Journal of Business Finance & Accounting, 27(5) & (6), June/July 2000, 0306-686X

The Theory-Practice Gap in Capital Budgeting: Evidence from the United Kingdom
Glen C. Arnold and Panos D. Hatzopoulos*
1. INTRODUCTION

The survival and vitality of a corporation are determined by its ability to regenerate itself through the allocation of capital to productive use. The selection and employment of processes and techniques to decide major financial commitments are crucial. Inadequate evaluatory and decision tools risk the possibility of applying scarce resources to areas which provide a return less than the cost of capital, resulting in a destruction of value (Rappaport, 1986; Stewart, 1991; McTaggart, et al., 1994; and Copeland, et al., 1996). On the other hand an appraisal system which leads to a failure to apply resources to projects offering a return greater than the cost of capital results in an opportunity cost (Arnold, 1998) and potential loss of competitive position (Porter, 1985). This study considers the extent to which modern investment appraisal techniques are being employed by the most significant UK corporations. In addition to reporting the results of an extensive survey conducted in 1997 this paper explores some of the reasons for the continuing high use of traditional,
* The authors are respectively from Aston Business School and Chrislia Hotels. They would like to thank the Finance and accounting group at Aston University for financial support and constructive criticism. Thanks are also due to the anonymous referee of an earlier draft of this article who made extremely valuable observations and suggestions which led to significant improvement. (Paper received May 1999, revised and accepted November 1999) Address for correspondence: Glen Arnold, Lecturer, Aston Business School, Aston University, Aston Triangle, Birmingham B4 7ET, UK. e-mail: g.c.arnold@aston.ac.uk
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rule-of-thumb techniques, alongside discounted cash flow (DCF) methods.

2. SURVEY METHOD AND SAMPLE

A structured survey approach was adopted which enabled information on firms' capital investment decision-making procedures to be collected in a systematic way. The questionnaire used mainly structured multi-choice questions. However, respondents were able to give answers not listed on the form, and were encouraged to provide more expansive responses. Three hundred UK companies taken from the Times 1000 (1996)1 ranked according to capital employed (excluding investment trusts) were sent the questionnaire in the summer of 1997. The first 100 (large size) of the sample were the largest 100 firms; another 100 are in the ranking of 250^400 (medium size); the final 100 are ranked 820^1,000 (small size).2 The capital employed ranged between 1.3bn and 24bn for the large firms, 207m and 400m for the medium-sized firms and 40m and 60m for the small companies. A charge is made against surveys of this nature that the respondent is usually a junior executive with a limited viewpoint (Aggarwal, 1980). To address this concern the questionnaire was addressed to the finance director of each company personally. In order to improve the response rate and the reliability and honesty of the responses the directors were offered complete anonymity.3 In numerous cases it was revealed that the most senior and relevant director or manager had indeed responded, despite the offer of anonymity. Four questionnaires were returned untraced, or companies liquidated or merged, giving a reduced sample of 296. Of these 145 (49%) replies were received and 96 were completed and useable, 38 large, 24 medium and 34 small (a response rate of 32.4%). All the small firms had annual capital budget totals of under 50m. Of the medium-sized firms three-quarters spent less than 50m per annum on capital projects and the remaining quarter spent between 50m and 200m. Two-thirds of the large firms committed over 200m per annum to the capital budget ^ see Table 1.
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Table 1 Annual Capital Budgets for Responding Companies

Small % Up to 1m 1m to 50m 50m to 100m 100m to 200m 200m or more Blank 3 97 Medium % 75 21 4 Large % 5 8 18 66 3

3. FINDINGS

The responses to questions concerning project appraisal method (Tables 2, 3 and 4) provide some confirmatory evidence of trends established over a twenty-two year period. However, there are some interesting points of contrast. The results of research conducted by Pike (1982, 1988 and 1996) and McIntyre and Coulthurst (1985) are presented where possible, in order to
Table 2 Financial Analysis Techniques Used for the Appraisal of Major Investments
McIntyre & Coulthurst b (Small/ Medium Firms)

Current Study

Pike a (Large Firms)

Small Medium Large Composite 1992 1986 1980 1975 1984 % % % % % % % % % Payback ARR IRR NPV DCF (IRR or NPV) Non-financial criteria used 71 62 76 62 91 32 75 50 83 79 96 17 66 55 84 97 100 39 70 56 81 80 96 31 94 50 81 74 88 ^ 92 56 75 68 84 ^ 81 49 57 39 68 ^ 73 51 44 32 58 7 82 33 28 36 45 4

