Capital Budgeting Practices of Twelve Large Manufacturers

Capital Budgeting Practices of Twelve Large ManufacturersAuthor(s): Marc RossSource: Financial Management, Vol. 15, No. 4 (Winter, 1986), pp. 15-22Published by: Wiley on behalf of the Financial Management Association InternationalStable URL: http://www.jstor.org/stable/3665776 .

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Perspectives on Capital Budgeting

Capital Budgeting Practices of

Twelve Large Manufacturers

Marc Ross

Marc Ross is a member of the faculty of the Physics Department at the University of Michigan, Ann Arbor.

1. Introduction Surveys of capital budgeting practices among large

firms have indicated a widespread use of discounted cash flow (DCF) methods, especially internal rate of return.1 At the same time, many firms state that they also continue to use simple payback or related methods [8]. The study reported here sheds light on the differ- ences between theory and practice in the implementation of DCF analysis.

Surveys have shown that many firms use either a weighted average cost of capital or the cost of a specif- ic source of funds in determining a hurdle rate. Most firms, however, employ some form of capital rationing - that is, they restrict capital expenditures even

though it generally means neglecting profitable projects.2 Under rationing, projects compete against each other, not against a profitability standard. The study reported here uses empirically determined hurdle rates and other data to examine these capital allocation practices.

A. The Alliance Study The study, by the Alliance to Save Energy [1], was

undertaken to evaluate tax incentives for industrial energy conservation. It was supported by the John D. and Catherine T. MacArthur Foundation. Data were gathered, primarily in 1981-82, from 15 large firms, with three each from the steel, paper, aluminum, and petroleum refining industries. Since the author did not par- ticipate in the petroleum refining interviews, petroleum refining is omitted here. The firms studied account for about one-third of the combined sales of the four industries. Much of the information collected is proprietary and the firms cannot be identified.

I would like to express my pleasure in working with the project group at the Alliance to Save Energy: Robin Miller, Bob Rauch, Mike Reid, and Jim Wolf. The help of Carliss Baldwin of the School of Business Administration, Harvard University for extensive comments on an early draft is also appreciated. I also thank the Editor and the anonymous reviewers of Financial Management for their extensive and useful suggestions.

'Two recent surveys of the literature are those by Scott and Petty [9] and Gumani [5].

2See the surveys by Gitman and Forrester [4] and Petty, Scott, and Bird [6]. A survey of capital budgeting practices is presented by Fremge [3].

15



16 FINANCIAL MANAGEMENT/WINTER 1986

Information was gathered from two sources at each firm: one to three days of interviews, and records of the analysis of energy-related investment projects. The interviews focused on examples of projects at the margin of acceptability and on the financial analysis of these projects.

Although the study was designed to address tax incentives, its field-study approach and its focus on energy conservation projects lent themselves to learning about the investment decision-making process in general. The field-study approach enabled examination of actual operating procedures; and, since energy conservation is not usually an area of proprietary concern, discussions were often open and information gener- ously provided. Moreover, respondents stated that the capital budgeting process for energy conservation is essentially the same as for other discretionary projects of the same size.

B. The Sample Data The firms typically categorize capital investments as

either mandatory (regulations and contracts, capital- ized maintenance, replacement of antiquated equipment, product quality) or discretionary (expanded markets, new businesses, cost cutting). Decisionmak- ing is different for mandatory and discretionary projects. We culled the project data to omit (the few) projects that appeared to be mandatory. We also omitted many projects for which the financial information was inadequate for our analysis. The final sample con- tained some 400 projects: roughly 100 completed projects, almost all in 1980-81, and 300 projects either underway or prospective, primarily intended for the period 1982-1985.

Interviews at the firms showed that most firms' decision-making processes are different for different project sizes. Typical levels of approval authority are shown in Exhibit 1. Using the size categories from Exhibit 1, we found the data to contain roughly 300 small and very small projects, 100 medium-sized projects, and 12 large projects. Unlike the samples of small and medium projects, that of large projects was probably not representative of those under consideration across these industries, because some firms did not provide data on large projects (due to proprietary concerns). In this study most of the information thus concerns discretionary projects of $10 million or less.

