Capital Investment 5Sources of Finance for the Proposed .docx

Capital Investment 5
Sources of Finance for the Proposed CI Project and the Gap
between the Theory and Practice of Capital Budgeting
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Introduction Comment by Ufuk Misirlioglu: No need along
introduction, and add a very limited contribution.
Capital budgeting is one of the key processes businesses use to
determine the potential of projects succeeding or failing to
recuperate the initial financial investments. The process is very
critical when large companies want to expand or introduce huge
assets, which probably require colossal amounts of first cash
investment as well as maintenance. These investments and
projects can range from constructing massive new production

plants to other long-term schemes. In such instances, business
capital investment managers often spend a significant amount of
time assessing the new project’s prospective lifetime success,
including the cash outflows and inflows. This investment
appraisal process is important in evaluating whether the
potential outcomes or revenues generated can meet the target
benchmark.
After achieving a successful capital budgeting plan, it is critical
that a firm evaluates its prospective financial sources to fund
the proposed projects. For example, based on its financial
position, the projected amount of investment capital, and the
repayment duration, an organization can either opt for a bank
loan or sells its equity to other potential investors. That being
said, Foster Construction Ltd needs to assess a wide range of
possible financiers to support the purchase of the new ALII.
This paper, therefore, mainly discusses some of these capital
financing proposals the company can explore, with the last
section detailing the existing gap between theory and practice of
capital budgeting.
Discussion
A. Sources of Finance for the Proposed CI Project
Foster is a reputable company and boasts of a sizeable annual
revenue-meaning that the firm cannot struggle to pay its debts.
We truly have quite a range of options that can assist us to fund
the new ALII capital project as a private firm. The following
are some of the two most viable financial alternatives for the
organization:
Firstly, I propose we obtain a short-term loan, probably payable
within four years, from a renowned financial institution or
commercial bank. I strongly believe a short-term loan can assist
the Foster Construction Ltd to buy and maintain the modern
ALII crane and restore the old one for the next four years.

However, there are critical factors that must be considered
before identifying the right financier and the amount we can
apply. Current and projected inflation rates in the country will
definitely play a central role. We must also consider the interest
rates offered by each particular organization to determine the
lowest repayable amount within the four years. Comment by
Ufuk Misirlioglu: Mismatch. Comment by Ufuk Misirlioglu:
This is not a short-term. Comment by Ufuk Misirlioglu: What
does it mean exactly?
Obtaining a loan, which is a form of debt financing, is the most
preferred option since the company will not give up its business
ownership in terms of equity for funding. Another main benefit
is that the loan the company will borrow is potentially subject
to tax deductions because it is classified as a business expense.
Thus, the interest and principal payment may all be subtracted
from the firm’s income taxes. However, some of the drawbacks
associated with debt financing range from the potential of
facing high-interest rates, a possibility of failing to meet the
deadline agreed upon by the lender perhaps if the investment
does not succeed, and the chances of the loan affecting the
company’s credit rating. Considering our annual revenues and
financial performance, I believe Foster Construction Ltd can
never fail to repay the loan in a span of four years (Gower,
2012, p. 44). Comment by Ufuk Misirlioglu: Why?
Comment by Ufuk Misirlioglu: Evidence? Comment by
Ufuk Misirlioglu: What is it for?
Secondly, if the owners opt not to obtain a loan perhaps because
of the significantly higher interest rates, I believe issuing the
company’s equity shares to private investors or the public can
assist raise the funds. Without question, FCL is a large and
renowned private company. I truly think the organization can
decide to go big and global in January by issuing an initial
public offer (IPO) for the public to purchase some of its shares.
Besides giving Foster the required financial muscle to expand
and purchase modern equipment, issuing an IPO is a critical
marketing plan that can familiarize the firm with potential

customers. On the downside, enlisting the firm as an IPO can
result in equity dilution and loss of management control (Baker,
Filbeck, & Kiymaz, 2015, p. 220). Comment by Ufuk
Misirlioglu: ? Comment by Ufuk Misirlioglu: ? Comment by
Ufuk Misirlioglu: ?
B. The Gap between Theory and Practice of Capital Budgeting
Today, there is no doubt that there exists a huge gap between
the theoretical aspect and the practical implementation of
capital budgeting concepts and techniques. Theoretically,
capital budgeting methods are identified as crucial techniques
firms can use to authorize capital spending, especially on long-
term projects. As AlKulaib, Al-Jassar, & Al-Saad (2016, p.
1273) note, capital budgeting experts must apply both
qualitative and quantitative methods to appraise the viability of
their projects. Most essentially, capital investment decision-
making implies that managers should establish the expected
value that a project is expected to create effective capital
budgeting requires the use of exquisite and all-inclusive
techniques, including the discounted payback periods (DPP), the
payback periods (PP), the net present value (NPV), the modified
rate of return (MIRR), and the internal rate of return (IRR).
Therefore, a project is only approved or termed viable if it
exceeds all these hurdles or requirements. But, as AlKulaib, Al-
Jassar, & Al-Saad (2016, p. 1273) note, the theoretical
requirement of capital budgeting is never reflected in practice.
For example, most companies mistakenly use cash outflows and
inflows as opposed to net income, while others occasionally
compute cash flow using amortization and depreciation plus net
income. Comment by Ufuk Misirlioglu: What does it mean
exactly? Comment by Ufuk Misirlioglu: What are they?
Comment by Ufuk Misirlioglu: Theory or practice?
Comment by Ufuk Misirlioglu: ? Comment by Ufuk
Misirlioglu: What are they? And why? Comment by Ufuk
Misirlioglu: Why are they important for capital budgeting?
Conclusion Comment by Ufuk Misirlioglu: ?
In summary, it can be deduced that capital budgeting is

very fundamental to the implementation of capital investments,
playing a central role in the identification of viable long-term
projects. Drawing from this benefit, Foster Construction Ltd
cannot negate the impact of capital budgeting in assessing the
potential financial impact of purchasing a modern ALII crane.
However, from the discussion, it is clear that getting the right
funding source for any organization is a major problem, with
companies often forced to make several crucial considerations.
For that matter, Foster Construction Ltd has two main sources
of capital financing for the purchase of ALII. The first one is
applying for a loan from a financial institution like a bank. The
second involves issuing the firm’s equity shares to private
investors or the public.
References
1. AlKulaib, Y. A., Al-Jassar, S. A., & Al-Saad, K., 2016.
Theory and Practice in Capital Budgeting: Evidence from
Kuwait. The Journal of Applied Business Research, 32(4), pp.
1273-1886.
2. Arnold, G. and D. Hatzopoulos, P. (2000). The Theory-
Practice Gap in CapitalBudgeting: Evidence from theUnited
Kingdom Comment by Ufuk Misirlioglu: Is it used in the main
text?

3. Baker, K., Filbeck, G., & Kiymaz, H., 2015. Private Equity:
Opportunities and Risks. Oxford: Oxford University Press.
4. Chittenden, F. and Derregia, M. (2015). Uncertainty,
irreversibility and the use of ‘rules of thumb’ in capital
budgeting Comment by Ufuk Misirlioglu: Not in the text?
5. Gilbert, E. 1999. An Investigation into Uncertainty and the
Capital Investment Decisions of Manufacturing Firms in South
Africa. University of Cambridge: unpublished PhD thesis.
6. Gilbert, E. 2003. Do managers of South African
manufacturing firms make optimal capital investment
decisions? South African Journal of Business Management.
Comment by Ufuk Misirlioglu: No, it was published in
2005.
7. Morrison, R., 2012. The Principle of Project Finance. Gower
Publishing Ltd.
UMADNJ-30-M Fundamentals of Accounting and Finance
INDIVIDUAL REPORT (CW2) - Feedback to PG Students
2018/19
Feedback From: IUM
Date: January 2019
Total Marks
42
Strengths of this assignment are:
The report provides a limited discussion on the issues.
Main ways to improve this assignment are:
The first part provides some weak discussion on the issues.
There is also mismatching (a short term loan for a long term
asset) and incorrect definition (e.g. a four-year loan payable in
the short run). In order to improve this part, the report should
clearly discuss a variety of finance forms for a non-current
asset.
The second part provides a short discussion, but not very much
focused to the gap between theory and practice. The report
should evaluate the techniques used in practice and compare

them with theory. A review of A review of the recommended
articles would be useful for further improvements. Also more
care needs to be taken in the reference list as some references
are not available in the main body of the report. Further, the
report should give more weight to the required issues rather
than the introduction.
More feedback comments are provided in the annotated
assignment.
The British Accounting Review 47 (2015) 225–236
Contents lists available at ScienceDirect
The British Accounting Review
journal homepage: www.elsevier.com/locate/bar
Uncertainty, irreversibility and the use of ‘rules of thumb’ in
capital budgeting
Francis Chittenden a, Mohsen Derregia b,*
a Manchester Business School, Harold Hankins Building, Booth
Street West, Manchester M13 9PL, UK
b Libyan Investment Authority, 22nd Floor Tripoli Tower,
Tripoli, Libya
a r t i c l e i n f o
Article history:
Available online 21 December 2013
Keywords:
Capital budgeting
Real options
Uncertainty
Irreversibility
* Corresponding author.
E-mail address: [email protected] (M. Derregia).

