AUTHOR INDEX OF REVIEWED CAPITAL BUDGETING ARTICLES

SORTED BY AUTHOR

(Author name preceded by article index #)

6

Antle, R.; Eppen, G

1985

CAPITAL RATIONING AND ORGANIZATIONAL SLACK IN CAPITAL BUDGETING

Management Science

11

Clark, Ephraim; Jokung, O

1998

CAPITAL BUDGETING, POLITICAL RISK, AND PRUDENCE

The International Journal of Finance

2

Gitman, Lawrence J; Forrester, J

1977

A Survey of Capital Budgeting Techniques Used by Major U.S. Firms

Financial Management

4

Harris, Milton; Kriebel, C; Raviv, A

1982

ASYMMETRIC INFORMATION, INCENTIVES AND INTRAFIRM RESOURCE ALLOCATION

Management Science

9

Harris, Milton; Raviv, A

1996

The Capital Budgeting Process: Incentives and Information

Journal of Finance

10

Harris, Milton; Raviv, A

1998

Capital budgeting and delegation

Journal of Financial Economics

1

Mao, James C.T.

1970

SURVEY OF CAPITAL BUDGETING: THEORY AND PRACTICE

Journal of Finance

7

Ross, Marc

1986

Capital Budgeting Practices of Twelve Large Manufacturers

Financial Management

3

Schall, Lawrence D.; Sundem, G; Geijsbeek, W

1978

SURVEY AND ANALYSIS OF CAPITAL BUDGETING METHODS

Journal of Finance

5

Stanley, Marjorie; Block, S

1984

A SURVEY OF MULTINATIONAL CAPITAL BUDGETING

The Financial Review

8

Taggart, Robert A.

1987

ALLOCATING CAPITAL AMONG A FIRM'S DIVISIONS: HURDLE RATES VS. BUDGETS

The Journal of Financial Research

CITATION INDEX OF REVIEWED CAPITAL BUDGETING ARTICLES (11 Total)

(IN CHRONOLOGICAL ORDER)

1

SURVEY OF CAPITAL BUDGETING: THEORY AND PRACTICE

Mao, James C.T.

J of Finance, vol. 25, 1970, 349-360.

2

A Survey of Capital Budgeting Techniques Used by Major U.S. Firms

Gitman, Lawrence J; Forrester, J

Financial Management, 6 Fall 1977, p. 66-71.

3

SURVEY AND ANALYSIS OF CAPITAL BUDGETING METHODS

Schall, Lawrence D.; Sundem, G; Geijsbeek, W

J of Finance, vol. 33, no. 1, March 1978, pp. 281-87.

4

ASYMMETRIC INFORMATION, INCENTIVES AND INTRAFIRM RESOURCE ALLOCATION

Harris, Milton; Kriebel, C; Raviv, A

Management Science, vol. 28, no. 6, June 1982, pp. 604-620.

5

A SURVEY OF MULTINATIONAL CAPITAL BUDGETING

Stanley, Marjorie; Block, S

The Financial Review 19, 1984, pp. 36-54.

6

CAPITAL RATIONING AND ORGANIZATIONAL SLACK IN CAPITAL BUDGETING

Antle, R.; Eppen, G

Management Science, vol. 31, no. 2, February 1985, pp. 163-174.

7

Capital Budgeting Practices of Twelve Large Manufacturers

Ross, Marc

Financial Management 15, Winter 1986, pp. 15-22.

8

ALLOCATING CAPITAL AMONG A FIRM'S DIVISIONS: HURDLE RATES VS. BUDGETS

Taggart, Robert A.

The Journal of Financial Research, vol. 10, no. 3, Fall 1987, 177-189.

9

The Capital Budgeting Process: Incentives and Information

Harris, Milton; Raviv, A

J of Finance, vol. 51, no. 4, September, 1996, pp. 1139-74.

10

Capital budgeting and delegation

Harris, Milton; Raviv, A

Journal of Financial Economics 50 (1998) 259-289.

11

CAPITAL BUDGETING, POLITICAL RISK, AND PRUDENCE

Clark, Ephraim; Jokung, O

The International Journal of Finance, vol. 10, no. 1, 1998.