The data were complete (except for very small projects) for four of the twelve firms under consideration; i.e., they spanned all energy-conservation projects under consideration regardless of project size. Complete

Exhibit 1. Project Size and Decision-Making Author- ity

Primary Site for Project Size Typical Boundaries Investment Decision

Very small Up to $100,000 Plant Small $100,000 to $1 million Division Medium $1 million to $10 million Corporate invest-

ment committee Large Over $10 million CEO & board

records for projects based at one or more plants were obtained for five more firms. For the remaining firms only samples of the projects under consideration were obtained.

II. Example of a Project Proposal Decisionmaking on smaller projects can be suc-

cinctly described by a hypothetical example. Typical features that we observed are incorporated; the specif- ics would, of course, vary.

Bill Johnson is part of an energy-conservation team (created in 1979) at a large plant of a basic-materials manufacturer. On the initiative of a vendor, he has identified an approach to cutting energy costs at a heater: advanced combustion controls, which could reduce excess air in the combustion zone.3

Bill looks into other approaches, such as total replacement of the heater or added heat exchangers (to capture heat from the stack gases to preheat the product). However the projects overlap; he can advocate at most one.

Opinions on technical issues are sought out by Bill, especially from an operating engineer at the facility where the heater is located and from his supervisor. He obtains rough quotes from vendors and estimates annu- al benefits for several schemes. A critical test for the combustion-control option is passed in a discussion with the manager of the facility in question. These managers are typically like kings in their realms. Their tastes and the production problems they face may lead them to veto any modification out of hand. The facility manager is primarily concerned with technological risks, such as a long breaking-in period and possible operational problems. Use of automatic controls would involve operating the heater close to conditions that are analogous to being at the edge of a cliff; a small mistake could be very damaging. Bill selected a proj-

3His idea could also have come from an energy-conservation audit of the plant, corporate energy conservation staff, professional literature, or contacts with peers.



ROSS/CAPITAL BUDGETING PRACTICES 17

ect for this particular heater in part because he knows that this facility manager is open to new technology. He is able to tell the manager that one of the control options has been applied in a similar situation and has operated without trouble.

Bill gets the go-ahead for detailed design work on the control option. One consideration is that, since the likely project cost is over $100,000 (but less than a million), the final investment decision would be made at division headquarters. Bill knows that the plant manager has many things to ask for at the division and would prefer that the decision on this project be kept at the plant level. He cannot bring the cost below $100,000, however. He also knows that other alterna- tives would create a project in the $1 million to $10 million range, putting the final decision with the Cor- porate Investment Committee (CIC). Paradoxically, while he knows that the CIC is more generous in ap- proving projects than the division, he wants to avoid going to the CIC because a very extensive case would have to be prepared, and enthusiastic support would be needed from the division, plant, and facility managers. That would be hard to get for a project that cuts costs but has no other production benefits. He has observed that higher-level managers give higher priority to new markets than to cost cutting and that lower-level managers give higher priority to maintaining and improv- ing the manufacturing process (with respect to product quality, flexibility and reliability of production, production capacity, etc.) than to cost cutting.

The control system is designed by Bill with the help of a vendor and representatives of plant service organi- zations, and in collaboration with the operating engineer. He obtains good capital cost quotes and calculates initial-year operating costs and benefits. He calculates the ratio of capital cost to first year net benefits (without considering taxes) and calls this the payback.

Bill notes with concern that the cost is higher than his preliminary estimate, so that the payback is 1.7 years, near the cut-off on projects approved by the division in the past two years. Bill's plant is relatively modem and the businesses with which the heater is associated are sound; if the project were at a less- favored location, the division would certainly not approve it. A substantial risk that the plant or production line will be shut down creates an expectation of substantially reduced profitability, even where management does not expect the shutdown to occur soon.

