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A Survey of Capital Budgeting Techniques Used by Major U.S. Firms Author(s): Lawrence J. Gitman and John R. Forrester, Jr. Source: Financial Management, Vol. 6, No. 3 (Autumn, 1977), pp. 66-71 Published by: Blackwell Publishing on behalf of the Financial Management Association International Stable URL: http://www.jstor.org/stable/3665258 Accessed: 27/02/2009 21:46 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=black. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit organization founded in 1995 to build trusted digital archives for scholarship. We work with the scholarly community to preserve their work and the materials they rely upon, and to build a common research platform that promotes the discovery and use of these resources. For more information about JSTOR, please contact support@jstor.org. Financial Management Association International and Blackwell Publishing are collaborating with JSTOR to digitize, preserve and extend access to Financial Management. http://www.jstor.org Forecasting and Evaluation. Practices and Performance A Survey of Capital Budgeting Techniques Used by Major U.S. Firms* Lawrence J. Gitman and John R. Forrester, Jr. Lawrence J. Gitman is Associate Professor of Finance at the University of Tulsa. He is author of a number of articles, books, and papers on various aspects of financial management. John R. Forrester, Jr., is Administrator of the Richardson Heights Baptist Church in Richardson, Texas. He received an M.B.A. from the University of Tulsa, after which he was employed as an officer of the First National Bank of Tulsa. * The capital budgeting decision process remains one of the key decision areas confronting the contem- porary financial manager, since its results help mold the firm's future opportunities. Academicians have preached the use of the more sophisticated approaches to capital budgeting analysis and have suggested that certain adjustments for risk be made. Support for the use of quantitative risk-adjustment was provided by the findings of Petty and Bowlin in their Winter 1976 Financial Management article [7] concerned with the use of quantitative methods by financial managers. This article surveys the level of sophistication used in capital budgeting by the nation's leading firms. Where possible, the findings of this study are related to com- parable previous studies. Sample Selection, Response, and Characteristics The large business firms utilized in this study were selected on the basis of two factors: 1) stock price growth, and 2) total dollars of capital expenditures. All of the sample firms came from a list of 600 com- panies which experienced the greatest stock price growth over the 1971-1976 period as reported in Forbes [12, pp. 186-206]. The sample was in effect limited to those firms having exhibited the type of growth which would be expected to accompany in- creased levels of capital expenditure. The firms also appeared in a list of the 500 companies having made the greatest dollar capital expenditures during 1969 as *The cost of preparation, distribution, and other clerical chores required by this study was funded through a University of Tulsa Faculty Research Grant. 66 L. J. GITMAN AND J. R. FORRESTER, JR./CAPITAL BUDGETING TECHNIQUES reported in Forbes [11, pp. 111-118]. These 1969 data were used since they reflected the behavior of firms during an inflationary or expansionary period. Ques- tionnaires personally addressed to the chief financial officer of the firm were mailed in June, 1976, to 268 firms appearing on both lists [10]. One hundred and ten responses were received, with 103 completed questionnaires (38.4% of the 268 firms). To become more familiar with the character- istics of the respondents, a few questions were asked pertaining to the firm and its chief financial officer. Job titles of those primarily responsible for capital budgeting analysis as well as the completion of the questionnaire were: Vice President of Finance, Treasurer, Director of Planning, Director of Capital Programs, or Director of Facilities Management. As can be seen in Exhibits 1 and 2, the firms responding primarily were manufacturing firms with total assets in excess of $100 million. Exhibit 1. Industry Classification of Respondents average size of $3,375,000. All of the respondents indi- cated that a minimum outlay of $10,000 or more was required in order to justify formal analysis of a pro- posed project: because of the response choices given (See Exhibit 4), this result may be a bit misleading since the questionnaire's minimum was $10,000. Of projects formally analyzed, two-thirds of