Arnold Capital Budgeting

The Theory-Practice Gap in CapitalBudgeting: Evidence from the

United Kingdom

Glen C. Arnold and Panos D. Hatzopoulos*

1. INTRODUCTION

The survival and vitality of a corporation are determined by itsability to regenerate itself through the allocation of capital toproductive use. The selection and employment of processes andtechniques to decide major financial commitments are crucial.Inadequate evaluatory and decision tools risk the possibility ofapplying scarce resources to areas which provide a return lessthan the cost of capital, resulting in a destruction of value(Rappaport, 1986; Stewart, 1991; McTaggart, et al., 1994; andCopeland, et al., 1996). On the other hand an appraisal systemwhich leads to a failure to apply resources to projects offering areturn greater than the cost of capital results in an opportunitycost (Arnold, 1998) and potential loss of competitive position(Porter, 1985). This study considers the extent to which moderninvestment appraisal techniques are being employed by the mostsignificant UK corporations. In addition to reporting the resultsof an extensive survey conducted in 1997 this paper exploressome of the reasons for the continuing high use of traditional,

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

ß Blackwell Publishers Ltd. 2000, 108 Cowley Road, Oxford OX4 1JF, UKand 350 Main Street, Malden, MA 02148, USA. 603

* The authors are respectively from Aston Business School and Chrislia Hotels. Theywould like to thank the Finance and accounting group at Aston University for financialsupport and constructive criticism. Thanks are also due to the anonymous referee of anearlier draft of this article who made extremely valuable observations and suggestionswhich led to significant improvement. (Paper received May 1999, revised and acceptedNovember 1999)

Address for correspondence: Glen Arnold, Lecturer, Aston Business School, AstonUniversity, Aston Triangle, Birmingham B4 7ET, UK.e-mail: [email protected]

rule-of-thumb techniques, alongside discounted cash flow (DCF)methods.

2. SURVEY METHOD AND SAMPLE

A structured survey approach was adopted which enabledinformation on firms' capital investment decision-makingprocedures to be collected in a systematic way. The questionnaireused 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 (excludinginvestment trusts) were sent the questionnaire in the summerof 1997. The first 100 (large size) of the sample were the largest100 firms; another 100 are in the ranking of 250^400 (mediumsize); the final 100 are ranked 820^1,000 (small size).2 Thecapital employed ranged between £1.3bn and £24bn for the largefirms, £207m and £400m for the medium-sized firms and £40mand £60m for the small companies.

A charge is made against surveys of this nature that therespondent is usually a junior executive with a limited viewpoint(Aggarwal, 1980). To address this concern the questionnaire wasaddressed to the finance director of each company personally. Inorder to improve the response rate and the reliability andhonesty of the responses the directors were offered completeanonymity.3 In numerous cases it was revealed that the mostsenior and relevant director or manager had indeed responded,despite the offer of anonymity.

Four questionnaires were returned untraced, or companiesliquidated or merged, giving a reduced sample of 296. Of these145 (49%) replies were received and 96 were completed anduseable, 38 large, 24 medium and 34 small (a response rate of32.4%). All the small firms had annual capital budget totals ofunder £50m. Of the medium-sized firms three-quarters spent lessthan £50m per annum on capital projects and the remainingquarter spent between £50m and £200m. Two-thirds of the largefirms committed over £200m per annum to the capital budget ^see Table 1.

604 ARNOLD AND HATZOPOULOS

ß Blackwell Publishers Ltd 2000

3. FINDINGS

The responses to questions concerning project appraisal method(Tables 2, 3 and 4) provide some confirmatory evidence of trendsestablished over a twenty-two year period. However, there aresome interesting points of contrast. The results of researchconducted by Pike (1982, 1988 and 1996) and McIntyre andCoulthurst (1985) are presented where possible, in order to

Table 1

Annual Capital Budgets for Responding Companies

Small Medium Large% % %

Up to £1m 3£1m to £50m 97 75 5£50m to £100m 21 8£100m to £200m 4 18£200m or more 66Blank 3

Table 2

Financial Analysis Techniques Used for the Appraisal of MajorInvestments

McIntyre &Coulthurst b

(Small/Pike a Medium

Current Study (Large Firms) Firms)

Small Medium Large Composite 1992 1986 1980 1975 1984% % % % % % % % %

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

Notes:a Pike (1996) 100 firms.b McIntyre and Coulthurst (1985) 141 firms.