Using a microcomputer, Bill calculates several after-tax DCF measures of investment worth. He has

instructions for certain aspects of the evaluation: He must assign a ten-year life to all projects, although he suspects the life of this project will be shorter because the technology will probably become obsolete. He must use 6% per year escalation of all prices over the project life, in spite of the different expectations he has for natural gas and other factors.4 He assumes that the heater is operated at design levels and that the energy saved per year is constant over the ten-year period. No risk assessment is included in the analysis. In any case, although the DCF evaluations are carried out, the project is discussed at the plant in terms of its 1.7 year payback.

The request for funds includes a two-page financial analysis prepared by computer, a brief technical de- scription of the project and very brief comments on its possible impacts on production and on pollution. The request is sent to the plant manager. He has an over- view of the requests that will go from the plant to the division. Although he is not especially impressed by a cost-cutting project with this payback, he wants to get experience with advanced control systems and is satisfied the project will not interfere with production; so he approves the request. It is then forwarded to Corporate Engineering for technical evaluation. The plant manager or Corporate Engineering often returns a request at this stage, putting it on hold or asking for substantial changes. This time it goes through.

The request is sent to division headquarters as part of a group of requests. On the basis of an earlier plan- ning process, the plant manager knows that the total requested is in line with the capital the division expects to allocate to his plant.

Decisionmakers at the division include a vice president who has responsibility for the products made at the facility in question. He has a good relationship with the facility manager and knows about the request from personal conversation. He notes the project's internal rate of return of 44%, but pays no attention to the NPV or profitability index, which are also shown in the financial analysis. He is accustomed to the fact that standard project life and escalation rates have been used in the evaluation, and believes this to be an effective procedure for preventing some plant managers from exaggerating the benefits of their projects. The vice president believes the engineering estimate of

4Although many interviewees in our study discussed the uncertainty of future energy prices, the recent steep drop in oil and gas prices was not expected or even hinted at by anyone in our interviews. In the following, no consideration of this price drop is made.




capital costs and initial benefits to be unbiased. He has his own ideas about rates of inflation, which lead him to feel that the calculated IRR may be a few points high. As an expert in the prospects of the business in question, he believes this facility will operate at a full schedule for the next few years and so he is satisfied with this aspect of the analysis.

The division has a fixed amount of capital to allocate, similar to that of the previous year.5 At the critical meeting on the project in question, it is learned that the requests for mandatory projects are larger than usual.6

Considering the funds remaining, if all discretionary projects were ranked by their IRR, this particular project would not make it. On the other hand, division management likes to approve requests from this plant manager because he is cautious in his proposals and is very effective in other respects. The project is approved but it is noted that implementation may be delayed.

III. Financial Analysis of Projects As the example suggests, many of the firms studied

severely simplify the DCF evaluation of projects and, in any case, rely primarily on simple payback. (It should be kept in mind that projects of the kind under study have, as suggested in the hypothetical example, very simple benefit streams.) Exhibit 2 summarizes the observations at the twelve firms.

Not surprisingly, perhaps, sensitivity analysis for various potential risks is typically avoided. For example, reduced production because of weak sales or changes in the production process could affect the benefit stream from an energy-saving project. How- ever, only a few of the firms studied have considered such contingencies. Two chemical firms retroactively studied the performance of energy-conservation projects associated with organic chemicals and found that, while engineering analyses proved fairly accurate in a narrow sense, benefits and economic lives tended to be less than predicted because of unanticipated changes in production rates and technology. These insights were not formally incorporated into the financial analyses.

Exhibit 2. Distribution of 12 Firms by Measure of Investment Worth Used for Smaller Projects

Number Measure Primarily Number Measures Calculated of Firms Relied Upon of Firms

IRR* 5 IRR, with both variable 5 project life and price escalation

Simplifed IRR and 5 IRR, with fixed life 3 simple paybackt and/or escalation

Simple payback onlyt 2 Simple payback 4 *NPV and other DCF measures were also calculated but not referred to in discussion or in other documents. tOf the five, one approximated the DCF calculation so it could be easily hand calculated, and all required use of a single economic life for all projects and/or a single uniform price escalation rate. tOr a return on investment directly based on simple payback.

