Beruflich Dokumente
Kultur Dokumente
Firms
Author(s): Lawrence J. Gitman, John R. Forrester and Jr.
Source: Financial Management, Vol. 6, No. 3 (Autumn, 1977), pp. 66-71
Published by: Wiley on behalf of the Financial Management Association International
Stable URL: http://www.jstor.org/stable/3665258
Accessed: 13-09-2017 13:42 UTC
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Forecasting and Evaluation.
Practices and Performance
*The cost of preparation, distribution, and other clerical chores required by this study was funded through a University of
Research Grant.
66
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L. J. GITMAN AND J. R. FORRESTER, JR./CAPITAL BUDGETING TECHNIQUES 67
reported in Forbes [11, pp. 111-118]. These 1969 data average size of $3,375,000. All of the respondents indi-
were used since they reflected the behavior of firms cated that a minimum outlay of $10,000 or more was
during an inflationary or expansionary period. Ques- required in order to justify formal analysis of a pro-
tionnaires personally addressed to the chief financial posed project: because of the response choices given
officer of the firm were mailed in June, 1976, to 268 (See Exhibit 4), this result may be a bit misleading
firms appearing on both lists [10]. since the questionnaire's minimum was $10,000. Of
One hundred and ten responses were received, with projects formally analyzed, two-thirds of the respon-
103 completed questionnaires (38.4% of the 268 dents have an acceptance rate of over 75%. This sug-
firms). To become more familiar with the character- gests that projects are not formally analyzed unless
istics of the respondents, a few questions were asked they are expected to meet the firm's acceptance
pertaining to the firm and its chief financial officer. criteria.
Job titles of those primarily responsible for capital
budgeting analysis as well as the completion of the Exhibit 3. Size of Annual Capital Budget
questionnaire were: Vice President of Finance, Responses
Size of Annual
Treasurer, Director of Planning, Director of Capital Number Percent
Capital Budget
Programs, or Director of Facilities Management. As
Less than $10 million 0 0.0
can be seen in Exhibits 1 and 2, the firms responding
$10 to $50 million 11 11.2
primarily were manufacturing firms with total assets $50 to $100 million 23 23.5
in excess of $100 million. More than $100 million 64 65.3
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68 FINANCIAL MANAGEMENT/FALL 1977
The respondents were asked to choose one of a flows is the most critical stage. These results confirm
number of possible areas to identify which division or those of Fremgen [2, pp. 24-25] who in his 1973 study
department has the responsibility for analyzing capital found that most firms believed that the definition and
expenditure proposals - Finance, Operations, Plan- estimation of project cash flows were both the most
ning, or Production. The responses to this question are difficult and most critical parts of the capital budget-
shown in Exhibit 6. Total responses (123) exceed the ing process.
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 Capital Budgeting Techniques
shared between two or more departments. Exhibit 6 One of the goals of this study was to determine the
clearly indicates that in the majority of firms the capital budgeting techniques most commonly used by
responsibility for analyzing capital budgeting projects the nation's leading business firms: by comparing the
is that of the Finance or Planning Departments. findings with the results of previous studies, the prog-
ress of business firms toward the use of more sophisti-
Exhibit 6. Division of Department Responsibility cated techniques was assessed. Another area of inter-
est was the cost of capital or cutoff rate utilized by
Division or
Responses these firms.
Department Number Percent Several capital budgeting techniques are available
Finance 74 60.2 for use in evaluating projects. Net Present Value,
Operations 16 13.0 Benefit/Cost Ratios (or Profitability Index), and the
30 24.4
Planning Internal Rate of Return (or Discounted Rate of
Production 3 2.4
Return) are quite "sophisticated," since they ex-
Total Responses 123 100.0
plicitly consider the time value of money. Although
there are numerous "unsophisticated" capital bud-
The capital budgeting process cantechniques,
geting be viewedthe best as
knowncon-
are the Rate of
sisting of four stages: 1) project definition and estima-
Return (or Average Rate of Return) and the Payback
tion of cash flows; 2) project analysis and selection;
Period. The respondents were asked to 3)
indicate the
project implementation; and 4) project review. Ex-
primary and secondary technique used, given a choice
hibit 7 indicates that the most
of difficult aspect
the three sophisticated of unsophisticated
and two the
capital budgeting process involves defining
techniques mentioned. projects
Their responses are summar-
and estimating their cash flows.
ized inThis result
Exhibit 8. is not
From the total numbersur-
of responses
prising since specification of cash
to the questionflows
on primaryinvolves
technique in use (112), it
numerous forecasts and tax-related decisions. Since
can be seen that some respondents consider more than
what is viewed as "most difficult" might not be con-
one technique to be a primary tool.
sidered "most important," the respondents were asked
which stage of the capital budgeting process is most
Exhibit 8. Capital Budgeting Techniques in Use
critical. The responses, also shown in Exhibit 7, indi-
Primary Secondary
cate that project definition and estimation of cash Number Percent
Number Percent
Technique
Internal (or Discounted)
Rate of Return 60 53.6 13 14.0
Exhibit 7. Most Difficult and Most Important Stages
Rate of Return (Average
of Capital Budgeting Process Rate of Return) 28 25.0 13 14.0
Net Present Value 11 9.8 24 25.8
Responses 10 8.9 41 44.0
Payback Period
Most Difficult Most Critical Benefit/Cost Ratio
(Profitability Index) 3 2.7 2 2.2
Stage Number Percent Number Percent
Total Responses 112 100.0 93 100.0
Project Definition and
Cash Flow Estimation 65 64.3 53 52.0
Financial Analysis and The results indicate a strong preference for sophis-
Project Selection 15 14.9 34 33.3
ticated capital budgeting techniques as the primary
Project Implementation 7 6.9 9 8.8
Project Review 14 13.9 6 5.9 tool of analysis, and the use of internal rate of return
101 100.0 102 100.0
as the dominant technique, confirming the findings of
Total Responses
Fremgen [2] and Petty, Scott, and Bird [8, pp.