the respon- dents have an acceptance rate of over 75%. This sug- gests that projects are not formally analyzed unless they are expected to meet the firm's acceptance criteria. Exhibit 3. Size of Annual Capital Budget Size of Annual Capital Budget Less than $10 million $10 to $50 million $50 to $100 million More than $100 million Total Responses Responses Number Percent 0 0.0 11 11.2 23 23.5 64 65.3 98 100.0 Classification Distributor Manufacturer of Durables Manufacturer of Non-durables Service Company Total Responses Responses Number Percent 4 3.9 35 34.0 41 40.0 23 22.1 103 100.0 Exhibit 2. Asset Size of Respondent Firms Responses Asset Size Number Percent Less than $100 million 0 0.0 $100 to $500 million 10 9.7 $500 to $1 billion 22 21.4 More than $1 billion 71 68.9 Total Responses 103 100.0 Capital Budgeting Statistics A portion of the questionnaire was devoted to deter- mining various statistics describing the respondent firms' capital budgeting activities: Exhibits 3, 4, and 5 provide these data. Capital budgets of over $100 million were in the majority, and the number of proj- ects formally analyzed averaged 238 per respondent per year. These data indicate that the responding firms were actively engaged in capital budgeting evaluation and analysis. An open-ended question relating to proj- ect size elicited a wide range of responses with an Exhibit 4. Project Size for Formal Analysis Responses Project Size Number Percent Greater than $10,000 31 31.3 Greater than $50,000 27 27.3 Greater than $100,000 23 23.2 Greater than $500,000 12 12.1 Greater than $1,000,000 6 6.1 Total Responses 99 100.0 Exhibit 5. Percent of Projects Accepted ?~Percent ~Responses Percent Accepted Number Percent Less than 10% 4 4.1 10 to 25% 1 1.0 25 to 50% 5 5.1 50 to 75% 20 20.6 75 to 90% 34 35.1 More than 90% 33 34.1 Total Responses 97 100.0 Capitol Budgeting Procedures Respondents were asked to indicate whether their firms utilize a central review committee. The re- sponses to this "yes-no" question indicated that a great majority of the firms do: 76 of 101 respondents indicated that their firms utilize the committee, while the other 25 indicated they did not. 67 FINANCIAL MANAGEMENT/FALL 1977 The respondents were asked to choose one of a number of possible areas to identify which division or department has the responsibility for analyzing capital expenditure proposals - Finance, Operations, Plan- ning, or Production. The responses to this question are shown in Exhibit 6. Total responses (123) exceed the number of respondents, because a number of respon- dents picked more than one choice, since the responsi- bility for capital budgeting analysis in their firm was shared between two or more departments. Exhibit 6 clearly indicates that in the majority of firms the responsibility for analyzing capital budgeting projects is that of the Finance or Planning Departments. Exhibit 6. Division of Department Responsibility Division or Department Finance Operations Planning Production Total Responses Responses Number Percent 74 60.2 16 13.0 30 24.4 3 2.4 123 100.0 The capital budgeting process can be viewed as con- sisting of four stages: 1) project definition and estima- tion of cash flows; 2) project analysis and selection; 3) project implementation; and 4) project review. Ex- hibit 7 indicates that the most difficult aspect of the capital budgeting process involves defining projects and estimating their cash flows. This result is not sur- prising since specification of cash flows involves numerous forecasts and tax-related decisions. Since what is viewed as "most difficult" might not be con- sidered "most important," the respondents were asked which stage of the capital budgeting process is most critical. The responses, also shown in Exhibit 7, indi- cate that project definition and estimation of cash Exhibit 7. Most Difficult and Most Important Stages of Capital Budgeting Process Stage Project Definition and Cash Flow Estimation Financial Analysis and Project Selection Project Implementation Project Review Total Responses Responses Most Difficult Most Critical Number Percent Number Percent 65 64.3 15 14.9 7 6.9 14 13.9 101 100.0 53 52.0 34 9 6 102 33.3 8.8 5.9 100.0 flows is the most critical stage. These results confirm those of Fremgen [2, pp. 24-25] who in his 1973 study found that most firms believed that the definition and estimation of project cash flows were both the most difficult and most critical parts of the capital budget- ing process. Capital Budgeting Techniques One of the goals of this study was to determine the capital budgeting techniques most commonly used by the nation's leading business firms: by comparing