Notes: a Pike (1996) 100 firms. b McIntyre and Coulthurst (1985) 141 firms.
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Table 3 Frequency of Use of Financial Analysis Technique

Rarely % Small firms Payback ARR IRR NPV Medium-sized firms Payback ARR IRR NPV Large firms Payback ARR IRR NPV Composite Payback ARR IRR NPV 15 6 6 9 8 8 8 13 18 8 3 3 14 7 5 7 Often % 12 18 9 18 25 29 25 21 16 11 3 5 17 18 10 14 Mostly % 15 15 18 18 8 13 13 8 24 16 26 29 16 15 20 20 Always % 35 29 44 26 33 13 42 42 24 32 55 58 30 26 48 43

provide benchmarks for comparison and to shed light on the issue of longitudinal shifts in approaches to capital budgeting. These studies were selected for comparison because they have characteristics similar to those of the current study: The firms surveyed are UK companies; the sample sizes are relatively large, and; mail questionnaires were used to gather data. Pike's studies focus on 100 large firms comparable to the `large' category in this study. The 141 firms examined by McIntyre and Coulthurst had sales between 1.4m and 5m and 50 to 250 employees. This would generally make these companies smaller than the current study's `small firms' category. Caution is needed in comparing survey based studies, even without this size discrepancy, due to variations ranging from different samples to changes in questions asked. Despite these problems there is sufficient comparability, particularly with Pike's surveys, to allow (tentative) inferences to be drawn.
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Table 4 Frequency of the Use of Combinations of Appraisal Methods

Current Study 1997 Small % No method Single method Payback ARR IRR NPV Two methods Payback + ARR Payback + IRR Payback + NPV ARR + IRR ARR + NPV IRR + NPV Three methods Payback + ARR + IRR Payback + ARR + NPV Payback + IRR + NPV ARR + IRR + NPV Four methods Payback + ARR + IRR +NPV Any simple method: Payback or ARR
Notes: a Pike (1996). b McIntyre amd Coulthurst (1985).

Pike a (Large Firms) Composite Results % 1 1 ^ 2 4 7 2 3 2 5 3 8 23 5 5 22 6 38 29 85 1992 % ^ 4 ^ ^ 0 4 8 9 6 ^ ^ 5 28 5 1 26 ^ 32 36 95 1986 % ^ 6 ^ 2 0 8 10 8 5 2 1 3 29 5 3 21 ^ 29 34 97 1980 % ^ 12 7 4 1 24 13 15 6 2 1 4 41 10 4 9 1 24 10 90 1975 % 2 14 12 5 0 31 14 14 4 ^ 1 1 34 7 4 10 1 22 11 92

McIntyre and Coulthurst b (Small Firms) 1984 % 2 35 4 2 4 45 11 5 10 ^ 2 2 30 2 2 5 9 13 90