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, ex- tremely simple [7]. Decisions are then based on the primary quantitative measure from the analysis supple- mented by informal adjustments made in the minds of decisionmakers. The analysis of large projects was more detailed in the few cases we saw. For example, detailed DCF analyses were carried out, often includ- ing sensitivity analyses with respect to parameters like rates of price escalation.

IV. Rates of Return for Project Approval Many firms have internally published, or de jure,

hurdle rates for project approval. These rates may or may not correspond to the apparent, or defacto, rates that empirically characterize projects actually approved. At some firms the de jure rates were described as being out of date or intended only for a first cut, to help decide if preparation of a project proposal merits more effort.

At some firms, however, the de jure and de facto rates are essentially the same. These firms have a de- centralized capital budgeting process: Project decisions are made locally, with heavy reliance on a uniform rate of return criterion. Capital requirements are forwarded to higher management and, although there may be restraints at a given time or for a given business, the capital is typically provided. We call these flexible-budgeting firms.

A different approach to capital budgeting is fol- lowed at many firms. At these firms, project approval is not based on an announced or assumed hurdle rate. While people are typically aware, as suggested in the hypothetical example, of hurdle rates characterizing

51f division management wanted to, they could increase this capital allocation by making a good case for it. But this would require a major effort and would use up some of the division's "credit" with corporate headquarters. Division management feels it has more pressing problems to address.

6Requests for mandatory projects are not accompanied by financial analyses. They are generally approved after consideration of the project's nature and its cost, the priorities developed at the plant level, and the reputation of the plant and its management.




past decisions, the critical approval decision is based on competition among projects for an essentially fixed sum. We call firms employing this procedure capital- rationing firms.

The de facto rates reported here are all based on a uniform calculation of (nominal-dollar) internal rate of return (IRR).7 For this purpose, we examined projects at flagship plants associated with relatively solid product lines with stable process technology and with well established lives. For almost all the firms there were data on such projects. These projects roughly share the financial risks of the firm as a whole.

De facto hurdle rates for project approval were determined in part from the data on proposed and approved projects. Almost all projects in the sample were completed, approved, or expected to be approved. In other words, very few projects were being considered (and were included in the sample) which were not expected to be approved. The IRR distribution of these projects is very broad, but it has a few projects with IRRs that are close to the lowest IRR for an approved project. Hence, this lowest IRR is taken as the apparent hurdle rate. In addition, apparent hurdle rates were determined from information on projects specifically identified at the firm as barely acceptable. Hurdle rate results from these two sources of information were consistent (within roughly -+- 5 percentage points in the rate of return).8

V. Hurdle Rate Results Our information is consistent with the expectation

that all twelve firms had defacto hurdle rates for large projects close to the corporate average cost of capital (about 15%).9 Only four firms gave this treatment to the smaller projects, however. For the other eight

Exhibit 3. Investment Hurdle Rates by Project Size: Flexible-Budgeting and Capital-Rationing Firms

Hurdle Rate Range* Number in Sample (percent) (firms, projects)

Flexible Capital Flexible Capital Budgeting Rationing Budgeting Rationing

Firms Firms Firms Firms

Size of Projectt Small 14-17 35-60 (4,197) (6,96) Medium 14-17 25-40 (4,19) (6,73) Large - 15-25: - (3,12)

*Internal rate of return, discounting nominal dollar flows. tSee Exhibit 1 for definitions. tBased on a very small project sample; return on least profitable project is shown.

firms, hurdle rates for small and/or medium projects were high. Among the eight, all six providing information on small projects show very high hurdle rates (35% to 60%) and all six providing information on medium projects show moderately high hurdle rates (25% to 40%). These data are summarized in Exhibit 3 above.

The firms studied thus fall into two classes: (i) firms with uniform defacto hurdle rates near the

corporate average cost of capital for all discretionary projects, i.e., flexible-budgeting firms, and

(ii) firms with defacto hurdle rates that are high for small projects, moderately high for medium projects, and fairly near the cost of capital for large projects.