ARTICLES

Title

Author(s)

Journal, date

Sections

Sections Reviewed

Area

Theoretical/Empirical

1

SURVEY OF CAPITAL BUDGETING: THEORY AND PRACTICE

Mao, JCT

J of Finance, 1970

1-5

'1-5

Capital Budgeting

Survey

Level 1

Compares theory to practice based on eight case studies

Level 2

Identifies some discrepancies in theory vs. practice among small sample of firms in 1969. Major

differences were managers viewing risk as semi-variance of EPS (rather than variance) and their

reluctance to use IRR/NPV.

Level 3

Held day-long interviews with top management at eight different companies during 1969.

Asked the managers for their main objective, in financial management. They didn't always

answer "maximize share value", but it "was implicit in all their answers." The "goal of maximizing

share value is translated into operating targets of growth and stability in the earnings stream."

Author raises the issue of how a CEO should maximize the time series of his share price.

When asked about risk, the executives supplied answers that were "consistent with semi-variance

[average squared deviations of downside returns] as a concept of risk." When asked how they

incorporate risk, the executives primarily use the risk-adjusted discount rate approach, vs.

certainty equivalent approach, in decision making.

For executives, the author statess that the "real difficulty is the search for a reliable probability

distribution of cash flows to base the decision upon."

The author notes "the relatively slow acceptance of the IRR and NPV criteria." Of eight

companies, when asked about decision methodology, two reported use of IRR, four use both IRR

and accounting profit and payback, and two didn't use IRR.

Survey questions highlighted above in bold.

2

A Survey of Capital Budgeting Techniques Used by Major U.S. Firms

Gitman, LJ; Forrester, JR

Financial Management, Fall 1977

Short paper

Capital Budgeting

Survey

Level 1

Study confirms trend of increasing use of more sophisticated analysis tools

Level 2

1976 survey of 268 major companies yields 103 responses on capital budgeting procedures and

techniques, capital rationing, and handling of risk.

Level 3

Sample of 268 firms (103 responses) was drawn from firms having high stock price growth and

large capital expenditures.

Survey Questions:

i) Industry classification

ii) Asset size

iii) Size of annual capital budget

iv) Project size for formal analysis

v) Percent of projects accepted

vi) Department responsible for analyzing projects

vii) Most difficult and most important stages of capital budgeting process

Choose from: project definition & cash flow estimation, financial analysis & project selection,

project implementation, and project review

viii) Capital budgeting techniques in use

ix) Cost of capital

x) Capital rationing? If yes, check list of reasons why.

xi) Method used to adjust risk for uncertainty

Salient results:

Project definition and cash flow estimation viewed as both most difficult and most important part of

the process.

On techniques, 53% report use of IRR as their primary method, confirming an upward trend in the

use of IRR and NPV (only 10% report NPV as primary method).

On rationing, about half of the firms "operate in a capital rationing environment in which they

attempt to allocate a fixed budget on a competitive basis." Of those who ration, 69% report facing

limits placed on borrowing by internal management.

71% of firms incorporate explicit consideration of risk into their analysis with 43% increasing their

minimum rate of return to do so.

3

SURVEY AND ANALYSIS OF CAPITAL BUDGETING METHODS

Schall, LD; Sundem, GL; Geijsbeek, WR

J of Finance, Mar 1978

7 pages

Capital Budgeting

Survey

Level 1

"Trend toward use of more sophisticated capital budgeting techniques continues"

FR comment: If this trend were true, i.e. if businesses were becoming "smarter" at making

investment decisions, then one would presume an increase in productivity, ceterus paribus. If the

effects on productivity were week, then it places doubt on the importance of the techniques to

begin with.

Level 3

Sample of 424 large firms generated 189 responses (46%). Respondent firms tend to be more

stable than non-respondents.

Survey questions: (wording exactly as reported in the article)

1) For what investment decisions do you use capital budgeting techniques:

2) For what percentage of total corporate capital investment expenditures are capital budgeting

techniques applied (based on dollar values)?

3) What form do these capital budgeting techniques take? Check all applicable.

4) If you use a method requiring discounted cash flows, what do you use as your cost of capital

rate (discount rate)?

5) What is the numerical value of your cost of capital rate?

