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Article of Capital Budgeting Survey Essay

This research is motivated by two major factors: (1) the over twenty year hiatus since the last thorough review ofthe capital budgeting survey literature, and (2) past appeals to the finance academic community by researchers to explore neglected areas ofthe capital budgeting process.In response, and using a four-stage capital budgeting process as a guide, the authors review the capital budgeting survey literature from 1984 through 2008 and find that some ofthe neglected areas have infact been directly addressed. Unfortunately, the most prevalent focus of capital budgeting surveys continues to be that ofthe selection stage. As a result, many areas ofthe capital budgeting process still remain relatively unexplored, providing numerous survey research opportunities.This research effort is motivated by two tnajor factors: 1) the twenty year hiatus since the last thorough review of the capital budgeting survey literature, and 2) past observations and appeals made to the finance academic community by fellow researchers to explore neglected areas of the capital budgeting process through more focused and directed survey research.Richard M. Burns is a Professor of Finance at the University of Alabama at Birmingham, AL Joe Walker is an Associate Professor of Finance at the University of Alabama at Birmingham, AL.The authors wish to thank the Editor and the anonymous referee for their many helpful comments and suggestions.78The first factor stands on its own as justification for anupdate of the capital budgeting survey literature. The lastcomprehensive reviews were made by researchers Scott andPetty (1984) and Mukherjee (1987) over twenty years ago.Regarding the second factor, almost three decades ago,Kim (1979) noted that too much emphasis was being placedon methods of ranking and selecting capital budgetingproposals. Scott and Petty (1984) also noted the “…disproportionate (unjustified) amount of time [spent] on aparticular stage (financial analysis and project selection)…” Further, Gordon and Pinches (1984) generalizedthis complaint by arguing that “…the capital budgetingprocess must be viewed in its entirety.” Mukherjee (1987)agreed that “… further survey efforts need to be devoted to understanding the entire process.”To address these two factors, the authors have provideda current review of the capital budgeting survey studiesover the past twenty-four years. The results are reportedin a four-stage capital budgeting framework that allows amore detailed and clear assessment of the appeals by pastresearchers. As a result, fertile areas for future appliedresearch in the area of capital budgeting survey work aremore easily identified and summarized.The organization of this paper is as follows. In Section Ia four-stage capital budgeting process will be identified and used throughout the balance ofthe paper. It provides a useful framework to evaluate in more detail the most prominentcapital budgeting survey literature reviews of the past, tohighlight neglected areas of capital budgeting research, and to organize past appeals for future research in this area. In Section II this four-stage process will also be used to describe the procedures used in performing the capital budgeting79BURNS & WALKER – CAPITAL BUDGETING SURVEYS: THE FUTURE IS NOWsurvey literature update over the 1984-2008 period. Section III will continue to use this framework to present the detailed findings while Section IV will provide an overall summary. Finally, Section V will present conclusions, comments, and insights for future survey research.I. Past Reviews and Appealsappears on an executive’s desk and all that isneeded is for the manager to choose the project(s)with the highest expected payoff. However, asmost managers quickly learn, this is not the case.Further, once projects are chosen, the evaluation of an individual project’s subsequent performance is usually either ignored or often inappropriately handled. Our contention is that the capitalbudgeting process must be viewed in its entirety, and the informational needs to support effective decisions must be built into the firm’s decision comprehensive reviews support system.In the corporate finance capital budgeting survey literature the capital The lastbudgeting process has been were made by researchers Scott described in terms of fourThe two most significantstages: 1) identification,attempts to assess theand Petty (1984) and Mukherjee2)development, 3) balance of research among (1987) over twenty years ago. selection, and 4) control.’ these four stages were those The identification stage of Scott and Petty (1984) comprises the overall process of project idea generation and Mukherjee (1987), both of which occurred well over including sources and submission procedures and the twenty years ago.^ Scott and Petty provided a synthesis of earlier surveys of incentives/reward system, if any.The development stageinvolves the initial screening process relying primarily large American firms and organized their analysis based on a upon cash flow estimation and early screening criteria. The three stage classification: 1) project definition and cash flow selection stage includes the detailed project analysis that estimation 2) financial analysis and project selection, and results in acceptance or rejection of the project for funding. 