THE THEORY-PRACTICE GAP IN CAPITAL BUDGETING

Medium % ^ ^ ^ ^ 4 4 4 4 4 8 4 4 28 4 ^ 33 4 41 25 92

Large % ^ ^ ^ ^ 8 8 ^ 3 ^ ^ 3 11 17 ^ 5 24 13 42 34 81

3 3 ^ 6 ^ 9 3 3 3 9 3 9 30 12 9 12 ^ 33 26 82

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We can now cast doubt on Pike and Wolfe's (1988, p. 92) comment that payback's `popularity increases with the years'. Previous surveys have shown that the increase in the adoption of discounted cash flow (DCF) techniques has not been at the expense of the payback method and that payback continued to gain support. While we show a reduction in the use of payback it remains at a high level. This survey presents evidence that is consistent with the proposition that the theory-practice gap has been narrowed. DCF was used by only 58% of large firms in 1975, whereas all large firms are now using either IRR or NPV, and over 90% of small and medium-sized firms are using these methods. For the largest UK firms NPV has overtaken IRR as the most widely used method: 97% of large firms use NPV compared with 84% which employ IRR. Pike's earlier surveys show that IRR dominated, for example in the 1986 survey (Pike, 1988) 23% of large firms always used NPV whereas 42% always used IRR. The current survey shows that in the late 1990s the position was reversed with 58% of large firms always conducting NPV analysis compared with 55% always calculating IRR. Whereas one-third of large firms in 1975 used one technique only, with approximately one-third using two techniques and the remainder using three or more techniques, this survey shows 67% of firms (76% of large firms) using three or more methods ^ Table 4. The most popular choice is to use all four evaluatory methods (29%) closely followed by the combination of payback, IRR and NPV. Textbooks tend to emphasise the NPV rule, often arguing that it is theoretically superior to other methods (e.g., Zimmerman, 1997, ch. 3; and Kaplan and Atkinson, 1998, p. 594). The results of this survey are consistent with the view that there is increasing knowledge and acceptance of the arguments presented in textbooks. The wider use of DCF has been assisted by technological developments, particularly the growth of computing power, making calculations easy and at low cost (Klammer and Walker, 1984; Pike, 1988; and Sangster, 1993). Yet despite the trend toward NPV, other methods, many of which do not involve discounting, are used in practice at least in conjunction with IRR and NPV-type methods. Since companies use these other methods, one of two conclusions can be drawn: either firms are making suboptimal
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decisions, or the assumptions underlying the NPV rule are not always met in practice (Arya, Fellingham and Glover, 1998). If the first conclusion is correct improvements in financial knowledge may be advanced as a solution. However, given the widespread awareness of DCF it has to be acknowledged that traditional `theoretically inferior' methods retain a remarkably tenacious hold on practice. In searching for an explanation it is appropriate to consider the possibility that the theory-practice gap is being bridged, at least partially, due to theory moving toward practice. As Arya, Fellingham and Glover (1998) have pointed out, the standard NPV rule implicitly makes two assumptions which are often overlooked. First, the project approval decision is a `now-ornever' decision (if the project is turned down it cannot be undertaken in the future) and that real options to defer, expand, contract, abandon, switch use or alternatively alter a capital investment can be ignored. Second, decisions are made either in a single person firm or in a multi-person firm in which there are no information asymmetries between the firm's owners and managers (or between managers), and each member is motivated to the same objective. Dixit and Pindyck (1994), Ross (1995), Trigeorgis (1996) and Arya, Fellingham and Glover (1998) have conducted analysis in which the first assumption is relaxed. Harris et. al., (1982), Antle and Eppen (1985) Emmanuel et. al. (1990) and Arya, Fellingham and Glover (1998) have relaxed the second assumption. In practice uncertainty, information asymmetry, multiple (conflicting) objectives, real options and multi-period multi-project considerations greatly complicate capital budgeting, beyond the focus of the standard textbook treatment. When the NPV rule's assumptions are violated, the use of multiple criteria is a way of evaluating the project from different perspectives. If many of the criteria suggest the project should be taken, the chance is greater that the project is desirable (Arya, Fellingham and Glover, 1998). As Demski (1994, p. 385) stated, there is:
ambiguity in the present value frame itself . . . In this case, we then acknowledge an ambiguous framing exercise coupled with a portfolio of approaches to the framing task.

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Ross et al., (1995, p. 218^9) take a similar view:

Because the true NPV is unknown, the astute financial manager seeks clues to assess whether the estimated NPV is reliable. For this reason, firms would typically use multiple criteria for evaluating a proposal . . . [if] different indicators seem to agree [then] it's `all systems go'.

A consideration of the impact of information asymmetry, real options and other complications on the budgeting exercise gives one the view that there is no unique correct technique and that there is a need for multiple methods. Some indication of the continued attraction of traditional nonDCF methods is given in the responses to the question concerning changes in methods used over the last five years (Table 5). Almost one-quarter replied that they had changed their approach. Three firms stated a greater reliance on cash flow based methods. A further seven were more specific and stated an increased emphasis on, or the introduction of, IRR whereas five other firms mentioned a shift toward NPV. However, four firms said they were focusing more on traditional measures. One commented: `More emphasis on payback due to tighter cash control', and another mentioned, `More interest in discounted payback coupled with IRR and NPV'. Nine firms pointed out that they now employ value-based management metrics. Three use economic profit and three use a variant of economic profit, economic value added. Two companies used cash flow return on investment and one makes use of total shareholder return. This survey did not specifically enquire into the adoption of valuebased metrics but the information provided by the respondents confirms an impression of an increasingly important role for
Table 5 Replies to the Question: Has There Been a Major Switch in Techniques Used Over the Last 5 Years?
Small % Yes No Blank 23 71 6 Medium % 25 75 ^ Large % 21 76 3 Composite % 23 74 3