6) Is your required rate of return or cost of capital a: pre-tax or post-tax return on investment?

7) How do you compute the cash flow that you analyze using your required rate (or cost of capital)

on investment (i.e., how do you define cash flow)? Is this cash flow a pre-tax or a post-tax flow?

8) How do you assess risk in investment decisions?

9) Do you assign projects to risk categories that are treated differently in the capital budgeting

process? If yes, what categories?

10) Do you use different types of capital budgeting techniques for different classes of risk?

11) What do you use as the basis for determining the risk of a project?

12) How do you take risk into account in capital budgeting techniques?

Salient results:

Most popular capital budgeting technique was payback (74% mentioned). Most firms used

multiple methods, 86% used IRR or NPV or both. The 86% figure is an increase over prior surveys.

"Risk analysis is also becoming more sophisticated." "78% of the firms adjust the capital

budgeting techniques for risk…" "The most common method of determining a required rate of

return is to use an after-tax weighted average cost of capital."

"…there remains a wide variation in sophistication among firms." "There is slight evidence within

this sample that the level of sophistication in capital budgeting methods is positively related to the

size of the firm's capital budget and negatively related to the firm's beta value."

4

ASYMMETRIC INFORMATION, INCENTIVES AND INTRAFIRM RESOURCE ALLOCATION

Harris, M; Kriebel, CH; Raviv, A

Management Science, June 1982

1-7

1,7

Capital Budgeting

Theoretical

Level 1

Provides rationale for allocating resources via transfer pricing in an asymmetric information,

principal-agent model.

Level 2

Model features an environment of asymmetric information between division managers and top

management, where preferences differ. Top management trades off informational benefits of

delegating decisions vs. costs of division managers acting in their self-interest.

Level 3

Model consists of "a headquarters unit, N intermediate product divisions and one division…which

produces a resource used in production by the other divisions."

Each division manager uses the central resource and their own effort to produce output. Only the

division managers know their division's productivity. Manager's preferences diverge from top

management since they prefer less effort for same compensation.

Cost-minimization results show "that certain types of transfer pricing schemes are optimal." The

schemes depend on whether production of the central resource is capacity bound. If not capacity

bound, then the "optimal process is for each division to choose a transfer price from a schedule

announced by the headquarters. Division managers receive fixed compensation minus the cost of

the resource allocated to them at the chosen transfer price." A similar, yet slightly more

complicated, scheme results if the central resource is capacity constrained.

5

A SURVEY OF MULTINATIONAL CAPITAL BUDGETING

Stanley, MT; Block, SB

The Financial Review, 1984

Short paper

Capital Budgeting

Survey

Level 1

Survey of multinational firms affirms trend of greater capital budgeting sophistication

Level 2

"U.S. multinational firms appear to be moving toward a more normative approach to the capital

budgeting decision-making process as the gap between the prescribed and the actual continues to

narrow."

Level 3

1981 survey of 339 multinational firms drawn from Fortune 1000 list generated 121 responses

(36%) to a fourteen-item two-page survey mailed to CFOs.

To detect survey respondent bias (none found), follow-up phone calls were made to 15 randomly

selected non-respondents.

Survey Topics

i) Primary financial objectives of the firm

ii) Capital budgeting evaluation techniques

iii) Do you use weighted average cost of capital?

iv) Do you use a risk-adjustment technique?

v) Initiation and approval of projects, centralized or not

Results:

Stockholder wealth maximization mentioned as the primary goal of the firm (vs. 1960s when firm

growth often mentioned). "Further sophistication is also evidenced by the fact that the internal rate

of return is the primary method of evaluation for 65 percent of the respondents." Larger firms appear

to use more advanced techniques.

"Eighty-eight percent of our respondents reported that they use the weighted average cost of

capital." Vast majority responded that projects were initiated from the bottom up while

decision-making was centralized.

6

CAPITAL RATIONING AND ORGANIZATIONAL SLACK IN CAPITAL BUDGETING

Antle, R; Eppen, GD

Management Science, 1985

1-6

1,2,6

Capital Budgeting

Theoretical

Level 1

"[R]esource rationing and organizational slack arise in response to asymmetric information among

the members of the firm."