THE THEORY-PRACTICE GAP IN CAPITAL BUDGETING 605


provide benchmarks for comparison and to shed light on theissue of longitudinal shifts in approaches to capital budgeting.These studies were selected for comparison because they havecharacteristics similar to those of the current study: The firmssurveyed 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 byMcIntyre and Coulthurst had sales between £1.4m and £5mand 50 to 250 employees. This would generally make thesecompanies smaller than the current study's `small firms' category.Caution is needed in comparing survey based studies, evenwithout this size discrepancy, due to variations ranging fromdifferent samples to changes in questions asked. Despite theseproblems there is sufficient comparability, particularly with Pike'ssurveys, to allow (tentative) inferences to be drawn.

Table 3

Frequency of Use of Financial Analysis Technique

Rarely Often Mostly Always% % % %

Small firmsPayback 15 12 15 35ARR 6 18 15 29IRR 6 9 18 44NPV 9 18 18 26

Medium-sized firmsPayback 8 25 8 33ARR 8 29 13 13IRR 8 25 13 42NPV 13 21 8 42

Large firmsPayback 18 16 24 24ARR 8 11 16 32IRR 3 3 26 55NPV 3 5 29 58

CompositePayback 14 17 16 30ARR 7 18 15 26IRR 5 10 20 48NPV 7 14 20 43



Table 4

Frequency of the Use of Combinations of Appraisal Methods

Current Study Pike a McIntyre and Coulthurst b

1997 (Large Firms) (Small Firms)

Small Medium Large Composite Results 1992 1986 1980 1975 1984% % % % % % % % %

No method 3 ^ ^ 1 ^ ^ ^ 2 2Single methodPayback 3 ^ ^ 1 4 6 12 14 35ARR ^ ^ ^ ^ ^ ^ 7 12 4IRR 6 ^ ^ 2 ^ 2 4 5 2NPV ^ 4 8 4 0 0 1 0 4

9 4 8 7 4 8 24 31 45Two methodsPayback + ARR 3 4 ^ 2 8 10 13 14 11Payback + IRR 3 4 3 3 9 8 15 14 5Payback + NPV 3 4 ^ 2 6 5 6 4 10ARR + IRR 9 8 ^ 5 ^ 2 2 ^ ÂRR + NPV 3 4 3 3 ^ 1 1 1 2IRR + NPV 9 4 11 8 5 3 4 1 2

30 28 17 23 28 29 41 34 30Three methodsPayback + ARR + IRR 12 4 ^ 5 5 5 10 7 2Payback + ARR + NPV 9 ^ 5 5 1 3 4 4 2Payback + IRR + NPV 12 33 24 22 26 21 9 10 5ARR + IRR + NPV ^ 4 13 6 ^ ^ 1 1 ±

33 41 42 38 32 29 24 22 9Four methodsPayback + ARR + IRR +NPV 26 25 34 29 36 34 10 11 13

Any simple method:Payback or ARR 82 92 81 85 95 97 90 92 90

Notes:a Pike (1996).b McIntyre amd Coulthurst (1985).

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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 ofdiscounted cash flow (DCF) techniques has not been at theexpense of the payback method and that payback continued togain support. While we show a reduction in the use of payback itremains at a high level.

This survey presents evidence that is consistent with theproposition that the theory-practice gap has been narrowed.DCF was used by only 58% of large firms in 1975, whereas alllarge firms are now using either IRR or NPV, and over 90% ofsmall and medium-sized firms are using these methods. For thelargest UK firms NPV has overtaken IRR as the most widely usedmethod: 97% of large firms use NPV compared with 84% whichemploy IRR. Pike's earlier surveys show that IRR dominated, forexample in the 1986 survey (Pike, 1988) 23% of large firms alwaysused NPV whereas 42% always used IRR. The current surveyshows that in the late 1990s the position was reversed with 58% oflarge firms always conducting NPV analysis compared with 55%always calculating IRR.