3) project implementation and review. Citing Gitman and Finally, the control stage involves the evaluation of project Forrester (1977), they noted that: … project definition and cash flow estimation isperformance for both control purposes and continuousconsidered the “most difficult” aspect ofthe capitalimprovement for future decisions. All four stages havebudgeting process. The financial analysis andcommon areas of interest including personnel, procedures,project selection stage, which receives the mostand methods involved, along with the rationale for each.attention in the literature, is considered the leastAll four stages are critical to the overall process, butdifBcult ofthe three stages … the selection stage is arguably the most involved since itincludes the choices of analytical methods/techniques used,Also covering surveys of large American corporations,how the cost of capital is determined, how adjustments for Mukherjee (1987) agreed that there had been too much projects risks are assessed and reflected, and how, if relevant, survey focus on the selection stage and not enough on the capital rationing affects project choice.The selection stage other stages as well as the overall capital budgeting process. has also been the most investigated by survey researchers, Paraphrasing that paper’s recommendations, it called for particularly in the area of selection techniques, resulting in more research into specific questions relevant for each stage. a relative neglect ofthe other stages.This in turn has led to For example, in stage 1, future surveyors were urged to appeals to future researchers to consider the other stages in investigate the reward systems, procedural aspects, and the their survey research efforts. As Gordon and Pinches (1984) organizational structure ofthe firm. In stage 2, more research note:was suggested on the topics of divisional vs. corporateMost of the literature on the subject of capitalbiases, strategic considerations, cash flow estimationbudgeting has emphasized the selection phase,details, data details, cannibalization, risk, and inflation. giving little coverage to the other phases. Instead,Even within the more widely-studied Stage 3, neglectedit is usually assumed that a set of well-definedcapital investment opportunities, with all of theinformational needs clearly specified, suddenly^ o t e that these two reviews are only three years apart based on publication ‘See Gordon and Pinches (1984) and Mukherjee (1987). Scott and Petty (1984) use a similar 3-stage process. It is interesting to note, however, that an even earlier survey by Gitman and Forrester (1977) had used a 4-stage analysis.date, and that the latter does not cite the former, likely due to publication lags. As noted in the procedures section, this paper uses the Mukherjee format. Furthermore, the title of this paper derives from Mukherjee’s title.80areas were identified such as the rationale for the variousmethods used, how firms compute their cost of capital, thelow rate of risk recognition, the associated low rates of risk adjustment and assessment sophistication, capital rationing(and the low usage of linear programming), and the detailsof authorization levels. Finally, with regard to Stage 4, more research was encouraged into the details of performanceevaluation, how the company follows up on such evaluation,the details of expenditure control procedures, and the reward system for performance.’How well these appeals have been answered withsubsequent survey research is the primary focus of thispaper. In the next section the authors describe the procedures employed to assess the effectiveness of these appeals madeover twenty years ago.II. ProceduresConsistent with the reviews by Scott and Petty (1984)and Mukherjee (1987), the following criteria were used tochoose capital budgeting survey articles for inclusion in this review: the surveys had to involve large US firms, they hadto be broad-based (not focused on one particular industry),and they had to be published in mainline academic journalspost-1984. Using these criteria resulted in the selection of the nineteen capital budgeting surveys included in Figure1.” The Figure provides, in chronological order, the survey year (which in all cases differs from the publication year), authors, research method, usable responses and the audiencesurveyed.Each of these 19 survey articles was then thoroughlyexamined in an effort to identify the stages and areaswithin each stage that the survey covered. The results ofthis process are reported in Figure 2 and consistent withMukherjee’s (1987) chronological ordering in a tabular formindicating areas of investigation within the four stages ofthe‘These more specific questions are largely paraphrased from Mukherjee (1987) and are not fully exhaustive. The interested reader is, of course, encouraged to read this very thorough article in its entirety. ••The initial search using Proquest (ABI Inform) specifying “capital budgeting surveys” in scholarly journals after January 1, 1984, yielded over two hundred results.However, the great majority were published in the non-mainline journals, including many strictly practitioner (trade journal) outlets and /or were focused on a particular country or industry and thus eliminated by the screening criteria. To insure against missing articles due to any limitations ofthe ABl database, the authors checked the references ofthe surviving articles, and in addition, conducted