Level 2

Adapts the Harris, Kriebel, Raviv model to explain three stylized facts: existence of organizational

slack, (simultaneous) resource rationing, and hurdle rates greater than the cost of capital.

Level 3

As in HKR, there is asymmetric information between a division manager and headquarters. The

division manager knows the true rate of return for a project while top management knows only the

probability distribution of returns over N outcomes.

Also, the manager knows exactly the amount invested in the project. The difference between the

amount allocated by headquarters and the amount actually invested is slack. Slack is valued by

the division manager and is costly for top management to audit. Slack must be greater than 0 to

retain the manager.

"The optimal allocation policy involves a hurdle rate criterion in which the hurdle rate is strictly in

excess of the cost of capital, thus inducing rationing in some states of the world. Typically,

resources are optimally allocated such that slack exists in other states. The optimal allocation

policy trades off these two inefficiencies."

The solution is found as a linear programming problem: maximize profit subject to constraints of:

i) manager minimum compensation ii) manager reveals the project's true rate of return (revelation

principle) iii) existence of an upper bound on project cash flows.

7

Capital Budgeting Practices of Twelve Large Manufacturers

Ross, M

Financial Management, Winter 1986

1-8

1-8

Capital Budgeting

Survey

Level 1

"[S]maller projects are subject to high de facto hurdle rates."

Level 2

Capital rationing not "a rational scheme for focusing effort on the most profitable investment

opportunities."

Level 3

Sample of 400 energy conservation projects spanning (approx.) 1980-1985 at 12 large

manufacturing firms. There were one to three days of interviews at each firm, plus other records

were provided for sample projects.

"Decisionmaking is different for mandatory and discretionary projects."

"The practice at most firms is thus to keep both the financial analysis of smaller projects, and the

process of communicating this analysis to decisionmakers, extremely simple." At lower levels

one is likely to see avoidance of sensitivity analysis and more reliance on payback (vs. DCF).

Firms that explicitly rationed capital had much higher hurdle rates than those that didn't. Also,

"financial analysis of smaller projects at flexible-budgeting firms tends to be more sophisticated

than at capital-rationing firms."

Results indicate "the importance of asking how capital budgeting practices differ at the plant,

division, investment committee, and CEO and Board levels."

8

ALLOCATING CAPITAL AMONG A FIRM'S DIVISIONS: HURDLE RATES VS. BUDGETS

Taggart, RA

The Journal of Financial Research, Fall 1987

1-6

1,2,3-,4-,5,6

Capital Budgeting

Theoretical

Level 1

"Most firms use budgets as only one part of their capital allocation system."

Level 2

Most large firms use a hybrid capital allocation system comprising hurdle rates, budgets, and

occasional full-information analysis

Level 3

Capital budgeting, or rationing, may be driven by external factors "but this explanation is viewed

with skepticism by most financial economists." So the authors investigate rationing as an

organizational control device.

The authors (relying on previous empirical research) describe the hybrid process as iterative. Top

management sets preliminary divisional budget targets, as a first step, based on strategic

considerations. Firms then distinguish between large and small projects and investments in new

or existing businesses. Larger projects or new businesses require approval from headquarters.

A problem with decentralized decision making (i.e. hurdle rates) is that "none of the division

managers perceives the effect of his or her own investment on the profitability of the other divisions'

investments." The firm may have, for example, limited growth ability.

Decentralization is balanced by the fact that "each division manager has specialized knowledge of

the division's business." So a headquarters that dictates a budget level may not adequately take

advantage of that information (a consistent theme in Harris & Raviv).

Taggart also mentions that top management may want to avoid large errors on the part of divisional

managers. Perhaps CEOs are just better at avoiding big errors.

Given the cost of communication, hurdle rates can be an effective way to decentralize decisions,

thus economizing top management effort.

9

The Capital Budgeting Process: Incentives and Information

Harris, M; Raviv, A

J of Finance, Sept. 96

Intro, 1-5

Intro, 1, 5

Capital Budgeting

Theoretical

Level 1

Provides theory for internal capital allocation processes

Level 2

Model features an agency environment (headquarters vs. division) in which division managers have

private information and a desire for greater investment. Model shows how capital spending limits

arise and that under or over investment (relative to productivity) can occur. Authors also show how

the process varies with firm or division characteristics.