Whereas one-third of large firms in 1975 used one techniqueonly, with approximately one-third using two techniques and theremainder using three or more techniques, this survey shows67% of firms (76% of large firms) using three or more methods ^Table 4. The most popular choice is to use all four evaluatorymethods (29%) closely followed by the combination of payback,IRR and NPV.

Textbooks tend to emphasise the NPV rule, often arguing that itis theoretically superior to other methods (e.g., Zimmerman, 1997,ch. 3; and Kaplan and Atkinson, 1998, p. 594). The results of thissurvey are consistent with the view that there is increasingknowledge and acceptance of the arguments presented intextbooks. The wider use of DCF has been assisted by technologicaldevelopments, particularly the growth of computing power, makingcalculations easy and at low cost (Klammer and Walker, 1984; Pike,1988; and Sangster, 1993). Yet despite the trend toward NPV, othermethods, many of which do not involve discounting, are used inpractice at least in conjunction with IRR and NPV-type methods.

Since companies use these other methods, one of twoconclusions can be drawn: either firms are making suboptimal



decisions, or the assumptions underlying the NPV rule are notalways met in practice (Arya, Fellingham and Glover, 1998). If thefirst conclusion is correct improvements in financial knowledgemay be advanced as a solution. However, given the widespreadawareness of DCF it has to be acknowledged that traditional`theoretically inferior' methods retain a remarkably tenacioushold on practice. In searching for an explanation it isappropriate to consider the possibility that the theory-practicegap is being bridged, at least partially, due to theory movingtoward practice.

As Arya, Fellingham and Glover (1998) have pointed out, thestandard NPV rule implicitly makes two assumptions which areoften overlooked. First, the project approval decision is a `now-or-never' decision (if the project is turned down it cannot beundertaken in the future) and that real options to defer, expand,contract, abandon, switch use or alternatively alter a capitalinvestment can be ignored. Second, decisions are made either ina single person firm or in a multi-person firm in which there areno information asymmetries between the firm's owners andmanagers (or between managers), and each member is motivatedto the same objective. Dixit and Pindyck (1994), Ross (1995),Trigeorgis (1996) and Arya, Fellingham and Glover (1998) haveconducted 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 thesecond assumption. In practice uncertainty, informationasymmetry, multiple (conflicting) objectives, real options andmulti-period multi-project considerations greatly complicatecapital budgeting, beyond the focus of the standard textbooktreatment.

When the NPV rule's assumptions are violated, the use ofmultiple criteria is a way of evaluating the project from differentperspectives. If many of the criteria suggest the project should betaken, 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 thenacknowledge an ambiguous framing exercise coupled with a portfolio ofapproaches to the framing task.



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

Because the true NPV is unknown, the astute financial manager seeks cluesto assess whether the estimated NPV is reliable. For this reason, firms wouldtypically use multiple criteria for evaluating a proposal . . . [if] differentindicators seem to agree [then] it's àll systems go'.

A consideration of the impact of information asymmetry, realoptions and other complications on the budgeting exercise givesone the view that there is no unique correct technique and thatthere is a need for multiple methods.

Some indication of the continued attraction of traditional non-DCF methods is given in the responses to the questionconcerning changes in methods used over the last five years(Table 5). Almost one-quarter replied that they had changedtheir approach. Three firms stated a greater reliance on cash flowbased methods. A further seven were more specific and stated anincreased emphasis on, or the introduction of, IRR whereas fiveother firms mentioned a shift toward NPV. However, four firmssaid they were focusing more on traditional measures. Onecommented: `More emphasis on payback due to tighter cashcontrol', and another mentioned, `More interest in discountedpayback coupled with IRR and NPV'. Nine firms pointed out thatthey now employ value-based management metrics. Three useeconomic profit and three use a variant of economic profit,economic value added. Two companies used cash flow return oninvestment and one makes use of total shareholder return. Thissurvey did not specifically enquire into the adoption of value-based metrics but the information provided by the respondentsconfirms 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 Medium Large Composite% % % %

Yes 23 25 21 23No 71 75 76 74Blank 6 ^ 3 3



them as described by Mills et al. (1996) where 49% of large UKfirms were found to have adopted value-based measures ofperformance in the context of acquisition and divestmentdecisions.