a manual search ofthe most cited finance journals tables of contents and the reference sections of the various survey articles found.JOURNAL OF APPLIED FINANCE – ISSUES 1 & 2, 2009capital budgeting process.’It should be noted that the Figures herein were slightlyaltered from Mukherjee’s original format to better focuson selected issues that were identified specifically as areas of neglect. For example, the category of “techniques” wasdivided into “techniques used” and “reasons for techniquesused”. Similarly, the risk category was divided into “riskrecognition”, “risk assessment”, and “risk adjustment”.III. Findings by StageA quick perusal of Figure 2 reveals an obviousconcentration of “checks” in Stage 3 (selection) similar tothe previous findings of Mukherjee. Although a carefullook at some of the stage categories individually indicatesthat several neglected areas have been researched over theperiod, there is still an obvious and relative lack of research into Stages 1, 2, and 4.To further assess the effectiveness ofthe research appeals,the analysis and reported results in this section will be ordered by the four stages. Summary comments are provided only on those surveys which provide a significant contributionto a previously neglected area of capital budgeting surveyresearch. As a result, the findings of Bierman ( 1993), Gilbert and Reichert (1995), Payne, Heath, and Gale (1999), andRyan and Ryan (2002) are not summarized.A. Stage 1 : IdentificationSuggested areas of study within this stage include howproject proposals are initiated, whether the proposal process is on-going or on an “only-when-needed” basis, at what level projects are generated, whether there is a formal process for submitting ideas, how that process works when present, andif there is an incentive system for rewarding good ideas.*Unfortunately, there has never been an in-depth surveyfocused on this stage, leaving no question that it remainsstrongly neglected. The only contribution of a minor natureto this topic is the incidental finding by Stanley and Block (1984). They found that in over 80% of the respondingfirms that capital budgeting proposals originated bottom up‘In the 1987 article, note that on Figure 4, the stages are described somewhat differently from the discussion in the paper itself Specifically, in the body of the paper, the four stages are: (1) identification, (2) development, (3) selection, and (4) the post-audit. But in the table, the 4 stages are idea generation, proposal development, selection of projects, and control or performance evaluation.‘As in footnote 3, the following suggested areas of study for all four stages are largely paraphrased from Mukherjee (1987)..81BURNS & WALKER – CAPITAL BUDGETING SURVEYS: THE FUTURE IS NOWFigure 1. Surveys of Capital Budgeting of Large US FirmsSurveyedYear(s)Survey Author(s)MethodNumber ofUsableResponses1982Stanley & Block(1984)questionnaire1211986Pruitt & Gitman(1987)questionnaire1211986Pohlman,Santiago, &Markel(1988)questionnaire2321988Gordon & Myers(1991)19881992199019911992Myers, Gordon, &Hamer(1991)Bierman (1993)Porterba &Summers (1995)Gilbert & Reichert(1995)Trahan & Gitman(1995)SampleCFO’s of Fortune 1000multinationalsVP Finance or Treasurer oflargest industrials in Fortune500CFO’s of Fortune 500questionnaire282questionnaire282questionnaire74Executives and capitalbudgeting directors of large USindustrials except utilities andtransportationLarge public firms from FASBData Bank100 largest of Fortune 500questionnaire160-228CEO’s of Fortune 1000questionnaire151Fortune Magazine DirectoryCFO’squestionnaire84CFO’s of Fortune 500 + Forbes200Managers of foreignmanufacturing subsidiaries ofUS industrials1992Shao & Shao(1996)questionnaire1881992Burns & Walker(1997)questionnaire180Fortune 5007,27,107 best-sellling texts, 27prestigious CFO’s, 10 leadingfinancial advisors1996-97 Bruneretal(1998) telephone survey1992-93Mukherjee &Hingorani(1999)questionnaire102Fortune 500 CFO’s1994Payne, Heath, &Gale (1999)questionnaire155USA and Canadian basedcompanies from S&PCompustat databasequestionnaire111CFO’s from Fortune 1000questionnaire392CFO’s from FEI corporationsinterviews39executives of large companiesquestionnaire205CFO’s of Fortune 1000questionnaire40top-ranking officers of Fortune100019971999199919992005Gitman &Vandenberg(2000)Graham & Harvey(2001)Triantis & Borison(2001)Ryan & Ryan(2002)Block (2007)z •^II O)(2002) ueAy “? uBAyo(0O)•a(0a>i2i2ou.a>•o(0(OO)IO)•o3OQareU3D)< ‘O6B!)UB9 ‘UBLU|L|OdS(8861.) |S>tJeiM(Z86l.)ueaJi!O’SH!n.id(W6l)>|00ia’8’^8|UBis|L Idea Generation|A. Source of Origination|B. Reasons for Idea Origination|C. Process of Origination & Submission|D. Time Pattern of Origination1II. ProposalDevelopment|A. Level at Which screening Takes Place|B. Screening Process¡C. Cashflow Estimates (and forecasting)|D. Responsibility for Budget Preparation (personnel)|lll. Selection of Projects|A. Classification of Projects for Economic AnalysisB. Personnel (Department) Responsible for AnalysisC1. Listing Techniques Used|C2. Reasons for Techniques UsedDl. Risk recognitionD2. Risk assessmentD3. Risk adjustmentEl. Capital Rationing: How Extensive?E2. Capital Rationing RationaleE3. Capital Rationing Methods UsedF. Cost of CapitalG. Project Approval|IV. Control (or Perfonnance Evaluation)A. Extent of Use of Post AuditB. Personnel Involved/ProcedureC. Performance MeasurementD. 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