We found through interviews that most of the second group of firms explicitly employ capital rationing at lower levels of decisionmaking. That is, fixed sums are allocated to those groups, below the level of CEO and Board, that make decisions about capital projects, with the result that much less discretionary investment is undertaken in smaller projects than would be justi- fied by conventional analysis. The rest of the firms in this group deny that they impose capital rationing, but at the plant/division level perceptions and behavior conform to capital rationing. The sample data suggest that the rationing of capital is most severe at plant and division levels, but, surprisingly, is often severe even at the level of the corporate investment committee (which typically makes the effective decision on medium-sized projects).

The results from our sample of firms are consistent with survey results that half or more of large firms impose capital rationing on all projects ([4], [7]). Our

7For comparative purposes it is important to choose project parameters that reflect the expectations at the firm, rather than mimicking the overly simple financial analyses sometimes made there. For example, in the cases of organic chemical products mentioned in the previous section, the adjustments suggested by the firms' studies were incorporated.

8Another issue in hurdle rate determination is possible time dependence. Were they rising because of the 1982 recession? Were they falling because the best energy-conservation projects had already been selected? Data from four firms that extended several years into the past and/or were planned several years into the future showed no significant change in hurdle rates. Interviews confirmed that there was no major change in project opportunities and that the firms' financial practices were not changing rapidly, except for delays in capital spending associated with the 1982 recession. These delays were not reflected in the information we collected.

9Two of these firms showed us their methods of calculating cost of capital, they correspond closely to textbook procedures. See, for example, Van Home [10].




new finding is that capital rationing, as practiced, has an especially severe impact on smaller projects.

Not surprisingly, financial analysis of smaller projects at flexible-budgeting firms tends to be more so- phisticated than at capital-rationing firms. All of the former employ DCF analysis and essential attention is given to details in the calculation. At only one of the eight capital-rationing firms is a DCF analysis with essential details carried out.

Although the firms cannot be named, general observations can be made. The flexible-budgeting firms are all relatively strong financially. From comments made at a few capital-rationing firms, it seemed that interest coverage might be negatively correlated with the effective hurdle rate. It is, roughly. A linear regression (using data from nine firms) of hurdle rates, HR, for small projects (in percent) against interest coverage (four-year average), IC, yielded HR = 60 - 5 x IC, with r2 ? 0.5. (The hurdle rates also correlate rather well with other financial characteristics of the firms.) The reason for such a correlation is probably related to inhibitions on capital spending resulting from the diffi- culties that firms with poorer ratings face in raising capital, as discussed subsequently.

VI. Possible Rationales for Severe Capital Rationing for Smaller Projects

The high hurdle rates for smaller projects do not primarily reflect greater uncertainty about return on investment for smaller projects at capital-rationing firms. Such concerns have, to a large degree, been taken into account:

(i) Engineering data on the projects (i.e., within their design context) is relatively accurate. This has been confirmed by retrospective studies of projects at several of the firms.

(ii) The disadvantages of projects associated with less favored plants and product lines, with rapidly changing products and processes, and with short-lived types of equipment were compen- sated for in the hurdle-rate determinations. The sample of low-risk projects at flagship plants defines the hurdle rates for almost all the firms. Without doubt, incomplete financial analysis of smaller projects at most capital-rationing firms leads to some discounting by management of even the least risky projects. This does not ap- pear, however, to be a major consideration.

There was no suggestion from our interviewees at capital-rationing firms that smaller projects at better

plants and product lines suffer from a degree of uncertainty that would justify subjecting them to higher hurdle rates. Instead, as discussed at several interviews, all cost-cutting projects in the firm's major businesses suffer from the same downside uncertainty as the firm as a whole: the risk of low capacity utilization, especially during recessions. The evidence indicates, then, that limitations in capital budgeting procedures, rather than unusual risk levels, are the direct cause of high hurdle rates for smaller projects. What then is the cause of these capital budgeting procedures?

Two explanations were suggested at interviews at capital-rationing firms, both of which have merit:

(i) The shadow cost of capital is much higher than the average cost of capital to the firm. Under this explanation, capital rationing is imposed on firms by outside suppliers of capital.

