made comparing the usage and nonusage of two capital budgeting techniques. These tests were designed to test the association of individual techniques.

9. A x2 test indicates that there is a strong relationship between risk analysis and management science techniques.

392 The Journal of Business

Management Science Techniques Out of the many techniques associated with the approaches of manage- ment science and operations research, the questionnaire asked about eight. Percentage responses are summarized in table 5. Again, firms re-

Table 5 Management Science Techniques Used

Percentage Using In: *

Technique 1970 1964 1959

Game theory ............... ............. 3 2 0 Linear programming ......... ............. 17 8 5 Nonlinear programming ........ ........... 4 3 1 Computer simulation ......... ............. 28 7 4 Probability theory ...................... 32 8 5 Decision theory ............ .............. 9 4 3 Per/critical path ............ ............. 28 13 4 Utility theory .............. ............. 4 1 0 At least one of the above ....... ........... 51 22 13 Two or more of the above ................. 32 11 7 Three or more of the above ....... ......... 21 4 3

* Percentages shown are yes divided by responding firms multiplied by 100, disregarding nonresponse. For this question, total responding firms are 184 in 1970, 157 in 1964, and 149 in 1959.

porting any use often report the use of several of these techniques. And once again, firms in the Petroleum Refining industry reported the heaviest use: 85 percent of such firms say they used one or more of these methods. No other industry group reported usage greater than the all-industry average.

Project Evaluation Methods Two questions covered the proportion of projects for which profit con- tribution estimates were made and on which minimum profitability standards were imposed. Recognizing that considerations of cost and the value of information would lead a sophisticated firm to avoid these pro- cedures for some sorts of projects, it still seems likely that movement away from the lowest and toward the highest proportions indicates in- creased sophistication during the period covered by this survey. The results, as reported in table 6, show such movement. Even among the relatively sophisticated respondents of this survey, however, it remains true that about a quarter of the firms say they make profitability esti- mates for a quarter or less of their capital outlays and nearly a tenth say they impose minimum profitability standards on only a few of their proposals.

Respondents cited a variety of projects as not subject to estimates of profit contribution. Most frequently, these were governmentally re- quired projects such as those for safety or pollution control, replacement

393 Empirical Evidence of Budgeting Techniques

proposals, particularly in emergencies, and projects for employee morale, such as paving parking lots and the purchase of newer office furniture.

Lumping respondents who said that "most" and "some" projects had to meet minimum profitability requirements in 1964, we obtain re- sults that are very similar to those obtained by Christy.10

When asked to designate their primary standard of project evalu- ation, a number of firms gave more than one answer. The percentages given in the lowest section of table 6 count only the most sophisticated

Table 6 Project Evaluation Techniques

Percentage Using In: *

Technique 1970 1964 1959

profit contribution analysis required: For over 75% of projects ...... ......... 53 53 50 For 25%-75% of projects ...... ......... 41 40 34 For less than 25% of projects ...... ...... 6 7 16

Total ............ ................... 100 100 100 Minimum profitability standards required:

For most projects ......... ............. 77 65 58 For some projects ......... ............. 13 23 20 For few projects ......... .............. 10 12 22

Total ............ ................... 100 100 100 Most sophisticated primary evaluation standard:

Discounting (rate of return or present worth) ............... .............. 57 38 19

Accounting rate of return ....... ......... 26 30 34 Payback or payback reciprocal ..... ...... 12 24 34 Urgency ................ .............. 5 8 13

Total ............ ................... 100 100 100

* Percentages shown are yes divided by yes + no multiplied by 100.

method designated by each respondent, where "Urgency" is taken as the least sophisticated and any discounted net cash flow method is taken as the most sophisticated. The results show a clear majority using dis- counting methods in 1970.

The method of eliminating multiple answers entails an obvious bias in the direction of more sophisticated standards. For the current period, about one-third of the firms reporting the use of discounting as their most sophisticated primary method reported that they used more than one primary method. Furthermore, an additional 25 percent of the firms that used discounting as a primary method reported use of some nondiscounting method as a secondary standard. Thus, only about 25 percent of the respondents say they are using discounting standards ex- clusively, although 67 percent make some use of discounting methods.

10. Christy, p. 12.

394 The Journal of Business

Beyond all this, one can make no further statement, from these data, about how and to what extent firms use any of these techniques.