This study confirms the observation made by Pike (1982) andothers that many firms consider strategic fit to be an importantcriterion for the acceptance of projects alongside the quantitativehurdles. In the space left on the questionnaire for comments onnon-financial criteria used in project appraisal statements such asàlignment with strategy' and `does investment help achievestrategic goals?' were made by twelve firms. This could beinterpreted as a further indication that standard NPV is unable tocapture the complexity of corporate investment decisions. Otherfactors taken into account include àvailability of staff' and`management strain' ^ indicating a constraint on the acceptanceof projects. `Culture fit' and Àugment skills range?' or`Technology platform building' were also considered important.

In 1975 a minority of large UK firms required a formalevaluation of risk (Pike, 1982), this rose to 94% in 1997 (Table6). The most widely used risk technique is sensitivity/scenarioanalysis (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 OtherScenario Required Assessment Analysis Payback Analysis RiskAnalysis Rate of Period

Return% % % % % % % %

Current studySmall 82 42 44 27 15 3 0 0Medium 83 71 33 21 42 0 0 4Large 89 50 55 42 11 5 3 5Composite 85 52 46 31 20 3 1 3

Pike(100 large UK firms)Year1992 88 65 n/a 48 60 20 n/a n/a1986 71 61 n/a 40 61 16 n/a n/a1980 42 41 n/a 10 30 0 n/a 41975 28 37 n/a 9 25 0 n/a 2



conjunction with raising the required rate of return, and/orsubjective assessment (Table 7). Beta analysis and shortening thepayback period are rarely used to adjust for risk. Probabilityanalysis is used by 31% of firms.

Investment analysis is conducted in the context of a process ofdialogue among managers ^ using a variety of risk techniques in acomplementary fashion enables different aspects of the proposedproject to be observed, offering valuable insights and allowingmore informed discussion, review, re-analysis, re-examinationand testing, thus increasing confidence in the final decision(Hertz and Thomas, 1983).

It would appear that there remains a wide theory-practice gapconcerning the use of risk analysis techniques. While textbooksand academic papers (e.g. Davey, 1975; Coats and Chesser, 1982;and Hertz and Thomas, 1984) advocate the use of probabilityanalysis few managers employ it. It would be wrong to jump tothe conclusion that this is due to ignorance and that, in time,managers will become sufficiently well informed to be able tohandle the complexity involved. There are sound behavioural,practical, and theoretical reasons for the revealed hesitancy ofmanagers. It is thought that probability analysis is not adoptedbecause individuals are unwilling to make their estimates ofoutcomes explicit. This is due to fear of future criticism if theirestimates turn out to be wrong. It is safer to sponsor a project ongrounds which are `consistent with some vague concept ofgeneral policy' (Cooper, 1975, p. 200) than to be too specific.Also, managers are generally uncomfortable with probabilisticestimates. There is a tendency to consider such activity to beàcademic', ill-defined and having little impact on the decisionoutcome (Neuhauser and Viscione, 1973; and Ho and Pike,1992). Practitioners may be suspicious of an analysis which isfundamentally based on subjective estimates of future outcomesexpressed in spuriously precise quantitative terms (Kee andBublitz, 1988).