(ii) Top corporate management is preoccupied with many other responsibilities and assigns low priority to cost cutting. Also top management feels unable to decentralize or delegate open-ended responsibility for investment in smaller projects, especially since information and decision costs for smaller projects are relatively high.

With respect to the first explanation, mature businesses typically provide for plant and equipment expenditures from their stream of earnings. For most of the capital-rationing firms the earnings would not be sufficient to allow expeditious implementation of all profitable cost-cutting projects. Our interviews showed that many perceived it would be potentially damaging for their firm to attempt to raise additional equity funds, and that lenders would resist the raising of debt money beyond some debt-equity or interest- coverage ratios (independent of the profitability of the investments). For example, rating services might draw negative conclusions about an attempt to raise additional capital, with the result that the firm could no longer borrow in certain markets and its bonds could not be purchased by certain institutional investors. The sense that an equity offering would, in particular, reduce stock prices is confirmed by a general analysis of public offerings of industrial stocks by Asquith and Mullins [2].

Interviewees perceived the effect to be strongly dif- ferentiated, however, depending on the general purpose of the investment: Debt can be raised by the capital-rationing firms without unacceptably weaken- ing their financial rating for certain major acquisitions. In the recent past, many of the firms in the study have




made major acquisitions. For added investment to modernize existing plants, however, the cost of capital is perceived to be very high.

Let us turn to the second explanation. For firms in a poor financial position, a perception that characterized a majority of the capital-rationing firms, arrangements for any financing from outside sources would be ex- traordinarily time consuming for top management. Given their priorities, top management often copes with productivity improvement by allocating relatively small fixed sums to divisions and plants. That leaves them the time to carefully analyze the large projects and the modes of financing them.

A related perspective was offered at some interviews. Many energy-conservation projects' lack of impact on production capacity, product quality, and product flexibility is perceived as a reason for giving them a low priority. Cost-cutting projects can be post- poned, it is thought, without losing much of the opportunity, whereas market opportunities associated with new or improved products or increased production may be altogether fleeting.

How important are the smaller projects being post- poned, or neglected altogether, at capital-rationing firms? There was enough information from six of the firms to roughly answer this question. Smaller energy- conservation projects (i.e., those decided below the CEO-Board level) accounted for 2% to 15% of total capital spending by these six firms. The highest fractions in this range were associated with flexible-budgeting firms or firms in very high energy-to-value- added businesses and the lowest fractions were associated with capital-rationing firms with somewhat lower energy costs. The average difference in these energy-conservation expenditures between flexible- budgeting and capital-rationing firms was roughly 10% of total plant and equipment expenditures.' In addition, the estimated returns for these smaller projects were substantially higher than for the average project." One can infer that the profits being post- poned by capital-rationing firms could be substantial.

The author concludes that capital rationing is not, as some might suspect, a rational scheme for focusing

effort on the most profitable investment opportunities. The evidence on the high returns of smaller projects shows that the average large project is less profitable than the smaller projects being neglected by capital- rationing firms. Capital rationing is a bureaucratic process, which was not responsive at the time of our study to the substantial opportunities for profits offered by small and medium-sized energy-related projects.

VII. Suggestions for Improved Capital Budgeting

We will focus on suggestions for efficient involve- ment of top management in decisions on smaller projects.

(i) Information on Individual Projects: Communi- cation is difficult at large firms and people at all levels are busy, so the financial analysis of a smaller project and the reporting of it must be kept simple and intu- itively clear. It should include easily digested information on the project's definition and input parameters, as well as internal evidence that the analysis has been done correctly and consistently with that of other projects.

(ii) Analysis of Groups of Projects: The second suggestion is less familiar. For those firms that feel unable to decentralize investment decisionmaking with uniform hurdle rates, we suggest that top management solicit from their staff, for selected plants and product lines, ambitious modernization proposals consisting of coherent combinations of smaller projects. The idea is to elicit a proposal for a program of smaller projects whose total cost is large enough to command the care- ful attention of top management on a par with large projects costing perhaps $100 million or more. Not only would such an approach make it possible for top management to evaluate the potential of smaller projects, but also it would free the people who define projects, like Bill Johnson of our hypothetical example, to consider competing projects of different size on their merits (without being biased by considering where the decision would be made) and to define a coherent program of projects rather than using a piecemeal approach.