0890-8389/$ – see front matter � 2013 Published b
http://dx.doi.org/10.1016/j.bar.2013.12.003
a b s t r a c t
Numerous studies of capital budgeting practice report continued
use of simple techniques to
evaluate decisions, a result that appears at odds with theory.
Some theoretical de-
velopments in the real options literature that highlight the
influence of uncertainty and
irreversibility on capital budgeting, however, suggest that these
techniques may be used as
proxies for more complex and theoretically correct evaluation.
We survey the use of simple
capital budgeting techniques to capture the effect of uncertainty
and irreversibility on
capital budgeting decisions in practice. We find that firms
adjust payback time and discount
rates in the presence of uncertainty and irreversibility and delay
investment decisions. We
also find that there are variations in responses received from
firms by size, sector, and
ownership. While most small and large firms find demand
uncertainty important in
delaying decisions, small firms find interest rate uncertainty
significantly more important
than large firms. Further, listed firms delay capital budgeting
decisions less frequently than
other firms. Irreversibility also affects the value of the option to
abandon and the option to
expand, and firms value flexibility, reversibility and first mover
advantages.
� 2013 Published by Elsevier Ltd.
1. Introduction

The practical application of capital budgeting techniques is
often seen as inconsistent with theoretical recommendations,
and is characterised by the use of payback (PB) along with
discounted cash flow (DCF) techniques and the adjustment of
discount rates and cash flows in response to risk (Arnold &
Hatzopoulos, 2000; Pike, 1988, 1996). Graham and Harvey
(2001)
find that many firms continue to use PB and adjust cash flows
and discount rates in response to a variety of risk factors other
than market risk. They also report that the use of PB is more
widespread in smaller firms where it is as frequently used as net
present value (NPV) and the internal rate of return (IRR). These
results are contrary to the advice often found in finance and
management accounting textbooks published in 1970s and
1980s, which, in line with the theory dominant at the time,
recommends the use of DCF techniques and the Capital Asset
Pricing Model (CAPM) (Scapens, 2006; Scapens & Sale, 1985).
The theory explains PB’s inferiority to DCF techniques by
highlighting its neglect of the time value of money and of cash
flow
beyond a cut-off date. It also explains why CAPM should be
employed to find an appropriate discount rate that takes into
account market risk for use with DCF techniques.
More recently, following the emergence of real options pricing
theory in the 1980s, textbooks point out the importance of
considering real options in capital budgeting and some of the
problems posed by the ‘naïve’ use of DCF (for example,
Brealey,
Myers, & Allen, 2007; Dixit & Pindyck, 1994). The application
of real options pricing theory in capital budgeting is reportedly
y Elsevier Ltd.
mailto:[email protected]
http://crossmark.crossref.org/dialog/?doi=10.1016/j.bar.2013.12

.003&domain=pdf
www.sciencedirect.com/science/journal/08908389
http://www.elsevier.com/locate/bar
F. Chittenden, M. Derregia / The British Accounting Review 47
(2015) 225–236226
limited (Alkaraan & Northcott, 2006; Brounen, de Jong, &
Koedijk, 2004; Graham & Harvey, 2001), and does not appear
to have
challenged the dominance of NPV, IRR and PB. Several
theoretical arguments and simulations, however, show that rules
of
thumb based on commonly used capital budgeting techniques,
such as PB and DCF, can approximately capture the effect of
uncertainty and irreversibility on capital budgeting decisions
(e.g., Berry, Coad, Harris, Otley, & Stringer, 2009; Dixit &
Pindyck,
1994; McDonald, 2000; Stark, 1990). Simulations by McDonald
(2000) show that rules of thumb could serve as proxies for
‘rational economic considerations’ absent from the standard or
‘Naïve’ DCF.1 By simulating capital investment decisions and
comparing results obtained using PB, discount rates and the
Profitability Index, he finds that these rules proxy for optimal
investment timing behaviour. He also finds the timing option is
the most valuable amongst other options and it is the least
sensitive to deviations from the optimal investment rule. Other
simulations by Klumpes and Tippet (2004) use a real options
model of an irreversible investment project to show that, given
a discount rate of 10% and a variance parameter – a measure of
uncertainty – increasing from 1 to 4, the optimal instantaneous
cash flow increases making the PB time of their example fall
from 3.7062 years to 2.6402 years. The simulated results they
present further support the possibility that, in practice, shorter

required PB time approximates the impact of higher uncertainty
on irreversible decisions.
These results, in light of the theoretical arguments and
simulations present in the literature, may be more consistent
with
theory than they appear. The focus on the application of
techniques in the accounting and finance literature rather than
the
wider context of investment decisions that practitioners
consider (Jones & Dugdale, 1994) may be exaggerating the gap
between theory and practice. Firms can be using PB time and
adjustment of discount rates in response to both uncertainty and
irreversibility to take into account the value of the option to
wait, in the absence of strategic and expiring options. The lack
of
evidence on this is a significant gap in the literature and this
paper uses data obtained from a survey questionnaire to address
the gap. It investigates the effect of uncertainty and
irreversibility on the hurdles that projects need to clear when
there is an
option to wait. It also investigates the importance of several
factors, such as, demand uncertainty and interest rate
uncertainty
in raising the value of the option to wait, and the frequency of
the options to abandon, mothball, expand and contract in
capital budgeting decisions. In investigating the above, the
paper recognises that firms are not homogeneous in their need
for,
and in the way they carry out, capital budgeting (Scapens,
2006). This is based on evidence that, first, the use of capital
budgeting techniques is usually related to the size of investment
under consideration (Schall, Sundem, & Greijsbeek, 1978)
and that firms vary in their need for capital and their capital
intensity – a characteristic often associated with manufacturing
firms (Abdel-Kader & Luther, 2008; Klammer, 1973). Firms,

therefore, are unlikely to be facing a common degree of irre-
versibility in their capital budgeting decisions. This will be
reflected in their use of capital budgeting techniques and the
effect
of uncertainty on their decisions.
Second, small firms tend to be more sensitive to uncertainty and
more financially constrained (Ghosal & Loungani, 2000).
This implies that delay of investment decisions may also be
caused by lack of funds as well as uncertainty and
irreversibility.
Third, the separation of ownership and control may lead
managers of listed firms to be less sensitive to uncertainty when
making capital budgeting decisions (Antle & Eppen, 1985;
Antle & Fellingham, 1990). The paper considers potential
differ-
ences between firms in their response to uncertainty and
irreversibility and in their use of rules of thumb resulting from
size,
sector, and ownership effects.
The paper proceeds as follows. In section two we review the
academic literature on the potential of adapting capital
budgeting techniques to account for the price of risk associated
with both uncertainty and irreversibility. Section three de-
scribes the research methodology utilised. Section four presents
results of the fieldwork on the use of simple capital
budgeting techniques as ‘rules of thumb’ to account for
uncertainty and irreversibility. In this section we also explore
the
factors that drive the value of options to expand or contract,
abandon, delay or mothball projects and the differences between
firms’ response to uncertainty and irreversibility on the basis of
size, sector and ownership. Finally, in section five the con-
clusions are presented.

2. Background
This section is organised in three parts. The first part deals with
the potential for common capital budgeting techniques to
approximate the value of the option to wait. In the second part,
the pricing of risk in real options is compared with the CAPM
approach and the potential for rules of thumb to take into
account the price of risk is explained. In the third and final part,
characteristics of firms that may lead to variations in the use of
capital budgeting techniques and in the response of firms to
uncertainty and irreversibility in capital budgeting decisions are
discussed.
2.1. Capital budgeting and the option to wait
Real options pricing theory considers the capital budgeting
decision structure to be flexible in that it is not a now-or-never
decision, with firms having the option to wait or delay decisions
(e.g., Brennan & Schwartz, 1985; Dixit & Pindyck, 1994;
McDonald & Siegel, 1986; Pindyck, 1991). It also considers
other options, e.g., flexibility, expansion, mothballing,
contraction,
1 The use of ‘naïve’ here follows Dixit and Pindyck (1994) who
point out that DCF techniques can be adjusted to deal with
irreversibility and uncertainty.
But, as often presented in textbooks, ‘naïve’ DCF techniques
ignore the role of irreversibility and uncertainty in the value of
real options that decision
makers have when evaluating investment projects, and during
and after implementation of projects.
(2015) 225–236 227
and abandonment to be relevant tothe evaluation of capital

investment opportunities and need tobe valued whenever
present.
In models of the option towait, uncertaintyabout payoffsand
irreversibilityof decisions are crucial in determining its value
(e.g.
Dixit & Pindyck, 1994; McDonald & Siegel, 1986; Trigeorgis,
1996). Further, given that uncertainty increases with time, firms
would prefer investments with quick payoffs (Dixit &
Pindyck,1994). Since raising the hurdle a project faces by
increasing the
discount rate or shortening the PB time can lead to similar
decisions (Narayanan, 1985), firms may raise the discount rate
or
shorten the PB time to ensure that sufficient payoffs are
received in the near and less uncertain future. With an option on
the
timing of an irreversible investment (in the absence of strategic
value and expiring options), uncertainty would increase the
value of the option to wait.2 This makes it necessary for the PB
time to become shorter or the discount rate to rise to ensure that
the decision takes into account the increase in the value of the
option. Conversely, if assets were reversible, then uncertainty
would encourage investment, given the possibility of high
payoffs and the ability to roll back a decision (Pindyck, 1991).
There is sufficient evidence from surveys of capital budgeting
practice to suggest, when looked at retrospectively in light of
the above results, that firms may be employing rules of thumb
in ways consistent with real options pricing theory. For
example, Block (1997) finds that the PB time used by small US
firms averages 2.81 years, which he reports is much shorter
time than the useful life of many of the assets evaluated. The
practice of raising the discount rate or shortening the PB time in
response to risk has been widely reported in the literature.
Schall et al. (1978) report that of the 120 respondents using PB
with either NPV or IRR, 8% adjust only the required PB period,