Level 3

The NPV rule "provides no role for details of the internal [capital] allocation process." The authors

consider the effects of information and incentive problems on capital budgeting procedures and

capital spending limits.

Simple model includes headquarters and a single division whose manager has private information

and preference for "empire". Headquarters can discover the manager's information only via a costly

audit. So "headquarters chooses an audit strategy, capital allocations, and salary as functions of

the manager's request for capital to maximize the value of the residual claim, given the constraints

implied by private information and the manager's preference for empire."

Authors show that in the optimal scheme:

i) there is an initial capital spending limit

ii) manager either accepts the initial spending limit or requests more capital

iii) hq either awards a compromise capital increase, or audits the manager

iv) audit results in binary decision: zero capital, or the "correct amount"; the probability of an audit

increases with the size of the additional capital request

As audit costs decline, the initial spending limits decline and the allocation process becomes more

flexible. As investment opportunities improve "initial spending limits decline, but approval of

requests becomes more likely and compromise allocations increase."

10

Capital budgeting and delegation

Harris, M; Raviv, A

Journal of Financial Economics 50 (1998)

1-8

1,8

Capital Budgeting

Theoretical

Level 1

Investigates the delegation of capital allocation decisions

Level 2

"[D]elegation is a way to save on costly investigation of proposed projects." Extends the Harris and

Raviv (1996) model to "address issues related to the allocation of capital across multiple projects."

The optimal scheme imposes negotiable capital spending limits on division managers that depend

on headquarters' cost of auditing. The degree of delegation is a function of project productivity and

is increasing in audit costs.

Level 3

Same setup as their 1996 paper, but now the division manager has two projects, each having either

high or low productivity. Headquarters designs "an incentive-compatible capital allocation scheme"

to balance auditing costs and division manager's preference for empire. "The focus of the analysis

is to uncover the conditions under which headquarters chooses to delegate the 'project allocation',

i.e. the distribution of capital across projects, to the division manager."

The optimal scheme is similar to the 1996 scheme, but now there is an "aggregate capital

spending limit (i.e., total for both projects)." Now the manager can request additional capital

depending on audit costs: if costs are low, he can request one of two larger capital amounts; if

costs are mid- level, he can request only a single higher amount; and if costs are high, he's stuck

with the initial aggregate allocation.

On the delegation decision, the authors find that "The main result is that headquarters will delegate

this decision over the set of realizations of productivities in which the same total capital is

allocated." So, depending on project productivity, the division manager "chooses the project

allocation subject to a minimum investment constraint".

The "extent of delegation increases with audit costs." Note that if the two projects occur

sequentially instead of simultaneously, then delegating the allocation among projects is the same

as allowing a rollover of the capital spending budget.

Also note that, in both models (1996 & 1998), the capital spending limit helps prevent

overinvestment. The purpose of the model's flexibility (i.e. the additional spending requests) and its

attendant audit structure is "to take advantage of the manager's private information."

The main result on delegation follows from the assumption that the division manager's marginal

utility for capital is increasing with project productivity. Thus "the manager's preferences are

similar to headquarters (i.e., he prefers to allocate more capital to more productive projects)."

11

CAPITAL BUDGETING, POLITICAL RISK, AND PRUDENCE

Clark, Ephraim; Jokung, O

The International Journal of Finance, vol. 10, no. 1, 1998.

1-5

1,2,4-,5

Capital Budgeting

Theoretical

Level 1

Uses absolute prudence to rank politically risky international investment alternatives.

Level 2

In international capital budgeting, with both project and political risk, "political risk associated with

good times (superior outcomes) is preferred to political risk associated with bad times (inferior

outcomes)." Using the concept of absolute prudence, "otherwise equivalent investments can be

ranked according to which possible outcomes are affected by the political risk factor."

Level 3

The two risks are: i) volatility of investment outcome, and ii) political risk--"white noise associated

with one or more of the possible investment outcomes."

"Absolute prudence measures the propensity to prepare and forearm oneself in the face of

uncertainty in contrast to risk aversion, which is how much one dislikes uncertainty and would like to

get away from it if one could."