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L. J. GITMAN AND J. R. FORRESTER, JR./CAPITAL BUDGETING TECHNIQUES 69
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70 FINANCIAL MANAGEMENT/FALL 1977
and uncertainty and to indicate any other techniques The first section presented basic statistics d
used. Responses to the four choices are shown in Ex-ing respondent firms. The second section
hibit 11. Other responses included: sensitivity analy-
budgeting procedures disclosed that most firm
sis, simulation, and risk models. A few respondents central review committee which chooses prop
use more than one technique (103 responses from 100that the responsibility for analysis normally
respondents). The most popular technique (43 per-
the Finance or Planning Departments. The
dents also indicated that the most difficult and most
cent of responses) involves adjusting the minimum
rate of return upward. important stage of the process involves the definition
and estimation of cash flows. The third section showed
Exhibit 1 1. Methods Used to Adjust for Risk that sophisticated techniques for primary analysis
and Uncertainty were most popular, particularly the internal rate of
Responses return. For secondary analysis, the use of the pay-
back period was indicated by a large number of
Method Number Percent
respondents. It was found that most firms at the time
Increase the Minimum Rate of
of the survey used costs of capital or cutoff rates of 10
Return or Cost of Capital 44 42.7
to 20 percent; the majority of responses were in the 10
Use Expected Values of Cash
Flows (Certainty-Equivalents) 27 26.2 to 15 percent range. The fourth section showed that
Subjective Adjustment of Cash Flows 19 18.5 most firms make capital expenditures on a competi-
Decrease Minimum Payback Period 13 12.6 tive basis to allocate a fixed budget. It was found that
Total Responses 103 100.0 the major cause of capital rationing was a debt limit
which was imposed internally by management. The
final section found that most firms give explicit con-
The popularity of the risk-adjusted rate of return is sideration to risk and uncertainty, and that the use of
not surprising since it is one of the easiest approaches risk-adjusted discount rates and/or certainty equiva-
available for risk adjustment. Petty, Scott, and Bird lents to adjust for risk is quite popular.
[8, p. 170] recognized the use of this technique in their In summary, it is evident that the major firms in the
1975 survey and contended that more sophisticated U.S. are utilizing many of the tools of analysis pre-
risk-adjustment techniques would not be employed sented in the financial theory for analyzing capital
until risk can be measured more precisely and one can budgeting projects. And, as indicated in previous
show its effect on the firm's cost of capital. The sec- studies (Fremgen [2] and Petty, Scott, and Bird [8]),
ond favored approach was expected values, and the firms are continuing to move forward in the adoption
third most popular technique was the subjective ad- of more sophisticated tools of analysis.
justment of cash flows. As one might expect from a
reading of capital budgeting texts [1, 6, 9], the use of References
either risk-adjusted discount rates or certainty equiva-
1. Harold Bierman, Jr., and Seymour Smidt, The Capita
lents is quite common (approximately 69 percent of Budgeting Decision, 3rd ed., New York, Macmillan,
the responses) among the nation's leading business 1971.
firms. These results again seem to confirm those of 2. James M. Fremgen, "Capital Budgeting Practices: A
Fremgen [2, pp. 22-23], who found both of these tech- Survey," Management Accounting (May 1973), pp.
niques to be quite popular. 19-25.
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L. J. GITMAN AND J. R. FORRESTER, JR./CAPITAL BUDGETING TECHNIQUES 71
5. James C. T. Mao, "Survey of Capital Budgeting: 9. David G. Quirin, The Capital Expenditure Decision,
Theory and Practice," Journal of Finance (May 1970), Homewood, Illinois, Irwin, 1974.
pp. 349-360. 10. Standard and Poor's, Inc., Register of Corporations,
6. Jerome Osteryoung, Capital Budgeting: Long Term Directors, and Executives, Vol. 1, New York, Standard
Asset Selection, Columbus, Ohio, Grid, 1974. and Poor's, Inc., 1976.
7. J. William Petty and Oswald D. Bowlin, "The Finan- 11. "The 500 Biggest Corporations by Capital Expendi-
cial Manager and Quantitative Decision Models," tures," Forbes (May 15, 1970), pp. 111-118.
Financial Management (Winter 1976), pp. 32-41. 12. "Who's Where in the Stock Market," Forbes (January
8. J. William Petty, David F. Scott, Jr., and Monroe M. 1, 1976), pp. 186-206.
Bird, "The Capital Expenditure Decision-Making Pro- 13. Ronald B. Williams, "Industry Practice in Allocating
cess of Large Corporations," The Engineering Econ- Capital Resources," Managerial Planning (May/June
omist (Spring 1975), pp. 159-172. 1970), pp. 15-22.
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