42% only adjust the required rate of return, 32% adjust both and
18% adjust either. Gitman and Forrester (1977) report that 44%
of respondents increase the required rate of return and 13%
decrease the minimum PB period. Further, the assessment of
risk is often done subjectively (Klammer, 1972). However, the
role of irreversibility, which is arguably important in capital
budgeting decisions, is absent from studies of capital budgeting
practice. A natural progression from the above, to address the
gap in the literature, is to investigate if the adjustments to PB
time and discount rates are in response to uncertainty and to
irreversibility and lead to delayed decisions.
2.2. Pricing risk and real options
The CAPM and real options pricing models offer methods for
pricing risk that differ in their approach to non-systematic
risk. The CAPM deals with non-systematic risk through
portfolio theory and diversification and offers a method for
pricing
systematic risk. By contrast, real options models regard both
systematic and non-systematic risk (and the degree of irre-
versibility) to be important to the investment decision. Graham
and Harvey (2001) investigate the use of CAPM and use a list
that comprises the factors proposed by Fama and French (1992),
momentum (Jegadeesh & Titman,1993), and macroeconomic
factors in Chen, Roll, and Ross (1986) and Ferson and Harvey
(1991,1993). The results show that in practice CAPM is often
used
in conjunction with assessing specific risk factors that are of
concern to firms depending on their exposure, a result that is
consistent with Jagannathan and Wang (1996) and Jagannathan,
Kubota, and Takehara (1998).
Simulations by Jagannathan and Meier (2002) show that
accurate estimates of the cost of capital may not be critical for
capital budgeting decisions. They show that in the presence of

an option to wait, assuming organisational and managerial
capital is rationed, a hurdle rate that is higher than the cost of
capital used in NPV calculations could account for the value of
the option to wait. Empirical evidence finds that companies
often use hurdle rates that are substantially higher than the
historical average rate of return on debt or equity observed over
several decades. Poterba and Summers (1995) in a survey of
all Fortune 1000 companies report that respondents, who are, as
in several other surveys, mostly manufacturing firms, use an
average hurdle rate of 12.2% in real terms.3 Their results show
wide variations in the levels of hurdle rates used within
companies, with the average difference between the highest and
the lowest rates at 11.2%.4
The incorporation of specific risk factors into CAPM
(Jagannathan & Wang, 1996; Jagannathan et al., 1998) reveals
that
some of these factors, not only market risk, influence the cost
of capital. Several empirical studies use secondary data to
investigate the impact of specific risk (uncertainty) on
investment levels as evidence of firms valuing their option to
wait,
assuming that manufacturing firms make irreversible decisions.
Some of the factors considered are: demand uncertainty
(Guiso & Parigi, 1999); profit uncertainty (Ghosal & Loungani,
2000); interest rate uncertainty measured by the premia on
long-term bonds (Ferderer,1993); and market value volatility
(Leahy & Whited,1996). The survey questionnaire employed for
this paper examines the link between the pricing of risk to both
uncertainty and irreversibility by exploring their impact on
the discount rate and PB time employed in decisions. Further,
several factors that can influence the timing of investment
decisions, such as interest rate levels and availability of funding
are also surveyed.
The presence of strategic and/or expiring options could reduce

the value of the option to wait. Evidence presented by
Poterba and Summers (1995) show that strategic projects face
lower than average discount rates. It is expected that firms do
not always raise the hurdles irreversible projects face under
uncertainty. This paper is primarily concerned with
investigating
2 When considering capital budgeting decisions that are
strategically important (i.e. have strategic value) or
opportunities that are expiring, the value of
the option to wait may be reduced. Further, flexible (multi use)
capital assets can mitigate the effect of uncertainty by reducing
irreversibility.
3 Jagannathan and Meier (2002) state that surveys of capital
budgeting often receive a majority of responses from
manufacturing firms. Examples of such
surveys are Klammer (1972), Poterba and Summers (1995), and
Block (1997). Graham and Harvey (2001) target the fortune 500
firms and members of the
Financial Executives Institute and their respondents are 40%
manufacturing – the highest proportion of respondents from a
single industry.
4 Long-term equity risk premium measures published by
Ibbotson Associates in the US find that between 1926 and 2000
the estimated annualised return
is 11.3% and the estimated risk free rate of interest is 3.6%,
giving a risk premium of 7.3%. In the UK, Barclays Capital and
Credit Swiss First Boston find that
between 1916 and 2000 the respective figures are 12.2%, 5.5%,
and 6.4%.
(2015) 225–236228

the link between uncertainty and irreversibility on the one hand,
and the hurdles facing projects on the other. However, we
also report on the importance firms attach to the valuation of
flexible assets, first mover advantages and reversibility of
assets.
The option to wait is one of several options that may typically
be encountered in capital budgeting decisions. The relative
importance of some other options, which compete with the
option to wait, can also be influenced by the degree of irre-
versibility in decisions. For example, if an investment is
irreversible, the option to contract will have little value since it
derives
its value from the ability to at least partly reverse a decision,
while the presence of reversibility reduces the value of the
option
to wait. The survey examines the frequency, and the role that
irreversibility (or conversely, reversibility) plays in creating the
value of the options to expand, contract, mothball, and to
abandon.
2.3. Firm characteristics and capital budgeting
The literature on capital budgeting reports that manufacturing
and capital intensive firms have more use for capital
budgeting. Empirical studies have pointed out that the use of
capital budgeting techniques is often related to the size of
investment under consideration (Schall et al.,1978) and the
capital intensity of firms (Klammer,1973).5 Capital intensive
firms
are more likely to experience a need to buy capital assets,
possibly because the assets are specialised (irreversible).6
Capital
budgeting decisions may also be affected by the separation of
ownership and control (Antle & Eppen,1985; Berry et al.,
2009),

which occurs more often in listed rather than unlisted firms.
This may lead to less sensitivity to uncertainty and
irreversibility
as managers in their capacity as agents seek to control more
resources and assets, without having to bear the full conse-
quences of bad decisions. Further, there are variations in the
way some specific risk factors affect firms, for example,
Graham
and Harvey (2001) report that small firms are more affected by
interest rate risk than large firms. Small firms are also more
likely to experience capital rationing, which can lead to delayed
capital decisions and needs to be distinguished from the
effect of uncertainty and irreversibility. Large firms, on the
other hand, generally have better access to finance and higher
confidence in their future prospects, reflected in less sensitivity
to uncertainty (Ghosal & Loungani, 2000).
Often empirical research into capital investment expenditure
focuses on manufacturing firms. Examples of such empirical
studies are numerous (see Chirinko, 1993; Hubbard, 1998 for
literature reviews). But few studies investigate the use of
capital
budgeting by non-manufacturing firms; one of these is Graham
and Harvey (2001), who find that they do use capital
budgeting techniques. Other studies report that some small
firms do not engage in capital budgeting as judged by their lack
of
use of capital budgeting techniques, for example, Block (1997)
and Arnold and Hatzopoulos (2000). It is not clear, however,
whether the use of capital budgeting is related to firms’ capital
intensity, size, or sector. These results motivate this paper to
investigate firm characteristics associated with the use and non-
use of capital budgeting and the role played by asset
specificity (irreversibility).
3. Methodology