the findings with the results of previous studies, the prog- ress of business firms toward the use of more sophisti- cated techniques was assessed. Another area of inter- est was the cost of capital or cutoff rate utilized by these firms. Several capital budgeting techniques are available for use in evaluating projects. Net Present Value, Benefit/Cost Ratios (or Profitability Index), and the Internal Rate of Return (or Discounted Rate of Return) are quite "sophisticated," since they ex- plicitly consider the time value of money. Although there are numerous "unsophisticated" capital bud- geting techniques, the best known are the Rate of Return (or Average Rate of Return) and the Payback Period. The respondents were asked to indicate the primary and secondary technique used, given a choice of the three sophisticated and two unsophisticated techniques mentioned. Their responses are summar- ized in Exhibit 8. From the total number of responses to the question on primary technique in use (112), it can be seen that some respondents consider more than one technique to be a primary tool. Exhibit 8. Capital Budgeting Techniques in Use Technique Internal (or Discounted) Rate of Return Rate of Return (Average Rate of Return) Net Present Value Payback Period Benefit/Cost Ratio (Profitability Index) Total Responses Primary Number Percent 60 53.6 28 11 10 3 112 25.0 9.8 8.9 2.7 100.0 Secondary Number Percent 13 14.0 13 24 41 2 93 14.0 25.8 44.0 2.2 100.0 The results indicate a strong preference for sophis- ticated capital budgeting techniques as the primary tool of analysis, and the use of internal rate of return as the dominant technique, confirming the findings of Fremgen [2] and Petty, Scott, and Bird [8, pp. 68 L. J. GITMAN AND J. R. FORRESTER, JR./CAPITAL BUDGETING TECHNIQUES 162-165]. A 1972 study by Klammer [4, pp. 387-395] showed that the use of sophisticated techniques in- creased from 19 percent of the firms in 1959 to 38 per- cent in 1964, and to 57 percent in 1970. The 1973 study by Fremgen [2, pp. 20-22] also confirmed this trend. This study supports these earlier findings and suggests that the use of sophisticated techniques is continuing to increase (57 percent of firms in 1970, 66 percent of responses in 1976). Petty, Scott, and Bird [8, p. 170] also show that "almost one-half of the respondents expressed that the firm has moved to more quantitative and formal analysis." Exhibit 8 indicates that the most popular secon- dary (or supplementary) technique used is the pay- back period. The popularity of this technique has prevailed for years. In Fremgen's 1973 study, the pay- back period was found to be the most popular tech- nique. Although Fremgen did not specifically ask for secondary techniques, it is apparent from his study that the use of payback was secondary to the use of the internal rate of return as has been suggested by numerous authors such as Gitman [3, pp. 290-291]. The use of net present value as a supplementary tech- nique was reported by nearly 26 percent of the respon- dents, but only 9.8% used it as a primary technique, which suggests that it is not utilized by most firms in a primary role but does find favor as a secondary tool of analysis. Respondents were asked to indicate which of a number of possible cost of capital values best de- scribed that of their firm. The responses to this ques- tion are summarized in Exhibit 9. At the time they responded, most of the firms had a cost of capital of 10 to 15 percent or more. 83.1 percent of the firms had costs of capital between 10 and 20 percent. Although this finding does not enhance our knowledge of the techniques being used, it does provide a general idea about the requirements for project acceptance even though these findings may only apply to a particular point in time. Exhibit 9. Cost of Capital or Cutoff Rate Rate Less than 5% 5 to 10% 10 to 15% 15 to 20% More than 20% Total Responses Responses Number Percent 0 0.0 9 9.5 57 60.0 22 23.1 7 7.4 95 100.0 Capital Rationing Respondents were asked to indicate "yes or no" on whether their firm made a competitive allocation of a fixed budget to competing projects. Of the 100 responses to this question, 52 indicated "yes" while the remaining 48 responded "no." Hence, about half of all large firms operate in a capital rationing en- vironment in which they attempt to allocate a fixed budget on a competitive basis. The principal causes of capital rationing are presented in Exhibit 10. Nearly 70 percent of the respondents indicated that the major cause of capital rationing was a limit placed on borrowing by the internal management. This con- firms the finding of Fremgen [2, pp. 23-24] who