Managers baulk at the resources and time which need to bedevoted to a sophisticated probabilistic analysis of project risk.This may reduce the number of project proposals advanced andsponsored. It is widely acknowledged (e.g. King, 1975; andEmmanuel et al., 1990) that the main obstacle to value creation isthe lack of an environment which encourages idea generation



Table 7

Combinations of Risk Methods

Small Medium-size Large Composite% % % %

No method 3 ^ 3 2Single methodSensitivity 18 4 5 9Subjective 9 ^ ^ 3Raise R. R. of R. ^ 8 ^ 2Shorten payback ^ 4 ^ 1

15

Two methodsSensitivity + Raise R. R. of R. 12 17 16 15Sensitivity + subjective 15 4 11 10Sensitivity + probability 3 13 8 7Shorten payback + Raise R. R. of R. ^ ^ 5 2Sensitivity + shorten payback 3 ^ ^ 1Raise R. R. of R. + subjective ^ 4 ^ 1Subjective + ignore risk ^ ^ 1 1

37

Three methodsSensitivity + Raise R. R. of R. + subjective 9 4 11 8Sensitivity + probability + subjective 3 ^ 13 6Sensitivity + shorten payback +Raise R. R. of R. 6 17 ^ 6

Sensitivity + Raise R. R. of R. + probability 6 ^ 5 4Sensitivity + shorten payback + subjective ^ ^ 3 1Sensitivity + beta + subjective ^ ^ 3 1Sensitivity + shorten payback + probability 3 ^ ^ 1Sensitivity + probability + other ^ ^ 3 1Sensitivity + subjective + other ^ 4 ^ 1Probability + beta + subjective 3 ^ ^ 1Raise R. R. of R. + probability + subjective 3 ^ ^ 1

31

Four methodsSensitivity + Raise R. R. of R. +probability + subjective 3 ^ 8 4

Sensitivity + shorten payback +Raise R. R. of R. + subjective ^ 13 ^ 3

Sensitivity + shorten payback +Raise R. R. of R. + probability 3 4 ^ 2

9

Five methodsSensitivity + shorten payback +Raise R. R. of R. + probability +subjective ^ 4 3 2

Sensitivity + Raise R. R. of R. +probability + beta + subjective ^ ^ 3 1

3

Note:Rounding errors are present in this table.



and enthusiastic project sponsorship rather than the absence ofmathematical 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 ofprobability analysis does not lead to a significant change incorporate performance. Confirming the practical objections toartificial precision Kim and Farragher (1981) discovered thatfirms in higher risk classes tend to use sophisticated analysistechniques less than lower risk firms:

If a firm does not have a good idea of the risk of a capital investment, itmight be logical to assume that it will not employ sophisticated riskadjustment techniques (p. 30).

Accompanying this line of reasoning is the notion that complexrisk analysis is also seen as unnecessary at the other end of therisk spectrum. In cases where the managers are very familiar withthe risks inherent in the proposed investment area they makeunconscious allowance for risk in deliberations without the needfor formal analysis (Pike, 1982). On the one hand probabilityanalysis is rejected because the uncertainty is too great to makerealistic estimates, on the other it is not needed when managersare able to analyse risk in a simple informal manner because it isso familiar.

Over three-quarters of the firms surveyed adjust for inflationeither by specifying cash flows in constant price terms applying areal rate of return or by expressing cash flows in inflated priceterms and discounting at the market rate of return (Table 8).There has been a significant bridging of the theory-practice gapin the treatment of inflation over the past two decades. In a 1973survey Carsberg and Hope (1976) noted that companies tendedto express cash flows in real (or constant) terms but used amoney (market) cost of capital for discounting those cash flows.Only 15 out of 103 UK firms used inflated cash flows with marketrates of return, and a further 5 firms adjusted cash flows by anestimate of general rather than specific inflation and discountedby market rate of return (this was regarded as à satisfactoryapproximation' by Carsberg and Hope). In their study the

procedure of setting a real target rate of return and estimating cash flows orprofit in real terms appears not to have been used, even approximately, byany of our respondents (p. 62).



Capital expenditure ceilings are placed on operating unitswhich sometimes lead to the rejection of viable projects in thecase of 49% of firms (Table 9). The most significant reason givenfor these limits is that investment decisions are important for thewhole group and require central control.