3.1. Design
The research for this paper requires data on the use of capital
budgeting techniques by individual firms, and on the levels
of uncertainty and irreversibility facing them. If the data were
available, a large sample data analysis would have facilitated
the use of powerful statistical tests. However, such firm-level
data are not readily available and so our data is collected using
a
survey questionnaire (a copy of the questionnaire is available
from the authors upon request). The questionnaire is developed
on the basis of the theoretical and empirical literature reviewed
in Section 2 above, and on the basis of interviews with 49
finance directors (FDs) of non-sample firms. The interviewees
included finance directors and chief executive officers of UK
headquartered multinational corporations and UK small firms,
including listed and unlisted firms from the service and
manufacturing sectors.7 The interviews were employed to
discuss capital budgeting practice and to refine the design of the
survey questionnaire. The involvement of the interviewees is
also used to reduce the potential for firms to misunderstand the
survey questions and as a robustness check for the survey
questionnaire results. Consistency between the information
gained
from the interviews and the survey responses makes it less
likely that the research results are biased.
In carrying out the research measures were taken to deal with a
number of important issues that are relevant to survey
research as discussed by Wallace and Mellor (1988) and Moore
and Reichert (1983). The first measure was the imposition of a
restriction on the time given to firms to respond to the survey,
limiting it to 4 weeks in total with a reminder sent after two
weeks to non-respondents. The second measure was to test for
differences in responses with and without late replies using

5 There is evidence that capital budgeting is limited to large
ticket items (Copeland, 2002; Schall et al., 1978). This does not
necessarily imply that the
decisions are not economically justified, but to save
management time they are approved without going through the
formality of capital budgeting at board
level. Capital intensive firms need to make more capital
investment decisions and thus have more use for capital
budgeting. On the other hand, companies
making decisions about small ticket items do not need to spend
valuable time analysing such decisions but often buy items
because they are needed, e.g., as
a result of regulatory requirements.
6 Williamson (1975, 1979) and Klein, Crawford, and Alchian
(1978) argue that asset specificity increases the transaction
costs and it is less costly for firms
to own such assets. Asset specificity implies that such assets
have limited residual value as opposed to generic assets
(Gompers, 1995).
7 To define small firms this paper uses a commonly used UK
definition of Small and Medium Enterprises, these being firms
that have two of these: sales
of no more than £25m, fixed assets of no more than £12m and
number of employees no more than 250.
(2015) 225–236 229
c2, which revealed no significant differences at the 5% level.
The third measure was employing c2 tests to assess whether
there are significant differences between the composition of
respondents and the target population, which includes listed and
non-listed firms, service and manufacturing, and small and large

businesses. This approach follows the suggestion of Moore
and Reichert (1983) and is employed by Graham and Harvey
(2001) to deal with non-response bias. No significant
differences
on the basis of size, sector, and ownership are found at the 5%
level.
The survey questionnaire uses multiple-choice questions and
scales to facilitate statistical tests on responses, including
tests for significant differences in the distribution of responses
on the basis of size, sector, and ownership. The questionnaire
also requests that respondents add answers in writing should
alternative answers be more appropriate. It first seeks to
establish whether firms use similar capital budgeting techniques
to those reported in the literature. Past surveys of US, UK and
other European countries find that firms continue to use
methods that do not always fit with what theory recommends
(for
example, UK studies by Pike (1996) and Arnold and
Hatzopoulos (2000), and Brounen et al. (2004) studying
European firms).
The survey then asks whether firms adjust the discount rate
and/or the PB time used in their capital budgeting decisions in
response to uncertainty and irreversibility. If irreversibility and
uncertainty explain the use of short PB time and high discount
rates as proxies for the value of the option to wait, then the
higher the uncertainty when considering an irreversible in-
vestment in fixed assets, the shorter the PB time and/or the
higher the discount rate. To assess the irreversibility firms face,
asset specialisation (specificity) is used. The interviews
conducted to develop the questionnaire reveal that firms find it
most
difficult to reverse decisions when assets are specialised and
easiest to reverse decisions when they are generic with
numerous users. This is very much in line with Williamson’s

(1988) distinction between general assets that can be hired,
rented or leased, and specific assets that generate high
transaction costs if not internalised.
The survey asks firms whether the time it takes an investment to
breakeven is important to the investment decision. Firms
are also asked about the frequency of delaying investment
decisions and to rate the importance of several factors that can
potentially lead to such delay. Further, the research looks at the
frequency of the options to abandon, mothball, expand, and
contract, and considers the relative importance of these options
when fixed assets are reversible and when they are
irreversible.
3.2. Research sample and response
To form a sample of firms to survey, two databases, Datastream
for listed firms and FAME for unlisted businesses, were
used. The firms selected had to have complete financial records
for at least 5 years. This period was chosen to ensure that
firms were survivors that had existed long enough to have
considered capital budgeting decisions under a range of
different
economic conditions. Firms were selected to include small and
large, manufacturing and service, and listed and unlisted
firms, to facilitate comparison of their responses.8 To identify
the sectors to which listed companies belong, contribution to
sales by Standard Industrial Classification Code (SIC) was used.
Many companies do not have a single activity that makes up
their total turnover, with companies being active in more than
one manufacturing or service SIC and in combinations of
manufacturing and service SICs. For listed firms, if two thirds
or more of a company’s sales come from activities that are
defined by the SIC code as belonging to a single sector, then the
firm is assigned to that sector. Firms that are active in both
service and manufacturing sectors are defined as mixed. For

unlisted firms, identification of sector is based on the SIC code
reported in FAME but the data on sales by sector are requested
from respondents since they are not reported by FAME.
The number of listed firms targeted by the postal questionnaire
is 183, and the number of unlisted firms sent a survey
questionnaire is 472. To improve the chances of obtaining a
high response rate, personal letters were sent to FDs of these
companies followed by reminders to those who agreed to
participate but were late in returning the questionnaire (after
two
weeks, to adhere to a four week response window). The
response rate for listed firms is 40% (74 firms), and for unlisted
firms,
the number of replies received is 166, giving a response rate of
35%. Table 1 provides information on respondents. To assess
whether the respondents are the FDs of the companies targeted,
reply-paid envelopes and reply slips were provided for the
FDs to reply to the letter requesting their participation. Those
who had agreed to participate were also asked for their business
card in order to forward to them the findings and contact them
to clarify responses once the study is complete. These two
factors indicate that FDs make up at least 91% of respondents.
4. Results
4.1. Use of capital budgeting techniques
The capital budgeting techniques in use by respondents are
shown in Table 2. It is clear that PB is the most widely used
technique in evaluating investment opportunities for the 152
firms that use capital budgeting techniques. More than 89% of
these report using PB either on its own or with other techniques,
while 6 firms report using real options. Ten firms report
using one or more of the following: commercial judgement
without any formal techniques; investing on the basis of need,

8 It is important to note that the definition of small firms in this
paper differ from the small firms in Graham and Harvey (2001)
who describe firms with
sales under $100 million to be “very small”. The UK company
population is much smaller than the US population and it is not
possible to have a large
enough sample using the Graham and Harvey (2001) definition,
something that would have aided comparison.
Table 1
Postal survey respondents by sector, size, ownership and
financial profile.
Numbers
of respondents
Listed Unlisted
Manufacturing Services Mixed Manufacturing Services Mixed
SME 4 8 2 11 100 7
Large 26 25 9 18 28 2
Total 30 33 11 29 128 9
Listed
£’000s Manufacturing Services Mixed
Min Max Mean Min Max Mean Min Max Mean
SME Total assets 3048 21,100 9434 3662 12,606 7955 3349
15,289 9319
Fixed assets 628 8800 3336 73 5112 2066 2868 14,588 8728
Turnover 675 8762 5160 138 10,418 6147 341 4043 2192

Large Total assets 6044 17,206,000 1,786,205 12,906
13,662,000 1,287,965 24,432 13,556,000 1,839,984
Fixed assets 1103 10,142,000 1,072,257 6301 11,103,000
957,417 18,054 11,503,000 1,491,222
Turnover 11,780 9,041,000 1,542,332 13,963 11,238,000
1,385,808 33,838 23,653,000 2,881,210
Unlisted
£’000s Manufacturing Services Mixed
Min Max Mean Min Max Mean Min Max Mean
SME Total assets 271 8172 2581 141 28,410 1621 231 8568
3557
Fixed assets 6 5025 1254 0 24,049 671 101 6474 2297
Turnover 401 9905 3223 352 11,181 2805 299 7733 3707
Large Total assets 6323 90,049 27,260 3583 36,467 17,713
14,762 16,019 15,391
Fixed assets 1082 45,921 12,876 71 26,116 7099 9456 10,519
9988
Turnover 13,768 109,613 42,875 11,742 85,220 36,781 17,016
19,514 18,265
Note:alldataisin£’000sintheListedCompany
‘Max’columns,thelargestcompaniesreportdatain£’Millionsandasa
resultthehundredsarepresentedaszeros.
Table 2
Techniques used for capital budgeting.
Techniques Number of firms Percentage
PB 28 18.4%