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them as described by Mills et al. (1996) where 49% of large UK firms were found to have adopted value-based measures of performance in the context of acquisition and divestment decisions. This study confirms the observation made by Pike (1982) and others that many firms consider strategic fit to be an important criterion for the acceptance of projects alongside the quantitative hurdles. In the space left on the questionnaire for comments on non-financial criteria used in project appraisal statements such as `alignment with strategy' and `does investment help achieve strategic goals?' were made by twelve firms. This could be interpreted as a further indication that standard NPV is unable to capture the complexity of corporate investment decisions. Other factors taken into account include `availability of staff' and `management strain' ^ indicating a constraint on the acceptance of projects. `Culture fit' and `Augment skills range?' or `Technology platform building' were also considered important. In 1975 a minority of large UK firms required a formal evaluation of risk (Pike, 1982), this rose to 94% in 1997 (Table 6). The most widely used risk technique is sensitivity/scenario analysis (85% of firms). However, this is often used in
Table 6 Technique(s) Used When Assessing the Risk of a Major Project
Sensitivity/ Raise the Subjective Probability Shorten Beta Ignore Other Scenario Required Assessment Analysis Payback Analysis Risk Analysis Rate of Period Return % % % % % % % % Current study Small Medium Large Composite 82 83 89 85 42 71 50 52 44 33 55 46 27 21 42 31 15 42 11 20 3 0 5 3 0 0 3 1 0 4 5 3

Pike (100 large UK firms) Year 1992 88 1986 71 1980 42 1975 28

65 61 41 37

n/a n/a n/a n/a

48 40 10 9

60 61 30 25

20 16 0 0

n/a n/a n/a n/a

n/a n/a 4 2

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conjunction with raising the required rate of return, and/or subjective assessment (Table 7). Beta analysis and shortening the payback period are rarely used to adjust for risk. Probability analysis is used by 31% of firms. Investment analysis is conducted in the context of a process of dialogue among managers ^ using a variety of risk techniques in a complementary fashion enables different aspects of the proposed project to be observed, offering valuable insights and allowing more informed discussion, review, re-analysis, re-examination and testing, thus increasing confidence in the final decision (Hertz and Thomas, 1983). It would appear that there remains a wide theory-practice gap concerning the use of risk analysis techniques. While textbooks and academic papers (e.g. Davey, 1975; Coats and Chesser, 1982; and Hertz and Thomas, 1984) advocate the use of probability analysis few managers employ it. It would be wrong to jump to the conclusion that this is due to ignorance and that, in time, managers will become sufficiently well informed to be able to handle the complexity involved. There are sound behavioural, practical, and theoretical reasons for the revealed hesitancy of managers. It is thought that probability analysis is not adopted because individuals are unwilling to make their estimates of outcomes explicit. This is due to fear of future criticism if their estimates turn out to be wrong. It is safer to sponsor a project on grounds which are `consistent with some vague concept of general policy' (Cooper, 1975, p. 200) than to be too specific. Also, managers are generally uncomfortable with probabilistic estimates. There is a tendency to consider such activity to be `academic', ill-defined and having little impact on the decision outcome (Neuhauser and Viscione, 1973; and Ho and Pike, 1992). Practitioners may be suspicious of an analysis which is fundamentally based on subjective estimates of future outcomes expressed in spuriously precise quantitative terms (Kee and Bublitz, 1988). Managers baulk at the resources and time which need to be devoted to a sophisticated probabilistic analysis of project risk. This may reduce the number of project proposals advanced and sponsored. It is widely acknowledged (e.g. King, 1975; and Emmanuel et al., 1990) that the main obstacle to value creation is the lack of an environment which encourages idea generation
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Table 7 Combinations of Risk Methods