Table 8

Inflation Adjustment Methods Used for Investment Appraisal

Small Medium-sized Large Composite% % % %

Specify cash flow in constant prices andapply a real rate of return 47 29 45 42

All cash flows expressed in inflatedprice terms and discounted at themarket rate of return 18 42 55 39

Considered at risk analysis or sensitivitystage 21 13 16 17

No adjustment 18 21 3 13

Other 0 0 3 1

Table 9

Capital Rationing:Are There Specific Capital Expenditure Ceilings Placed on Operating

Units Which Sometimes Lead to the Rejection of Viable Projects?


Yes 44 58 47 49No 56 42 53 51

Reasons ^ Percentage of Those That Replied Small Medium-sized Large Composite`Yes' % % % %

Investment decisions important for wholegroup and require central control 87 79 67 77

Management wants to control cash,because of a shortage of funds 53 57 44 51

Management wants to control areasof activity and mix of products 40 36 50 43

Shortage of other key resources 7 7 39 19

Other 0 7 7 4



Non-economic capital investments are made by 93% of firms(Table 10). Note however, as one respondent pointed out, evenostensibly 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 thiscategory:

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

Outline capital budgets looking beyond two years ahead areemployed in 72% of the firms surveyed (84% of large firms).Detailed budgets for two or more years ahead are prepared by45% of large firms, 21% of medium-sized firms and 30% of smallfirms (Table 11).

The current study does not support Pike and Wolfe's (1988)assertion that in the mid 1980s the trend towards increased use oflong term capital budgets was halted. Pike and Wolfe suggestedthat a lack of confidence in long term economic forecastsencouraged firms to limit their planning horizons. Perhaps thegreater macro-economic stability in the 1990s compared with the1970s or early 1980s has renewed interest in longer termplanning. Or, perhaps, a higher proportion of firms perceivethe value of planning further ahead.

The question `what are the cut-off points used to evaluate theviability of major capital investment?' produced some surprisingresponses (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 Non-economic Projects


Health and Safety 68 79 87 78Legislation 59 75 87 74R & D/Strategically necessary 56 38 68 55Social/Environmental 35 50 76 54Repair/Maintenance 38 42 53 45Other 6 0 11 6



Table 11

Capital Expenditure Budgets

Small Medium-sized Large% % %

Outline capital expenditure budgets are prepared for:1 year ahead 18 8 ^2 years ahead 18 25 133 years ahead 35 50 184 years ahead 9 ^ 5More than 4 years ahead 21 13 61Blank ^ 4 3

Detailed capital expenditure budgets are prepared for:1 year ahead 70 79 552 years ahead 21 13 213 years ahead 9 4 84 years ahead ^ ^ 5More than 4 years ahead ^ 4 11

Table 12

Cut-off Points Used to Evaluate the Viability of Major CapitalInvestments

Payback Period0^2 years 2^4 years 4^6 years 6^10 years Blank

Small 0 32 18 3 47Medium 8 13 17 13 50Large 3 13 18 11 55Composite 3 20 18 8 51

Accounting Rate of Return (Return on Capital Employed)11^15% 16^20% 21^30% 31% Blank

Small 9 21 18 3 50Medium 4 25 4 4 63Large 16 24 8 0 53Composite 10 23 10 2 54

IRR/NPV0^10% 11^15% 16^20% 21^30% 30% or more Blank

Small 9 41 15 15 3 18Medium 8 46 24 4 0 17Large 21 39 26 8 0 5Composite 14 42 22 9 1 12



low. For the small firms 2^4 years is the most common range. Themodal range for return on capital employed is 16^20%. Themodal range for IRR and NPV is 11^15%, with significantnumbers falling into the 16^20% range. In his 1986 study Pike(1988) found that two-thirds of firms used a hurdle rate ofbetween 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 aslate as 1994 Wardlow in his Bank of England sponsored surveyshowed that firms required average nominal returns of 20%. Heattributed this high rate to:

firms being cautious about changing their required rate of return, givenboth the past history of uncertainty and the relatively short period of low andstable inflation to date (p. 251).