PB with NPV and IRR 93 61.2%
PB with NPV and AARR 11 7.2%
PB with ROI and NPV 4 2.6%
NPV 5 3.3%
NPV and IRR 8 5.3%
IRR 3 2.0%
Total 152 100%
(2015) 225–236230
investing to meet health and safety regulations, and using
intangible improvements resulting from investment as a basis
for
making decisions. The remaining respondents, numbering 88,
state that they do not employ capital budgeting techniques.
Many of these firms state that they obtain the assets they need
but do not use the conventional set of evaluation techniques,
such as PB and DCF techniques.9
The activity, ownership, and size of businesses reporting the use
of capital budgeting techniques can be seen in Table 3. The
composition of these respondents reveals that small firms
operating in the service sector comprise the vast majority of
businesses that do not use capital budgeting. Virtually all large
firms state that they use capital budgeting techniques with
some exceptions in the service sector, and most listed
businesses of all sizes also do. This is in contrast to the
minority of small
service firms who use capital budgeting techniques. The
proportion of fixed assets to total assets employed by many of
the
smaller service firms is very low (20% or less), indicating that
they are investing very little in fixed assets. The small value of
the assets does not merit the same level of analysis and
economic justification needed by capital intensive firms
(Copeland,

2002; Schall et al., 1978).
Observing the capital intensity of the respondents using data
from Datastream and FAME, 47 firms have a proportion of
fixed assets to total assets of 10% or less, 35 firms with a
proportion of more than 10% but less than 20%, and 82 firms
have a
proportion of more than 50%. Of the 47 with a proportion of
10% or less, only 6 were manufacturing, while only 7
9 Arnold and Hatzopoulos (2000) and Block (1997) report that
some small firms do not use capital budgeting techniques, and
Copeland (2002) states that
not all investment decisions are analysed using capital
budgeting techniques because many investments are in response
to regulations or are small in value.
Table 3
Composition of firms using or not using capital budgeting
techniques.
Using Listed Unlisted
Manufacturing Service Mixed Manufacturing Service Mixed
SME 3 6 2 6 35 3
Large 26 25 9 16 19 2
Not using Listed Unlisted
SME 4 3 0 4 66 3
Large 0 0 0 0 8 0

(2015) 225–236 231
manufacturing firms and 2 mixed firms were amongst the 35
firms with a proportion between 10% and 20%. Amongst the 82
firms with a proportion of fixed assets to total assets of more
than 50%, 27 were manufacturing and 13 mixed. These statistics
suggest that manufacturing firms tend to be more capital
intensive than service firms – a commonly held view in studies
of
capital budgeting (e.g. Klammer, 1972; Schall et al., 1978).
Further to the non-use of capital budgeting techniques by some
firms, responses reveal that not all firms surveyed consider
owning land, buildings, plant and machinery to be necessary for
their business to function. While a clear majority of
manufacturing firms, 83%, state that fixed assets are necessary,
only 56% of service companies do (Table 4). Those of mixed
activities provide intermediate responses in line with the mix of
activities that make up the businesses. This informs us that it
is possible for a small proportion of manufacturing firms and
many service firms to carry out their mission without making
substantial capital investment, possibly because they are part of
the ecology of newer organisational forms researched by
Smith, Morris, and Ezzamel (2005). One hundred and seventy
one firms report leasing, renting, or hiring fixed assets, while
67
firms state that they do not, and 2 firms do not answer the
question.
When examining differences in responses on the basis of sector,
size and ownership, some differences between firms that
regard owning fixed assets as essential to their activity (as
shown in Table 5) and those that do not are revealed.
Significant
differences at the 1% level are found between the two groups
for both sector (c2 ¼ 9.638) and size (c2 ¼ 11.461), but not for

ownership.10 Manufacturing businesses and large firms are both
over represented in the companies finding it necessary to
own fixed assets. This implies that manufacturing businesses of
all sizes, both listed and unlisted, tend to need to own fixed
assets significantly more than service firms, and large listed and
unlisted service firms need to own fixed assets significantly
more than small service firms.
Respondents rate future prospects as important to the decision
to own fixed assets but not asset specialisation (Table 6).11
Differences in responses emerge when compared on the basis of
sector, size and ownership. Being in a strong position is
substantially more important for unlisted firms, which implies
that unlisted companies avoid investment in capital assets
whenever possible until they are more confident about their
future, i.e. facing less uncertainty. Tests reveal no statistically
significant difference at the 5% level on the basis of size or
sector when it comes to agreeing that being in a strong position
leads to more investment in capital assets. This suggests that
separation of ownership and control may be a factor in
determining confidence of respondents about the future and
listed firms appear less sensitive to uncertainty.
Although the overall responses do not suggest that
specialisation is a factor in companies’ decisions to own fixed
assets, on
the basis of sector there are significant differences at the 1%
level between service and manufacturing firms (Table 6).
Manufacturing firms find asset specialisation to be important in
the decision to own fixed assets. Comparing responses of
listed and unlisted firms on specialisation reveals no significant
difference at the 5% level. There are no significant differences
at the 5% level between small and large businesses. The results
demonstrate that manufacturing firms tend to need more
specialised (irreversible) assets than service firms. Firms

relying on generic, widely used assets, can use leasing, renting
and
hiring instead of buying and these assets tend to be less
specialised/more reversible (Williamson, 1988).
4.2. Irreversibility, uncertainty, and the use of rules of thumb
The survey asks firms to rate the importance of the time taken
by an investment to breakeven to the investment decision.
Respondents rate this as quite important with the mean response
at 3.76 on a scale from 1 to 5, mode and median both at 4
and standard deviation of 1.183. This is significantly more
important than a neutral response at the 1% level. There is a
general
agreement amongst firms here, as there are no significant
differences between respondents by size, sector, or ownership.
To clarify that the replies are not merely a reflection of firms
preferring short-term projects, an additional question asks
how firms respond to uncertainty. 113 Firms report raising the
required rate of return and/or reducing the PB time. Of these,
10 The tests of significance are carried out using Kruskal–
Wallis non-parametric test, and, for robustness, the results are
confirmed using the Mann-
Whitney non-parametric test and the standard test.
11 Importance is determined by the statistical significance of a
difference test between the ‘neutral’ expected mean, 3 on a
Likert scale from 1 to 5, and the
actual mean, given the standard deviation.
Table 4
Is owning fixed assets necessary for the business to function?
Number of firms

answering ‘no’
Percentage ‘no’ Number of firms
answering ‘yes’
Percentage ‘yes’
Manufacturing 10 17% 49 83%
Services 71 44% 90 56%
Mixed activity 7 35% 13 65%
Total 88 36% 152 64%
Table 5
Is owning fixed assets necessary for the business to function?
Composition of firms by yes or no answer.
No Listed Unlisted
SME 1 3 1 2 52 2
Large 7 8 4 0 8 0
Yes Listed Unlisted
SME 3 5 1 9 48 2
Large 19 17 5 18 20 5
Statistics for differences in distribution of responses
On the basis of size On the basis of sector On the basis of
ownership
c2 11.461 (0.001)** 9.638 (0.002)** 0.823 (0.364)

*Statistically significant at the 5% level, **statistically
significant at the 1% level.
(2015) 225–236232
47 were manufacturing, 13 were mixed and 53 service firms.
Clearly, the majority of manufacturing firms respond to un-
certainty by reducing the PB time or raising the required rate of
return. Service and mixed firms responding in this way tend
to be relatively capital intensive, with the mean proportion of
fixed to total assets ratio at 50% and a similar mode and
median.
In addition to the 113 firms, 39 firms do not respond to
uncertainty in this way but add that they reduce the projects’
cash flow
forecasts.
Beside altering the PB time and raising the hurdle rate to deal
with uncertainty, firms are asked whether they use scenario
analysis, sensitivity analysis, decision trees, or any other
techniques. One hundred and fifty seven report using scenario
analysis, 41 use sensitivity analysis, 80 use both with 11
additionally using decision trees, 1 firm uses scenario analysis
with
decision trees, and 5 use decision trees. Thirty-six firms use no
techniques at all. It is clear from these figures that many firms
not using any traditional capital budgeting techniques employ
techniques of risk appraisal. This indicates that uncertainty
about the payoffs from decisions is still important and firms
assess its impact on decisions.
Responses to the survey concur with the theoretical role
irreversibility plays in capital budgeting decisions. One hundred
and seventy-nine businesses stress that investing in ‘hard-to-
sell’ fixed assets requires that stricter conditions be satisfied.