dis- closed that "the most prevalent cause of capital ra- tioning is a limitation on borrowing." When the other causes of borrowing limitations imposed by outside agreements (10.7 percent) or external management (3.2 percent) are added, the total of 83 percent sug- gests that capital rationing results from some type of debt limitation. Exhibit 10. Major Cause of Capital Rationing Cause Debt Limit Imposed by Outside Agreement Debt Limit Placed by Management External to the Organization Limit Placed on Borrowing by Internal Management Restrictive Policy Imposed upon Retained Earnings for Dividend Payout Maintenance of a Target Earnings Per Share or Price-Earnings Ratio Total Responses Responses Number Percent 10 10.7 3 3.2 65 69.1 2 2.1 14 94 14.9 100.0 Risk and Uncertainty The final aspect of the capital budgeting process investigated was the treatment of risk and uncer- tainty. The literature of capital budgeting emphasizes the importance of giving some consideration to the differing risks associated with different projects. Two questions were included in the questionnaire on whether the firms explicitly consider risk and uncer- tainty, and, if so, what methods they use. Of 100 respondents, 71 percent indicated they gave explicit consideration to risk and uncertainty, while 29 per- cent said "no." This suggests that a great majority of large firms give explicit consideration to risk and un- 69 FINANCIAL MANAGEMENT/FALL 1977 certainty, and it confirms Fremgen's 1973 study [2, pp. 22], which found 67 percent of the firms respond- ing affirmatively. The respondents were asked to indicate which of four possible techniques they used to adjust for risk and uncertainty and to indicate any other techniques used. Responses to the four choices are shown in Ex- hibit 11. Other responses included: sensitivity analy- sis, simulation, and risk models. A few respondents use more than one technique (103 responses from 100 respondents). The most popular technique (43 per- cent of responses) involves adjusting the minimum rate of return upward. Exhibit 1 1. Methods Used to Adjust for Risk and Uncertainty Method Increase the Minimum Rate of Return or Cost of Capital Use Expected Values of Cash Flows (Certainty-Equivalents) Subjective Adjustment of Cash Flows Decrease Minimum Payback Period Total Responses Responses Number Percent 44 42.7 27 19 13 103 26.2 18.5 12.6 100.0 The popularity of the risk-adjusted rate of return is not surprising since it is one of the easiest approaches available for risk adjustment. Petty, Scott, and Bird [8, p. 170] recognized the use of this technique in their 1975 survey and contended that more sophisticated risk-adjustment techniques would not be employed until risk can be measured more precisely and one can show its effect on the firm's cost of capital. The sec- ond favored approach was expected values, and the third most popular technique was the subjective ad- justment of cash flows. As one might expect from a reading of capital budgeting texts [1, 6, 9], the use of either risk-adjusted discount rates or certainty equiva- lents is quite common (approximately 69 percent of the responses) among the nation's leading business firms. These results again seem to confirm those of Fremgen [2, pp. 22-23], who found both of these tech- niques to be quite popular. Summary and Conclusions This article has presented the findings of a survey of capital budgeting techniques sent to a sample of 268 major companies experiencing high stock price growth and known to make large capital expendi- tures. Based upon the 103 usable responses received, the findings were analyzed on the basis of five major areas. The first section presented basic statistics describ- ing respondent firms. The second section on capital budgeting procedures disclosed that most firms have a central review committee which chooses proposals and that the responsibility for analysis normally is within the Finance or Planning Departments. The respon- dents also indicated that the most difficult and most important stage of the process involves the definition and estimation of cash flows. The third section showed that sophisticated techniques for primary analysis were most popular, particularly the internal rate of return. For secondary analysis, the use of the pay- back period was indicated by a large number of respondents. It was found that most firms at the time of the survey used costs of capital or cutoff rates of 10 to 20 percent; the majority of responses were in the 10 to 15 percent range. The fourth section showed that most firms make capital expenditures on a competi- tive basis to allocate a fixed budget. It was found