Theoretical explanations have been advanced for the tendencyof firms to require apparently excessive rates of return. Antle andEppen (1985) and Antle and Fellingham (1990) have pointedout that a combination of asymmetric information betweenmanagers and an incentive system within a hierarchy that rewardsmanagers for amassing control over corporate resources caninduce the imposition of a countervailing force, that is highhurdle rates, to reduce the tendency to over invest. Ross (1995)has suggested that such rates are a practical way of dealing withuncertainty. Dixit and Pindyck (1994) consider that simple NPVanalysis fails to account for ìrreversibility and option value' (p. 6)inherent in accepting a project. High hurdle rates are rationalbecause they include compensation for the loss of the option totake the project at a later date if the firm commits itself now.

Academic literature promotes the use of a weighted averagecost of capital (WACC) to act as a hurdle rate for investmentappraisal (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 acost of capital:

the methods commonly applied in setting hurdle rates are a strange mixtureof folk-lore, experience, theory and intuition.

Westwick and Shohet (1976) had found in the UK the mostpopular method for selecting the minimum rate of return for usein investment appraisal decisions was to use the company's bankoverdraft rate. Less than 10% of firms mentioned the use of a



WACC. This changed significantly over the subsequent twodecades (Table 13). Slightly over one half of the respondents tothe current survey now employ a WACC, but a significantminority of small firms still use the interest rate payable on debt.

Despite years of academic expounding on the virtues of WACCand extensive managerial education, a significant minority offirms do not calculate a WACC for use in capital investmentappraisal. Furthermore, as Tables 14 and 15 show, many of thefirms which calculate a WACC do not follow the prescribedmethods. However, the use of the CAPM has increasedsignificantly since Brigham's (1975, p. 20) study which showedits employment in only two firms out of 31.

Some of the statements made by respondents show that manyof those who calculate a WACC fail to follow textbook procedure:

Above is a minimum (WACC). A hurdle rate is also used which is the mid-point of the above (WACC) and the lowest rate of return required by venturecapitalists.

WACC + safety margin.

Weighted average cost of capital plus inflation.

Table 13

Replies to the Question: How Does Your Company Derive the DiscountRate Used in the Appraisal of Major Capital Investment?


Weighted average cost of capital 41 63 61 54

The cost of equity derived from thecapital asset pricing model is used 0 8 16 8

Interest payable on debt capital is used 23 8 1 11

An arbitrarily chosen figure is used 12 4 3 6

Dividend yield on shares plusestimated growth in capital valueof share is used 0 0 3 1

Earnings yield on shares is used 3 0 0 1

Other 12 8 11 10

Blank 9 8 5 7100 991 100 981

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



Explanations advanced for the theory-practice gap revealed inTables 13, 14 and 15 include managerial ignorance of the moresubtle and complex elements of DCF analysis (Gitman andMercurio, 1982). Alternatively, companies are not using WACCbecause they are using a closely related method such as theadjusted present value (Myers, 1974; and Ross, Westerfield andJaffe, 1996). However, the fact that no respondents, when giventhe opportunity to do so, mentioned the APV or any othertheoretically recognisable method means we have no evidence tosupport this argument. There are theoretical, practical and

Table 14

Method of Calculating the Weighted Average Cost of Capital (Percentof those that use WACC)


Using the Capital asset pricing modelfor equity and the market rate ofreturn on debt capital 50 68 79 70

Cost of equity calculated other thanthrough the Capital asset pricingmodel with the cost of debt derivedfrom current market interest rates 50 32 18 29

Other 0 0 3 1100 100 100 100

Table 15

If the Weighted Average Cost of Capital is Used, Then the Weights areDefined by:


A long term target of debt andequity ratio 19 26 39 30

The present market values of debtand equity 44 47 42 44

Balance sheet ratios of debt and equity 37 26 19 26100 991 100 100

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



empirical doubts cast on the most heavily promoted method ofcalculating 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; Millset al., 1992; Strong and Xu, 1997; and Adedeji, 1997). Inaddition, it is often extremely difficult, if not impossible, to usethe CAPM to determine a particular divisional beta and cost ofcapital. One respondent expressed the frustration ofpractitioners by pointing out that precision in the WACC methodis less important than to have reliable basic data, `Real issue isone of risk premium on equity. Is it 2% or 8%?!'