Small Medium-size Large Composite % % % % No method Single method Sensitivity Subjective Raise R. R. of R. Shorten payback Two methods Sensitivity + Raise R. R. of R. Sensitivity + subjective Sensitivity + probability Shorten payback + Raise R. R. of R. Sensitivity + shorten payback Raise R. R. of R. + subjective Subjective + ignore risk Three methods Sensitivity + Raise R. R. of R. + subjective Sensitivity + probability + subjective Sensitivity + shorten payback + Raise R. R. of R. Sensitivity + Raise R. R. of R. + probability Sensitivity + shorten payback + subjective Sensitivity + beta + subjective Sensitivity + shorten payback + probability Sensitivity + probability + other Sensitivity + subjective + other Probability + beta + subjective Raise R. R. of R. + probability + subjective Four methods Sensitivity + Raise R. R. of R. + probability + subjective Sensitivity + shorten payback + Raise R. R. of R. + subjective Sensitivity + shorten payback + Raise R. R. of R. + probability Five methods Sensitivity + shorten payback + Raise R. R. of R. + probability + subjective Sensitivity + Raise R. R. of R. + probability + beta + subjective
Note: Rounding errors are present in this table.

3 18 9 ^ ^ 12 15 3 ^ 3 ^ ^ 9 3 6 6 ^ ^ 3 ^ ^ 3 3

^ 4 ^ 8 4 17 4 13 ^ ^ 4 ^ 4 ^ 17 ^ ^ ^ ^ ^ 4 ^ ^

3 5 ^ ^ ^ 16 11 8 5 ^ ^ 1 11 13 ^ 5 3 3 ^ 3 ^ ^ ^

2 9 3 2 1 15 15 10 7 2 1 1 1 37 8 6 6 4 1 1 1 1 1 1 1 31 4 3 2 9

3 ^ 3

^ 13 4

8 ^ ^

^ ^

4 ^

3 3

2 1 3

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and enthusiastic project sponsorship rather than the absence of mathematical analysis techniques. Indeed, empirical work (Christy, 1966; Klammer, 1973; Schall et al. 1978; Kim, 1982; and Ho and Pike, 1992) has shown that the adoption of probability analysis does not lead to a significant change in corporate performance. Confirming the practical objections to artificial precision Kim and Farragher (1981) discovered that firms in higher risk classes tend to use sophisticated analysis techniques less than lower risk firms:
If a firm does not have a good idea of the risk of a capital investment, it might be logical to assume that it will not employ sophisticated risk adjustment techniques (p. 30).

Accompanying this line of reasoning is the notion that complex risk analysis is also seen as unnecessary at the other end of the risk spectrum. In cases where the managers are very familiar with the risks inherent in the proposed investment area they make unconscious allowance for risk in deliberations without the need for formal analysis (Pike, 1982). On the one hand probability analysis is rejected because the uncertainty is too great to make realistic estimates, on the other it is not needed when managers are able to analyse risk in a simple informal manner because it is so familiar. Over three-quarters of the firms surveyed adjust for inflation either by specifying cash flows in constant price terms applying a real rate of return or by expressing cash flows in inflated price terms and discounting at the market rate of return (Table 8). There has been a significant bridging of the theory-practice gap in the treatment of inflation over the past two decades. In a 1973 survey Carsberg and Hope (1976) noted that companies tended to express cash flows in real (or constant) terms but used a money (market) cost of capital for discounting those cash flows. Only 15 out of 103 UK firms used inflated cash flows with market rates of return, and a further 5 firms adjusted cash flows by an estimate of general rather than specific inflation and discounted by market rate of return (this was regarded as `a satisfactory approximation' by Carsberg and Hope). In their study the
procedure of setting a real target rate of return and estimating cash flows or profit in real terms appears not to have been used, even approximately, by any of our respondents (p. 62).

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Table 8 Inflation Adjustment Methods Used for Investment Appraisal

Small Medium-sized Large Composite % % % % Specify cash flow in constant prices and apply a real rate of return All cash flows expressed in inflated price terms and discounted at the market rate of return Considered at risk analysis or sensitivity stage No adjustment Other 47 18 21 18 0 29 42 13 21 0 45 55 16 3 3 42 39 17 13 1

Capital expenditure ceilings are placed on operating units which sometimes lead to the rejection of viable projects in the case of 49% of firms (Table 9). The most significant reason given for these limits is that investment decisions are important for the whole group and require central control.
Table 9 Capital Rationing: Are There Specific Capital Expenditure Ceilings Placed on Operating Units Which Sometimes Lead to the Rejection of Viable Projects?
Small Medium-sized Large Composite % % % % Yes No Reasons ^ Percentage of Those That Replied `Yes' Investment decisions important for whole group and require central control Management wants to control cash, because of a shortage of funds Management wants to control areas of activity and mix of products Shortage of other key resources Other 44 56 58 42 47 53 49 51

Small Medium-sized Large Composite % % % % 87 53 40 7 0 79 57 36 7 7 67 44 50 39 7 77 51 43 19 4

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Non-economic capital investments are made by 93% of firms (Table 10). Note however, as one respondent pointed out, even ostensibly non-economic projects have economic consequences:
Careful! Even health and safety legislation can have drastic economic effects ^ e.g. operation closed down.