Even with the bias just discussed, it is clear that use of one or the other of the discounted cash flow methods has been gaining over time and that payback methods have been declining in popularity. Previous surveys usually showed payback as the most widely used standard." This is not strongly contradicted by the present survey responses for the two earlier periods, when we consider sample differences, normal errors of recall of earlier periods, and our method of eliminating multiple an- swers. The advanced theory of the 1950s has increasingly become the practice of the early 1970s.

11. Ibid.

395 Empirical Evidence of Budgeting Techniques

APPENDIX

No. of Respondents

Questions and Answers Current 1964 1959

Administrative Techniques

Are alternatives to major investment pro- posals specifically searched for and con- sidered?

Yes ............................. 171 130 112 No ........... .................. 10 20 25 NR* ............................. 3 34 47

Is a long-range capital budget formally pre- pared?

Yes ............................. 126 86 60 No ............................. 57 65 79 NR ........... .................. 1 33 45

Does your firm carry out postaudits of major projects?

Yes ............................. 162 92 71 No ............................. 22 60 71 NR ........... .................. 0 32 42

Are standard forms generally used for bud- get and appropriation requests?

Yes ............................. 177 141 124 No ........... .................. 6 15 24 NR ........... .................. 1 28 36

Is at least one member of your staff as- signed full time to capital budgeting?

Yes ............................. 103 78 64 No ............................. 81 76 79 NR ............................. 0 30 41

Newer Techniques

Does your firm have a formal method of considering risk?

Yes ............................. 71 36 26 No ............................. 112 113 111 NR ........... .................. 1 35 47

What method is used? a) Raising the required return ....... 38 24 17 b) Shortening payback period ....... 18 13 12 c) Determining probability

distribution ....... ........... 33 11 9 d) Measuring covariance of projects . . 5 3 1 e) Other ........................ 13 3 1

* NR = no response.

AP P ENDIX (Continued)

No. of Respondents

Questions and Answers Current 1964 1959

Newer Techniques

Management science techniques: a) Game theory ....... ........... 6 3 0 b) Linear programming ..... ....... 31 13 7 c) Nonlinear programming ..... ..... 8 4 2 d) Computer simulation ..... ....... 51 11 4 e) Probability theory ...... ........ 58 13 8 I) Decision theory ....... ......... 17 7 4 g) Pert/critical path ...... ......... 51 20 6 h) Utility theory ....... ........... 7 1 0

Project Evaluation Techniques

What is the approximate percentage (based on dollar value) of capital projects for which your firm makes an estimate of profit contribution?

100 ............................. 21 16 15 75-100 ............ ............. 72 62 45 50-75 .............. ............ 57 41 30 25-50 .............. ............ 16 19 11 0-25 .............. ............ 10 10 20

NR ............................. 8 36 63

Does your company require proposals for capital investment to meet minimum standards of profitability?

Most ............................. 140 103 85 Some ............................. 24 36 29 Few ............................. 17 20 33 NR .............................. 3 25 37

What form does your primary standard take?t

Urgency ..............5........... 5 8 13 Payback-before tax ...... ......... 26 24 25 Payback-after tax ...... .......... 34 27 25 Payback reciprocal-before tax ....2 2 2 Payback reciprocal-after tax ....... 4 3 3 Average accounting rate of return-on

total investment before tax ..... ... 26 19 20 Average accounting rate of return-on

total investment after tax ..... .... 27 23 23 Average accounting rate on return-on

average investment before tax ...... 8 3 3 Average accounting rate of return-on

average investment after tax ....... 11 7 6 Minimum rate of discounted cash flow . - 55 32 14 Discounted present value of cash flow . . 53 27 10

t Some respondents indicated more than one primary standard.

397 Empirical Evidence of Budgeting Techniques

A P P E NDIX (Continued)

No. of Respondents

Questions and Answers Current 1964 1959

Project Evaluation Techniques

What form does your secondary standard take?t

Urgency ............. ............ 11 6 6 Payback-before tax ...... ......... 12 8 6 Payback-after tax ....... ......... 35 24 21 Payback reciprocal-before tax ...... 0 0 0 Payback reciprocal-after tax ....... 1 1 1 Average accounting rate of return:

On total investment before tax 2 3 2 On total investment after tax ...... 8 6 1 On average investment before tax 4 2 1 On average investment after tax . 6 5 3

Minimum rate of discounted cash flow 11 3 2 Discounted present value of cash flow . . 13 6 4

t Some respondents indicated more than one secondary standard.