'Of the six firms, four practice capital rationing, with two each in the high and lower energy to value-added categories. One flexible-budgeting firm is in each of the two energy to value-added categories.

"There are three principal reasons why there were so many highly profitable energy conservation projects: (i) rapidly increased prices for energy, (ii) dramatic improvements in available energy-related technol-

ogy such as control systems, and (iii) qualitative changes in the management of energy projects (e.g., assignment of responsibilities, improved engineering capabilities, metering, and new cost accounting procedures). Given fixed energy prices, this opportunity might be largely, but not completely, used up in five years at a flexible-budgeting firm. Other categories of small projects also offer high profitability for some of the same reasons, e.g., automation based on new microprocessors.




It is essential that such modernization programs be solicited by top management and that the means of analyzing and presenting the programs be well developed.'2 Ad hoc efforts from below are not likely to succeed.

VIII. Summary Results have been presented from an in-depth study

of capital budgeting for discretionary projects at twelve firms in the process industries. They indicate that, while discounted cash flow techniques are nomi- nally used at most firms, it is important to ask whether the calculations are carried out incorporating essential details and whether it is a DCF criterion or simple payback that is actually relied on. For their smaller projects, most firms in the sample severely simplify their DCF analysis and/or rely primarily on simple payback.

Results (in eight of the twelve firms studied) also indicate that project approval at many firms follows different criteria depending on the locus of the decision. The effect of this is that smaller projects are subject to high de facto hurdle rates. At these firms only large projects are observed to face a hurdle rate near the cost of capital. Only four of the twelve firms studied impose uniform hurdle rates regardless of the locus of decisionmaking (or the size of project). Not surprisingly, firms with thorough financial analysis of smaller projects tend to be the same firms that do not discriminate against smaller projects.

These results suggest the importance of asking how capital budgeting practices differ at the plant, division, investment committee, and CEO and Board levels. A large firm's capital budgeting practices for smaller projects can be indicative of the firm's effectiveness in using information and skills from its lower levels.

12Helpful software (ENVEST) has been developed by M. W. Reid at the Alliance to Save Energy.

References 1. Alliance to Save Energy, Industrial Investment in Energy

Efficiency: Opportunities, Management Practices, and Tax Incentives, Washington, DC (July 1983).

2. P. Asquith and D. W. Mullins, Jr., "Equity Issues and Offering Dilution," Journal of Financial Economics (Jan./ Feb. 1986), pp. 61-89.

3. J. M. Fremge, "Capital Budgeting Practices: A Survey," Management Accounting, U.S. (May 1973), pp. 19-25.

4. L. J. Gitman and J. R. Forrester, Jr., "A Survey of Capital Budgeting Techniques Use by Major U.S. Firms," Finan- cial Management (Fall 1977), pp. 66-71.

5. C. Gurnani, "Capital Budgeting: Theory and Practice," Engineering Economist, 30 (Fall 1984), pp. 19-46.

6. J. W. Petty, D. F. Scott, and M. M. Bird, "The Capital Expenditure Decision-Making Process of Large Corpora- tions," Engineering Economist, 20 (Spring 1975), pp. 159-172.

7. E. M. Rudden, "The Misuse of a Sound Investment Tool," The Wall Street Journal (Nov. 1, 1982), p. 30.

8. L. D. Schall, G. L. Sundem, and W. R. Geijsbeek, Jr., "Survey and Analysis of Capital Budgeting Methods," Journal of Finance (March 1978), pp. 281-287.

9. D. F. Scott, Jr., and J. W. Petty, "Capital Budgeting Prac- tices in Large American Firms: A Retrospective Analysis and Synthesis," The Financial Review, 19 (May 1984), pp. 111-123.

10. J. C. Van Home, Financial Management and Policy, 5th ed., Englewood Cliffs, NJ, Prentice-Hall, 1980.



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Capital Budgeting Practices of Twelve Large Manufacturers

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