Another, a large company, added to the list of projects in this category:

Charitable e.g. donations/supply of drugs to third world.

Outline capital budgets looking beyond two years ahead are employed in 72% of the firms surveyed (84% of large firms). Detailed budgets for two or more years ahead are prepared by 45% of large firms, 21% of medium-sized firms and 30% of small firms (Table 11). The current study does not support Pike and Wolfe's (1988) assertion that in the mid 1980s the trend towards increased use of long term capital budgets was halted. Pike and Wolfe suggested that a lack of confidence in long term economic forecasts encouraged firms to limit their planning horizons. Perhaps the greater macro-economic stability in the 1990s compared with the 1970s or early 1980s has renewed interest in longer term planning. Or, perhaps, a higher proportion of firms perceive the value of planning further ahead. The question `what are the cut-off points used to evaluate the viability of major capital investment?' produced some surprising responses (Table 12). In a period of low risk-free rates of return (about 7%) the average payback hurdle rate is set remarkably
Table 10 The Following Considerations Have Led to the Acceptance of Noneconomic Projects
Small % Health and Safety Legislation R & D/Strategically necessary Social/Environmental Repair/Maintenance Other 68 59 56 35 38 6 Medium-sized % 79 75 38 50 42 0 Large % 87 87 68 76 53 11 Composite % 78 74 55 54 45 6

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Table 11 Capital Expenditure Budgets

Small % Outline capital expenditure budgets are prepared for: 1 year ahead 18 2 years ahead 18 3 years ahead 35 4 years ahead 9 More than 4 years ahead 21 Blank ^ Detailed capital expenditure budgets are prepared for: 1 year ahead 70 2 years ahead 21 3 years ahead 9 4 years ahead ^ More than 4 years ahead ^ Medium-sized % 8 25 50 ^ 13 4 79 13 4 ^ 4 Large % ^ 13 18 5 61 3 55 21 8 5 11

Table 12 Cut-off Points Used to Evaluate the Viability of Major Capital Investments
Payback Period Small Medium Large Composite 0^2 years 2^4 years 4^6 years 0 8 3 3 32 13 13 20 18 17 18 18 6^10 years 3 13 11 8 31% 3 4 0 2 Blank 47 50 55 51 Blank 50 63 53 54 Blank 18 17 5 12

Accounting Rate of Return (Return on Capital Employed) 11^15% 16^20% 21^30% Small Medium Large Composite IRR/NPV Small Medium Large Composite 0^10% 9 8 21 14 9 4 16 10 11^15% 41 46 39 42 21 25 24 23 16^20% 15 24 26 22 18 4 8 10

21^30% 30% or more 15 4 8 9 3 0 0 1

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low. For the small firms 2^4 years is the most common range. The modal range for return on capital employed is 16^20%. The modal range for IRR and NPV is 11^15%, with significant numbers falling into the 16^20% range. In his 1986 study Pike (1988) found that two-thirds of firms used a hurdle rate of between 15 and 24% for IRR and NPV with a modal range of 15^ 19% and as many as 27% of firms were using 20^24%. Even as late as 1994 Wardlow in his Bank of England sponsored survey showed that firms required average nominal returns of 20%. He attributed this high rate to:
firms being cautious about changing their required rate of return, given both the past history of uncertainty and the relatively short period of low and stable inflation to date (p. 251).

Theoretical explanations have been advanced for the tendency of firms to require apparently excessive rates of return. Antle and Eppen (1985) and Antle and Fellingham (1990) have pointed out that a combination of asymmetric information between managers and an incentive system within a hierarchy that rewards managers for amassing control over corporate resources can induce the imposition of a countervailing force, that is high hurdle rates, to reduce the tendency to over invest. Ross (1995) has suggested that such rates are a practical way of dealing with uncertainty. Dixit and Pindyck (1994) consider that simple NPV analysis fails to account for `irreversibility and option value' (p. 6) inherent in accepting a project. High hurdle rates are rational because they include compensation for the loss of the option to take the project at a later date if the firm commits itself now. Academic literature promotes the use of a weighted average cost of capital (WACC) to act as a hurdle rate for investment appraisal (Nantell and Carlson, 1975; Carsberg and Hope, 1976; Solomons, 1985; and Ross, Westerfield and Jaffe, 1996). Pike (1983, p. 203) had a poor opinion of techniques used to select a cost of capital:
the methods commonly applied in setting hurdle rates are a strange mixture of folk-lore, experience, theory and intuition.