Of
these, 95 see reducing the PB time as a tool to account for
irreversibility, and 93 raise the required rate of return. Forty of
these
respondents use both, but other firms state that they only buy
such assets if it is absolutely necessary. These responses
demonstrate that, in practice, irreversibility of investments
leads to higher capital budgeting hurdles.
Table 6
Descriptive statistics for reasons for owning assets.
Unimportant ¼ 1
Very important ¼ 5
N Median Mean Mode Std. deviation
Specialisation 240 2 2.16** 1 1.328
Prospects 240 4 3.95** 5 1.203
Statistics for differences in distribution of responses to
‘specialisation’
ownership
c2 2.222 (0.136) 30.204 (0.000)** 1.782 (0.182)
Statistics for differences in distribution of responses to
‘prospect’
ownership
c2 2.974 (0.085) 0.918 (0.338) 16.392 (0.000)**
See notes to Table 5. Significance of mean response is

determined by comparing it to the expected response.
Table 7
How often do you consider these when evaluating a new
investment?
Not often ¼ 1
Very often ¼ 5
N Median Mean Mode Std. Deviation
Abandonment 238 3 2.89 2 1.399
Mothballing 238 2 2.45** 2 1.286
Expansion 238 3 3.23** 4 1.096
Contraction 238 3 2.75** 3 1.21
See notes to Tables 5 and 6.
(2015) 225–236 233
4.3. Factors driving the value of the option to wait, and
frequency of real options
In response to questions relating to the frequency of some
commonly analysed real options, respondents state that in
investment evaluation the option to expand is the most
frequently considered, followed by abandonment, contraction,
and
mothballing (Table 7). The value of some real options is
influenced by the degree of reversibility of the assets in
question,
however. One hundred and twelve firms report considering the
consequences of abandonment to be most relevant when
investments are hard to reverse. In such circumstances the

abandonment option is the least valuable. The option to reduce
the
size of the investment at the evaluation stage and mothballing
are second and third in importance. When an investment is
seen as easy to reverse, 66 firms consider increasing the size of
the investment at the evaluation stage, indicating that they
experience less concern about the consequences of lower than
expected payoffs.
The results reveal that the hurdle a proposal has to clear is
raised in the presence of uncertainty and irreversibility. Most
respondents state that delaying investment decisions to wait for
clearer future prospects happens ‘sometimes’. A summary of
the frequency of responses is shown in Table 8 below.
Significant differences in the frequency of delay exist between
listed and
unlisted firms at the 1% level, with listed firms delaying
investment decisions less often. This may reflect the higher
levels of
confidence (less uncertainty) that listed firms have in their
market position. It is also possible that managers of listed firms
are
less cautious because they enjoy the benefits of controlling
more corporate resources but bear less of any negative conse-
quences of decisions than their unlisted counterparts (Antle &
Eppen, 1985; Antle & Fellingham, 1990).
Respondents are asked to rate the importance of a number of
variables in delaying investment decisions (Table 9). The
replies put demand uncertainty as the most important factor
responsible for delaying investment decisions. This is followed
by the lack of internal funding, high interest rates and interest
rates uncertainty. There are no significant differences between
respondents on the importance of demand uncertainty, but there
are significant differences on the importance of interest rate
uncertainty, high interest rates and lack of internal funding.

Small firms find high interest rates and interest rate uncertainty
significantly more important than large firms at the 1% level,
and lack of internal funding more important at the 5% level.
These results reflect the higher sensitivity of smaller firms to
the cost of capital and their reliance on internally generated
funds.
The real options pricing theory presents a number of models in
which firms face valuable strategic and expiring options
and uncertainty does not lead to delayed investment decisions
(Dixit & Pindyck,1994; Trigeorgis,1996). The survey asks firms
about the value of first mover advantages, flexibility, and
reversibility of assets. As can be seen from Table 10, the
respondents’
valuation of these is significantly higher than neutral at the 1%
level.
The option to wait implies that delayed investment decisions are
revisited when uncertainty falls. Most firms revisit a
delayed investment decision, if it is delayed because of
uncertainty. Two hundred and three firms confirm that they wait
for
uncertainty to clear then revisit a delayed project. Some hand
written replies state that delayed projects are kept under
review, while others state that the decision to revisit a delayed
project depends on how many alternative investment projects
there are. The large number of firms revisiting projects
demonstrates that even firms not using capital budgeting
techniques,
Table 8
Frequency of delaying investment decision.
Listed Unlisted
Never Rarely Sometimes Often Never Rarely Sometimes Often

SME Services 0 1 4 3 4 25 61 9
Manufacturing 0 0 1 3 2 0 7 2
Mixed 0 0 2 0 0 0 1 6
Large Services 0 3 14 7 0 12 10 4
Manufacturing 0 5 17 4 0 6 12 0
Mixed 0 1 6 2 0 0 2 0
Statistics for differences in distribution of responses
ownership
c2 0.001 (0.974) 0.176 (0.675) 9.374 (0.002)**
See notes to Table 5.
Table 9
Most important factors in delaying investment decisions.
Unimportant ¼ 1
Very important ¼ 5
High interest rates 240 3 2.76** 2 1.295
Interest rate uncertainty 240 2 2.59** 2 1.227
Demand uncertainty 240 4 4.19** 5 0.989
Lack of internal funding 240 4 3.45** 5 1.422
Lack of external funding 240 3 2.89 2 1.368
Statistics for differences in distribution of responses to ‘high
interest rates’

ownership
c2 17.445 (0.000)** 2.342 (0.126) 10.747 (0.001)**
Statistics for differences in distribution of responses to ‘interest
rate uncertainty’
ownership
c2 11.916 (0.001)** 0.549 (0.459) 8.473 (0.004)**
Statistics for differences in distribution of responses to ‘demand
uncertainty’
ownership
c2 0.040 (0.842) 1.212 (0.271) 0.983 (0.332)
Statistics for differences in distribution of responses to ‘lack of
internal funding’
ownership
c2 5.597 (0.018)* 0.547 (0.282) 1.489 (0.222)
Statistics for differences in distribution of responses to ‘lack of
external funding’
ownership
c2 0.174 (0.676) 0.938 (0.333) 0.455 (0.500)

(2015) 225–236234
which tend to be less capital intensive, delay investment
decisions under uncertainty. Such firms, while the assets they
purchase are likely to be small relative to their size and do not
require a sophisticated analysis to make a decision, have a
choice about the timing of investments.
5. Conclusion
The continued use of simple capital budgeting techniques in
ways that appear contrary to theoretical recommendations is
a practice that has been reported by many surveys of capital
budgeting practice. It has long been argued, however, that firms
cannot continue to make bad decisions and survive. Friedman
(1953) explains this by likening practitioners to a good pool
player who knows how to knock the billiards balls into one
another just right, but he or she may not be able to solve a
differential equation. The survey employed for this paper has
explored the possibility that intuition underlying the observed
practice is not at odds with theory, and we find the practical
relevance of the option to wait is in line with theoretical pre-
dictions and simulations. Firms respond to the presence of
uncertainty and irreversibility by raising the hurdles projects
have
to clear, and most respondents state that they delay projects to
wait for clearer prospects (less uncertainty) sometimes. This is
an important result, that represents a useful contribution to our
understanding of capital budgeting practices, as it offers an
explanation for the use of hitherto inexplicably high discount
rates and short PB times reported in the literature. These are not
associated with risk alone, but also irreversibility. Further,
firms are also aware of the value of first mover advantages,

flexibility, and reversibility of assets.
Table 10
How valuable are these factors in making investment decisions?
Low value ¼ 1
High value ¼ 5
Flexible use fixed assets 240 4 3.52** 4 1.150
Reversible fixed assets 240 3 3.30* 3 1.232
Moving first into a new market 240 4 3.52** 5 1.216
(2015) 225–236 235
In evaluating uncertainty, firms commonly resort to scenario
analysis, either alone or together with sensitivity analysis,
with a minority of firms using decision trees. Overall, firms
identify demand uncertainty, lack of internal funding, interest
rate
uncertainty and levels as important in delaying investment
decisions. However, the number of firms using such techniques
to
evaluate uncertainty exceeds the number of firms using capital
budgeting techniques, with firms concerned about uncer-
tainty even when they make small capital investments. This is
consistent with the observed decline in capital expenditure
across firms in times of economic uncertainty.
Analysis of responses shows that there are some significant
differences between firms on the basis of size, sector, and
ownership. The lack of internal funding, interest rate

uncertainty and interest rate levels are significantly more
important in
delaying decisions for small firms than for large firms. Further,
listed firms are less sensitive to uncertainty and delay decisions
less frequently, which may be due to the separation of
ownership and control. Other variations in responses between
small
and large, listed and unlisted, and service and manufacturing
can to a large extent be explained by capital intensity and asset
specialisation (irreversibility). It is firms with frequent and
substantial capital budgeting decisions that have more use for
capital budgeting techniques. But, although manufacturing firms
most commonly face such decisions, the use is not limited to
them. Large service firms are more capital intensive than small
and have more use for capital budgeting techniques.
Survey research has it limitations, and these limitations may
lead to doubts about the validity of the results. We have
attempted to deal with these limitations as best as we could. In
addition to taking measures to limit non-response bias, by
basing the survey questionnaire design on existing literature and
developing it in interviews with practitioners, we have
sought to limit the chance of respondents misunderstanding the
questions. Further, we have used the interviews, numbering
49, as a further check on the validity of the survey. Even so we
must acknowledge the possibility that the financial directors
responding believe that capital investment decisions in their
businesses are made in a more rigorous way than is actually the
case. Other senior staff may see capital budgeting as a ritual to
support decisions already taken. This may provide a partial
explanation for our results. Formal capital budgeting
techniques, required by financial policies, are evolving through
adap-
tations that capture commercial judgements. This survey has
demonstrated that, although firms engage in practice that is at
odds with how theory should be applied, the intuition

underlying the practice is not always at variance with theory. It
has also
shown the important role irreversibility plays in capital
budgeting decisions under uncertainty.
Acknowledgement
The authors thankfully acknowledge the financial support for
this research provided by the Institute of Chartered Ac-
countants in England and Wales and the support received from
Gillian Knight and Clive Lewis of the Institute. The authors are
also grateful to two anonymous referees and the editors for their
constructive comments and suggestions that have resulted
in improvements to this manuscript. Any errors remain the
responsibility of the authors.
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http://refhub.elsevier.com/S0890-8389(13)00090-
5/sref53Uncertainty, irreversibility and the use of ‘rules of
thumb’ in capital budgeting1. Introduction2. Background2.1.
Capital budgeting and the option to wait2.2. Pricing risk and
real options2.3. Firm characteristics and capital budgeting3.
Methodology3.1. Design3.2. Research sample and response4.
Results4.1. Use of capital budgeting techniques4.2.
Irreversibility, uncertainty, and the use of rules of thumb4.3.
Factors driving the value of the option to wait, and frequency of
real options5. ConclusionAcknowledgementReferences
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South African Journal of Accounting Research
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Capital budgeting: A case study analysis of the role
of formal evaluation techniques in the decision
making process
E Gilbert