Tomkins raises a doubt as to whether a disinclination to use theCAPM is sufficiently serious for us to be concerned:

If companies needed this more precise analysis to survive, would they nothave discovered this? Would not at least one major competitor havediscovered the secret of identifying increased profitability and forced theothers to follow suit in order to compete? From the evidence to date itappears that this has not occurred. The refinements to NPV calculationsalong 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 otherfactors may be more critical (Tomkins, 1991, p. 75).

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

4. CONCLUSION

The central aim of this study is to generate new evidenceconcerning the capital investment practices of UK firms. Given

Table 16

Replies to the Question: `Does Your Company Conduct Post-audits ofMajor Capital Expenditure?'


Always 41 17 24 28Sometimes/on major projects 41 67 71 59Rarely 12 17 5 10Never 6 ^ 2



the wealth of theoretical literature and the relative dearth ofinformation describing real world practice, it offers acontribution to the empirical base to further the quality ofdiscussion and research in the field. By combining the newevidence with the results of surveys conducted in earlier decadeswe can gain some insight into the changes in the approachestaken by managers. It is hoped that the information presentedwill stimulate those involved in major capital investment decision-making to consider their present practices in light of knowledgeof policies and techniques adopted by other firms. Furthermore,the preferences, actions and experience of the managers chargedwith the investment of shareholders' money should influenceacademic theory.

The survey results indicate that UK corporations haveincreasingly adopted prescribed textbook financial analysis. Thestage has now been reached where only a small minority do notmake 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 ofmethods with another, but rather, a widening of the range ofways of analysing a financial decision. Managers perceive thiscomplementary adoption of some of the more formalapproaches while persisting with tried and trusted methods asan enrichment of inputs to decision-making. The olderapproaches have numerous endearing qualities which moderntechniques seem unable to provide.

Some degree of caution is needed in generalising the results ofany sample-based survey to a wider population of firms (Scapens,1990), although the high response level in this case alleviates thispotential problem to a large extent. There is also the issue ofresponse bias to be borne in mind (Rappaport, 1979; andWallace and Mellor, 1988): Mailed questionnaires may tend toover-state the adoption and importance of sophisticatedtechniques due to the possibility that the users of sophisticatedtechniques are more likely to respond than those using lesssophisticated techniques. A more significant problem is theinterpretation of the results. It is conceivable that managers carryout calculations for the sophisticated procedures, and aretherefore able to tick a box on a questionnaire form to that



effect, but the result of the calculation is paid little heed in thereal decision making process. Yes, managers do compute on thebasis of DCF more today than they did twenty years ago, what hasnot been revealed is how they use the DCF information and whythey make the decisions they do (Emmanuel et. al., 1990; andNorthcott, 1991). The evidence of the calculations of numbers isnot sufficient to declare a more `rational' decision-makingprocess, especially in a world with widespread use of cheapcomputing power, producing a mass of data and information. Infurther research, attention needs to be directed to the decision-making process in an organisational context. Factors to beconsidered 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 thelegitimisation of previously agreed `strategic' actions (Burchellet al. 1980; Pinches, 1982; and Emmanuel et. al., 1990).

This study focuses on an empirical overview of capitalinvestment appraisal tools. Capital budgeting appraisal is but asmall part of the process of making investments. If we wish tounderstand and improve decision-making, research is needed toexplore other stages in the process which includes identificationof investment opportunities, the search for ideas, thedevelopment of proposals into projects, the early screening tomatch with strategy and culture, the implementation stage,control and review of performance (Hastie, 1974; King, 1975; andEmmanuel et. al., 1990). These other elements may be morecritical to the success of firms. An obvious extension of thisresearch would be an in-depth study of the capital investmentpractices employed by individual corporations. This will provide abetter understanding of the entire process. In particular, thequalitative factors influencing capital investment decision-making can be examined.

NOTES

1 An annual publication by Times Books listing the largest UK firms.2 The excluded firms in each category are investment trusts.3 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 respondentwas from a small, medium or large firm by the colour of the paper.



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Arnold Capital Budgeting