Westwick and Shohet (1976) had found in the UK the most popular method for selecting the minimum rate of return for use in investment appraisal decisions was to use the company's bank overdraft rate. Less than 10% of firms mentioned the use of a
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WACC. This changed significantly over the subsequent two decades (Table 13). Slightly over one half of the respondents to the current survey now employ a WACC, but a significant minority of small firms still use the interest rate payable on debt. Despite years of academic expounding on the virtues of WACC and extensive managerial education, a significant minority of firms do not calculate a WACC for use in capital investment appraisal. Furthermore, as Tables 14 and 15 show, many of the firms which calculate a WACC do not follow the prescribed methods. However, the use of the CAPM has increased significantly since Brigham's (1975, p. 20) study which showed its employment in only two firms out of 31. Some of the statements made by respondents show that many of those who calculate a WACC fail to follow textbook procedure:
Above is a minimum (WACC). A hurdle rate is also used which is the midpoint of the above (WACC) and the lowest rate of return required by venture capitalists. WACC + safety margin. Weighted average cost of capital plus inflation.

Table 13 Replies to the Question: How Does Your Company Derive the Discount Rate Used in the Appraisal of Major Capital Investment?
Small Medium-sized Large Composite % % % % Weighted average cost of capital The cost of equity derived from the capital asset pricing model is used Interest payable on debt capital is used An arbitrarily chosen figure is used Dividend yield on shares plus estimated growth in capital value of share is used Earnings yield on shares is used Other Blank 41 0 23 12 0 3 12 9 100 63 8 8 4 0 0 8 8 991 61 16 1 3 3 0 11 5 100 54 8 11 6 1 1 10 7 981

Note: 1 The failure of the totals to equal 100% is due to rounding.

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Table 14 Method of Calculating the Weighted Average Cost of Capital (Percent of those that use WACC)
Small Medium-sized Large Composite % % % % Using the Capital asset pricing model for equity and the market rate of return on debt capital Cost of equity calculated other than through the Capital asset pricing model with the cost of debt derived from current market interest rates Other

50

68

79

70

50 0 100

32 0 100

18 3 100

29 1 100

Table 15 If the Weighted Average Cost of Capital is Used, Then the Weights are Defined by:
Small Medium-sized Large Composite % % % % A long term target of debt and equity ratio The present market values of debt and equity Balance sheet ratios of debt and equity 19 44 37 100 26 47 26 991 39 42 19 100 30 44 26 100

Note: 1 The failure of the total to equal 100% is due to rounding.

Explanations advanced for the theory-practice gap revealed in Tables 13, 14 and 15 include managerial ignorance of the more subtle and complex elements of DCF analysis (Gitman and Mercurio, 1982). Alternatively, companies are not using WACC because they are using a closely related method such as the adjusted present value (Myers, 1974; and Ross, Westerfield and Jaffe, 1996). However, the fact that no respondents, when given the opportunity to do so, mentioned the APV or any other theoretically recognisable method means we have no evidence to support this argument. There are theoretical, practical and
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Table 16 Replies to the Question: `Does Your Company Conduct Post-audits of Major Capital Expenditure?'
Small Medium-sized Large Composite % % % % Always Sometimes/on major projects Rarely Never 41 41 12 6 17 67 17 ^ 24 71 5 28 59 10 2