To cite this article: E Gilbert (2005) Capital budgeting: A case
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E Gilbert 19
Capital budgeting: A case study analysis of
the role of formal evaluation techniques in the
decision making process
E Gilbert

Graduate School of Business, University of Cape Town
Received: September 2004 SAJAR
Revised: February 2005 Vol 19 No. 1
Accepted: March 2005 2005
pp.19 to 36
This paper furthers the understanding of capital budgeting by
reviewing two individual capital
investment decisions taken by manufacturing firms in South
Africa. This study indicates that
managers do not base their capital investment decisions on a
comparison of the expected value of
potential investment opportunities as recommended by theory.
Rather they follow a multi-stage
filtering process and reduce the list of projects by establishing
the alignment with the firm’s
strategic goals on a qualitative basis. Discounted cash flow
project evaluation methods (among
others) are then used to confirm that the selected projects are
expected to achieve satisfactory
levels of financial performance. This analysis promotes a better
understanding of the
unexpectedly limited use of discounted cash flow techniques by
managers in capital investment
decision making.
KEY WORDS
Capital Budgeting, Decision making processes, Discounted cash
flow techniques, Valuation, Net
Present Value (NPV), Case study.
Contact
Email: [email protected]

INTRODUCTION
Finance theory recommends that managers should undertake
capital investment projects
only if they add to the value of the firm. If we assume that
managers act so to maximize
the value of the firm, managers should then identify, and
undertake, all projects that add
value to the company so as to maximise shareholder value. This
theory of capital
investment decision-making implies that managers should
establish the expected value
that a project is expected to create. This should be done through
the use of value based
or discounted cash flow (DCF) techniques, in particular, the net
present value (NPV)
approach.1 Capital investment decisions should then be based
on these estimates of
value.
1See Copeland and Weston, 1992.
20 SA Journal of Accounting Research Vol. 19 : No. 1 : 2005
Multiple surveys indicate that managers do not always use DCF
techniques and that
when they do, they are used in conjunction with other,
theoretically deficient,
techniques such as Payback Period (PP). While these surveys

highlight the existence of
the gap between prescribed and observed behaviour in this area,
they do not suggest
why this is the case. There is, thus, a need for an explicit
analysis of the relative role
played by formal evaluation techniques in the capital
investment decision making
process.
In order to address this gap, case study analysis of two capital
investment decisions
made by manufacturing firms in South Africa was undertaken
with a particular focus on
identifying the role played by formal evaluation techniques in
the decisions taken. This
provides new evidence that allows for an enhanced
understanding of the role of these
techniques in capital budgeting decisions.
The structure of this paper is as follows. A brief discussion of
both the value
maximising model of capital investment decision-making and
the survey data
concerning its descriptive accuracy is presented in the next
section. Details of two
investment decisions are presented, with a particular focus on
the role played by DCF
evaluation techniques in the decision-making process. The key
differences between the
traditional model of capital investment decision-making and the
observed behaviour are
summarised and, finally, the implications of this for further
research are discussed.
Use of formal evaluation techniques

A basic tenet of finance theory is that managers act so as to
maximize shareholder
value. In the context of capital budgeting, this has been
interpreted to mean that
managers should choose all projects that add value to the
company. To do so, managers
should establish the estimated value of all projects under
consideration2 and select those
which add the most value to the firm (given a capital constraint,
if any).
Establishing the expected value of projects involves the
estimation of incremental cash
flows over the life of the project discounted at a rate that
reflects both the time value of
money and the risk associated with these cash flows.3 If
positive, the project adds value
and should be undertaken. In situations of capital rationing, the
management should
prioritise the projects in terms of their contribution to the value
of the firm and select all
that they can afford.
In terms of process, firms considering investments in new
projects should thus estimate
both the incremental cash flows, the appropriate project specific
risk adjusted discount
rate and then base their decisions to invest on the results of this
DCF analysis. Surveys
of international capital budgeting practices suggest that this is
not always the case.
2Note that this approach does not say anything about the
process whereby the projects being valued are
identified. The case study data presented in this paper suggests

that the company’s competitive
strategies directly affect the need for new projects as well as
provide the basis for judging the relative
attractiveness of the alternative projects.
3This approach does not consider the value of real options i.e.
the flexibility that firms have when
managing projects in the face of an uncertain future. While
these options exist and do add value to
capital investment projects, for the purposes of this paper, the
role of the traditional (no-flexibility)
investment evaluation techniques such as the Net Present Value
(NPV) or Internal Rate of Return (IRR)
will be examined.
E Gilbert 21
Cross sectional studies of use of formal evaluation techniques
There have been multiple cross sectional studies of the use of
formal evaluation
techniques by firms. These have covered the behaviour of both
international (see Istvan
(1961), Pullara and Walker, (1965), Meredith (1965), Christy
(1966), Bavishi (1981),
Moore and Reichert (1983), Pike (1983), Bailes and McNally
(1984), McIntyre and
Coulthurst (1987), Northcott (1992), Sangster (1993), Baddeley
(1996), Harvey and
Graham (2001), and Ryan (2002)) and South African firms (see
Andrews and Butler
(1986), Parry and Firer (1990), Hall (2000), and Gilbert
(2003)). The following

statements summarise the results of these surveys:
1. Discounted Cash Flow (DCF) techniques are used, but a
significant minority of
firms do not do so;
2. Larger firms are more likely to use DCF techniques; and
3. When these techniques are used, they are used in conjunction
with other
techniques that are both theoretically deficient and redundant.
A criticism of cross-sectional studies is that they do not
explicitly consider the
possibility that new evaluation techniques such as DCF would
take time to diffuse
across all firms. This problem is avoided by longitudinal studies
of evaluation technique
usage.
Longitudinal studies
Longitudinal studies of the use of evaluation techniques have
been conducted by
Klammer (1972), Klammer and Walker (1984), and Pike (1996),
for international firms
and by Andrews and Butler (1986), and Correia. Flynn, Uliana
and Wormald (2003) for
South African firms. In brief, these studies indicate that:
1. The use of DCF techniques has grown over time; but
2. Their increase in use is NOT accompanied by a decline in the
usage of other non-

DCF techniques.
This second point is a strong indication that DCF techniques are
not playing the
decisive role in the decision-making process that traditional
finance theory suggests it
should.
In summary, these surveys indicate that some (generally
smaller) firms do not estimate
the expected value of their capital investment projects at all
when considering capital
investment decisions. More unexpectedly, the firms that do use
DCF techniques also
consistently continue to use other non-value related techniques
when evaluating their
capital investments. This suggests that DCF techniques, when
used, do not play the
decisive role in the decision making process that is assumed
they should (in theory). An
analysis of the role of these evaluation techniques in the
decision making process is
necessary to understand why this occurs.
Research methodology
While the survey-based results discussed above indicate the
extent of this behaviour
they do not provide any real basis for understanding why this is

the case. The case study
approach is a very good way to acquire the data required to
better understand the role of
these formal investment evaluation techniques in the capital
investment decision
making process. This approach provides rich data on both the
context and process of a
capital investment decision which are necessary to identify the
relative role(s) of the
various investment evaluation techniques. The limitation of this
methodology is that the
results may not be necessarily representative of the population
of manufacturing firms.
However, given the current lack of data on this issue, these case
studies can provide the
insight required to allow for hypotheses to be developed
regarding the unexpected
behaviour reported in the previous section. The validity of these
hypotheses should then
be tested across a more representative sample of firms.
Gilbert (2003) presents the results of a survey of the capital
budgeting practices of
South African manufacturing firms conducted in 1997. 318
firms were approached of
which 118 responded to the survey. The respondent firms were
then invited to
participate in additional case-study based research which aimed
to understand the role
of DCF techniques in the decision-making process. Ten firms
responded positively.
Two firms were selected on the basis of their different sizes, the
importance of the
decision for the firms and (most importantly) the support of the
firms in terms of the
quantity and quality of data made available for this research

(including the provision of
access to the relevant decision makers). The following case
studies were prepared on
the basis of a review of all project related documentation and
interviews with related
managerial staff. The data was collected over the period of
January to September 1998.
FIRM A: RELOCATING A PRODUCTION FACILITY
Firm A produces sisal matting for sale as floor coverings. It has
two production
facilities - one in Johannesburg, Gauteng; and the other in
Polokwane, which is
approximately 330 kilometres further north. The latter facility is
the larger of the two.
The focus of this analysis is the decision to relocate this plant.
Figure 1 provides an
overview of the decision-making process followed by this firm.
Throughout the decision-making process, the management of
Firm A expressed a
commitment to two (sometimes conflicting) strategies4: export
promotion and cost
minimisation. The first strategy reflected the firm’s belief that
the export market
represented a better opportunity for sustained growth than the
domestic market. The
current proportion of domestic to international sales was 70:30.
The stated commitment
was to reverse this proportion within 10 years. Given the
perceived limited potential for
product diversification in the sisal carpeting market, the other
strategic commitment was
that of maintaining competitiveness through minimising costs.

4There are many competing definitions of strategy, and
consequently, how it should be dealt with (see
Mansfield, 1996). In this study the term strategy will refer to
the firm’s perception of both the current
and future external environment; and how it sees the optimal
role for itself in this environment. A
firm’s strategy thus will reflect its choice of what course of
action is most likely to lead to a sustainable
profitable outcome, given the current decision-making
environment.
E Gilbert 23
Step 1: Recognition of the need to move
Management reported three reasons for the consideration of a
move from the
Polokwane production facility: the loss of relative cost
advantages, the low levels of
productivity at Polokwane and the increasing importance of
export sales.
The original decision to locate the factory in Polokwane was in
response to government
incentives both direct (e.g. rent) and indirect (production of
sisal in the area was
subsidised). These have since been discontinued. The existence
of significant negative
productivity differentials between the Polokwane and
Johannesburg factories is a
continued management challenge. Finally, export sales, once
non-existent, now

comprise thirty percent of the firm’s total sales. As both the raw
materials and the
finished product are relatively bulky and raw materials need to
be imported and the final
product exported (both by sea) Polokwane’s inland position
counts heavily against it.
These reasons clearly reflect the firm’s strategic considerations.
Figure 1: Overview of firm A’s decision-making process
Step 2: Identify possible locations
The first step in the decision-making process was to identify a
list of possible
alternative locations. This list was composed in terms of the

following criteria:
1. Access to reliable, flexible and cheap transport networks
closely linked to a port
(for the imports of sisal and exports of finished goods);
2. Availability of adequate production premises;
3. Presence of supporting infrastructure of sufficient quality,
such as engineering
facilities, and access to other vital inputs, for example dyes and
latex; and
4. Identify optimal location (Mauritius)
3. Identify preferred locations:
1. Best Inland location (Johannesburg)
2. Best Coastal location (Durban/Pinetown)
3. Best Foreign location (Mauritius)
2. Identify possible locations
5. Final Decision (Set up a pilot plant in Mauritius)
1. Recognition of the need to move
4. Access to staff (preferably experienced/skilled in
manufacturing).

The initial list drawn up included Durban, Pietermaritzburg,
Port Elizabeth, the Gauteng
region (Johannesburg and its immediate environs), Polokwane,
Reunion, Mauritius,
Maputo (Mozambique).
The list compiled was directly affected by individual bias. Cape
Town, for example, had
every attribute required and yet was excluded because the
managing director ‘did not
like the people there’. When asked about other areas which
apparently fulfilled these
criteria the initial reaction was one of surprise that these
options might have been
considered followed by a justification of their exclusion on
some (apparently ad hoc)
basis, such as the lack of existing textile production facilities
(Bloemfontein,
Uitenhage); or the infrequent stopping of ships at the ports
(East London, Richards
Bay). No formal analysis of the cost (or value) implications of
these (apparent)
deficiencies was deemed necessary. The (assumed) existence of
these faults was
deemed sufficient for the exclusion of these alternatives from
the rest of the process.
Step 3: Identify preferred locations
The company felt that a complete analysis of the list of possible
locations identified was
not cost-effective. The second step in the decision-making
process consisted of
selecting three sites from the initial list (the eventual choices
made are in brackets):

1. The best domestic inland location (Gauteng/Johannesburg);
2. The best domestic coastal location (Durban/Pinetown); and
3. The best foreign location (Mauritius).
It was felt that these three categories captured the essential
strategic choices. An inland
centre would be closer to the existing market (mainly Gauteng)
which would be better
as domestic sales remained dominant in the short to medium
term. A coastal venue
would be superior in terms of reducing transport costs for the
export market – the long-
term strategic goal. Finally it was believed that a foreign
location might be even more
attractive in terms of achieving the long-term strategy of
increased export promotion.
Throughout the evaluation exercise, it was decided to retain
Polokwane as a benchmark
case. The influence of the two strategic goals can be clearly
seen at this point.
The destinations on the short list were selected on the basis of a
series of comparative,
non-formal analyses concentrating on qualitative differences:
two locations were
compared and the lack of a particular factor in one of the two
locations, ceteris paribus,
was deemed enough to warrant its exclusion. For example, Port
Elizabeth was excluded
(when compared to Durban) on the grounds of:
• It was further to Johannesburg than Durban. This would lead
to higher transport

costs;
• There were fewer road transport companies on the route as
compared to Durban.
There would be less flexibility in terms of the number of
alternatives available and
(probably) higher costs per kilometre; and
E Gilbert 25
• Shipping lines stopped less often in Port Elizabeth than
Durban. This would again
limit the flexibility and increase cost of the transport in, of raw
materials, and out,
of finished products.
No formal analysis of these existence or scale of these
deficiencies was carried out.
Their perceived existence was sufficient to exclude these
possible locations.
Step 4: Identify optimal location
For each of the three locations a comparison of estimated direct
costs for each location
to current direct costs at Polokwane was completed as was an
estimated profit/loss
statement. Two scenarios, based on differing assumptions
regarding the rates of growth

of the domestic and foreign components of their current
demand, were used in these
exercises. The first assumed an annual (compounded) rate of
growth (in real terms) of
the export market of 15 percent and the second, a growth in
export demand of 7
percent5. In both cases, demand in the domestic market was
assumed to grow by 5
percent (also in real terms). These rates of growth were
identified as being the two most
likely scenarios representing ‘good’ or ‘bad’ future outcomes.
These exercises indicated that the Mauritius option clearly
represented a superior choice
to all the domestic alternatives in terms of both relative costs
and expected profits. The
quantified benefits of significantly lower wages, the absence of
any company taxation,
and significantly reduced internal transport costs outweighed
the quantified negatives of
higher rental costs, higher transport costs to the South African
market; and the un-
quantified problems of managing across borders and over such a
distance.
The Polokwane region presented the most profitable domestic
site due to the
significantly cheaper current rental charge used. Two
qualifications to this result were
immediately raised by management. Firstly, the low rental
charge used for Polokwane
in the calculations was not likely to last for the period covered
by the model. Secondly,
the exercise assumed that the increases in output were to be
produced with the existing
labour and capital stocks which would be extremely difficult to

achieve in Polokwane.
Consequently the Gauteng/Johannesburg site was considered to
be the best domestic
alternative.
This penultimate stage of the decision-making process provides
the first application of a
formal evaluation technique. Identification of relative cost
differences is consistent (in
part) with the traditional model of decision-making and the
choice of the final location
was determined by the results of this technique. However there
are some key
shortcomings with the process.
Extensive efforts were made by management to establish the
extent of these cost
differentials. However, management only focussed on
estimating current cost
differentials – there was no systematic attempt to anticipate
future changes to
production costs in these alternative locations and so the
sustainability of these relative
5Both of these real growth rates are clearly not sustainable in
the long run. This, however, did not limit
their use in the evaluation exercise.
current cost advantages was not explicitly considered.6 Other

sources of incremental
cash flows were not established. Inflation and exchange rate
movements were ignored
which simplifies the analysis, but had the effect of increasing
Mauritius’ relative
attractiveness. The lack of any attempt to formally investigate
these variables further
highlights the importance of the question of minimising its
current costs – again
emphasising the importance of the firm’s cost management
strategy.
By not discounting the projected profits the time value of
money was ignored and, more
importantly, the risks of producing in the alternative locations
were effectively treated
equally. This is especially important given that Mauritius is
situated in an entirely
different economic, political and cultural environment and so
should be considered to
be on a different level of risk.
The formal evaluation exercise allowed management to identify
what the probable
relative production costs would be (in present terms) at the
various locations – not the
expected value of the alternative sites. This was sufficient as it
dealt with what the
decision makers believed was their key strategic objective –
minimising production
costs.
Step 5: The final decision
In spite of Mauritius’ overwhelming advantage over the
domestic locations in terms of

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