empirical doubts cast on the most heavily promoted method of calculating the equity component of WACC, that is, the CAPM (Lewellen, 1977; Mullins, 1982; Lowenstein, 1989; Tomkins, 1991; Fama and French, 1992; Rosenberg and Rudd, 1992; Mills et al., 1992; Strong and Xu, 1997; and Adedeji, 1997). In addition, it is often extremely difficult, if not impossible, to use the CAPM to determine a particular divisional beta and cost of capital. One respondent expressed the frustration of practitioners by pointing out that precision in the WACC method is less important than to have reliable basic data, `Real issue is one of risk premium on equity. Is it 2% or 8%?!' Tomkins raises a doubt as to whether a disinclination to use the CAPM is sufficiently serious for us to be concerned:
If companies needed this more precise analysis to survive, would they not have discovered this? Would not at least one major competitor have discovered the secret of identifying increased profitability and forced the others to follow suit in order to compete? From the evidence to date it appears that this has not occurred. The refinements to NPV calculations along the lines of a good grasp of the CAPM may still prove to be desirable, but it is clearly only one factor leading to successful investment and the other factors may be more critical (Tomkins, 1991, p. 75).

Only 12% of the firms surveyed never or rarely undertake postauditing. The vast majority always or sometimes post-audit projects ^ see Table 16.

4. CONCLUSION

The central aim of this study is to generate new evidence concerning the capital investment practices of UK firms. Given
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the wealth of theoretical literature and the relative dearth of information describing real world practice, it offers a contribution to the empirical base to further the quality of discussion and research in the field. By combining the new evidence with the results of surveys conducted in earlier decades we can gain some insight into the changes in the approaches taken by managers. It is hoped that the information presented will stimulate those involved in major capital investment decisionmaking to consider their present practices in light of knowledge of policies and techniques adopted by other firms. Furthermore, the preferences, actions and experience of the managers charged with the investment of shareholders' money should influence academic theory. The survey results indicate that UK corporations have increasingly adopted prescribed textbook financial analysis. The stage has now been reached where only a small minority do not make use of discounted cash flows, formal risk analysis, appropriate inflation adjustment and post-auditing. However, managers continue to employ simpler rules-of-thumb techniques. There has not, in general, been a replacement of one set of methods with another, but rather, a widening of the range of ways of analysing a financial decision. Managers perceive this complementary adoption of some of the more formal approaches while persisting with tried and trusted methods as an enrichment of inputs to decision-making. The older approaches have numerous endearing qualities which modern techniques seem unable to provide. Some degree of caution is needed in generalising the results of any sample-based survey to a wider population of firms (Scapens, 1990), although the high response level in this case alleviates this potential problem to a large extent. There is also the issue of response bias to be borne in mind (Rappaport, 1979; and Wallace and Mellor, 1988): Mailed questionnaires may tend to over-state the adoption and importance of sophisticated techniques due to the possibility that the users of sophisticated techniques are more likely to respond than those using less sophisticated techniques. A more significant problem is the interpretation of the results. It is conceivable that managers carry out calculations for the sophisticated procedures, and are therefore able to tick a box on a questionnaire form to that
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effect, but the result of the calculation is paid little heed in the real decision making process. Yes, managers do compute on the basis of DCF more today than they did twenty years ago, what has not been revealed is how they use the DCF information and why they make the decisions they do (Emmanuel et. al., 1990; and Northcott, 1991). The evidence of the calculations of numbers is not sufficient to declare a more `rational' decision-making process, especially in a world with widespread use of cheap computing power, producing a mass of data and information. In further research, attention needs to be directed to the decisionmaking process in an organisational context. Factors to be considered include the multiple goal structure of organisations, the political/social environment, information asymmetry, satisficing rather than optimising, real options, moral hazard, the ritualistic role of accounting information and the legitimisation of previously agreed `strategic' actions (Burchell et al. 1980; Pinches, 1982; and Emmanuel et. al., 1990). This study focuses on an empirical overview of capital investment appraisal tools. Capital budgeting appraisal is but a small part of the process of making investments. If we wish to understand and improve decision-making, research is needed to explore other stages in the process which includes identification of investment opportunities, the search for ideas, the development of proposals into projects, the early screening to match with strategy and culture, the implementation stage, control and review of performance (Hastie, 1974; King, 1975; and Emmanuel et. al., 1990). These other elements may be more critical to the success of firms. An obvious extension of this research would be an in-depth study of the capital investment practices employed by individual corporations. This will provide a better understanding of the entire process. In particular, the qualitative factors influencing capital investment decisionmaking can be examined.
NOTES 1 2 3 An annual publication by Times Books listing the largest UK firms. The excluded firms in each category are investment trusts. They were not asked to state their names or the company's name on the returned form ^ the researchers were able to judge whether the respondent was from a small, medium or large firm by the colour of the paper.

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