Empirical Evidence of the Adoption of Sophisticated Capital Budgeting Techniques

Author(s): Thomas Klammer

Source: The Journal of Business, Vol. 45, No. 3 (Jul., 1972), pp. 387-397
Published by: The University of Chicago Press
Stable URL: http://www.jstor.org/stable/2351494
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 Thomas Klammer*

Empirical Evidence of the Adoption of Sophisticated

Capital Budgeting Techniques

Previous research into capital budgeting procedures has usually shown

the following picture. At any one time, at least some theorists and schol-
ars are advocating relatively sophisticated capital budgeting methods.
These methods are being used or seriously considered by a small number
of firms, mostly large and in industries with high investment rates and
rapid changes. Most remaining firms are relying on methods which are
simpler and theoretically less satisfactory, although there may be con-
siderable sophistication in the way in which individual practitioners apply
formally simple capital budgeting methods.' For example, in the late
1950s theorists were advocating rate of return as a measure of an in-
vestment's worth, but this method tended to be in actual use only in
some of the larger oil, chemical, and automotive products companies,
while the majority of firms used relatively simple and formally unsatis-
factory methods, such as payback.
In recent years, leading theorists have gone beyond rate of return,
have attempted to deal more explicitly with the existence of risk, and
have suggested a variety of applications of management science or op-
erations research techniques to capital budgeting problems. Have there
been similar changes in the practices of business firms? This paper re-
ports on a survey aimed at answering this and related questions for large
manufacturingfirms in 1970.

SURVEY PROCEDURE
Sample
The sample was drawn from the 1969 Compustat listing of manufactur-
ing firms.2Firms in this list were omitted if they did not meet the follow-
ing requirements: (a) The Compustat listing contained at least fifteen
firms in the same major Standard Industrial Classification grouping (e.g.,
SIC no. 20, Food and Kindred Products). (b) The Compustat listing
showed at least five firms in the same SIC subclassification (e.g., SIC
no. 2082, Malt Liquors). (c) The firm made at least $1 million of capi-

* Assistant professor of business administration,North Texas State Univer-

sity.
1. See, for example, George A. Christy, Capital Budgeting-Current Prac-
tices and Their Efficiency (Eugene: Bureau of Business and Economic Research,
University of Oregon, 1966).
2. Compustat is a magnetic tape library containing financial information for
over 1,000 companies, including 678 manufacturingfirms in 1969. These represent
the major New York, American, over-the-counter, and regional stock exchange
companies. Compustat is a service of Standard Statistics Company of New York.
387
388 The Journal of Business

tal expenditures in each of the five years 1963-67 as determined from

the Compustat breakdown of capital expenditures.
These selection rules produced a sample of 369 rather large firms
with sizable and continuing capital expenditure programs. Such firms
would be expected to make relatively heavy use of the more sophisticated
capital budgeting techniques covered in the survey questionnaire, as
compared will all firms on the Compustat list.

Response Rates
The 369 firms were surveyed by mail in the first part of 1970. One
hundred eighty-four firms, about half of those surveyed, returned ques-
tionnaires with some usable data. Table 1 shows the two-digit SIC
classification of firms in the sample and of firms responding.

Table 1
Sample Size and Response Rates by Industry
Response
SIC No. and Firms in Responses Rate
Industry Sample Received (%)

20. Food and Kindred Products.4 5 .. 45 21 46.7

22. Textile Mill Products. 1 6 .. 16 4 25.0
26. Paper and Allied Products.2 0 .. 20 9 45.0
27. Printing, Publishing, and Allied
Products .......................... 8 2 25.0
28. Chemicals and Allied Products ..... .... 72 40 55.6
29. Petroleum Refining and Related
Industries ........... .............. 31 21 67.7
32. Stone, Clay, Glass, and Concrete
Products ............ .............. 17 6 35.3
33. Primary Metal Industries ...... ........ 20 10 50.0
34. Fabricated Metal Products, except
Ordinance, Machinery, and
Transportation Equipment ..... ...... 17 7 41.1
35. Machinery, except Electrical ..... ...... 45 23 51.1
36. Electrical Machinery, Equipment,
and Supplies .......... ............. 43 20 46.5
37. Transportation Equipment ...... ....... 35 21 60.0
Total ................................. 369 184 49.9

Measures of size and capital intensity were calculated for both re-
sponding and nonresponding firms. The response rate was higher for
larger and more capital-intense firms.3 Also, the response rate seemed
to be higher for those industries that are subject to more rapid changes
in technology and/or capital needs, such as chemicals, petroleum, and
transportation equipment. Overall, it appears that firms that have found
the greatest need for capital budgeting and therefore have the greatest

3. Size is based on the average operating assets for an eight-year period,

1961-68. Capital intensity is the yearly depreciation divided by the yearly oper-
ating assets for each of the eight years 1961-68. The larger this ratio, the higher
the capital intensity of the firm.
389 Empirical Evidence of Budgeting Techniques

interest in the practices of other firms were most likely to respond. The
bias which this introduces in the results appears to be in the same direc-
tion as that already inherent in the sample: toward more use of sophis-
ticated methods.

Questionnaire
All but one of the questions asked for yes-no or multiple-choice re-
sponses. Respondents were asked whether they used each of five specific
administrative procedures, four specific methods of appraising risk (with
an additional open-end question to cover any other method used), and
eight management science techniques. Additional questions covered the
proportion of projects for which profitability estimates were made and
the use and nature of minimum profitability standards, both primary and
secondary. The questions and summaries of the numerical responses
appear in the Appendix.
Respondents were asked to answer each question for each of three
time periods: the present, 1964, and 1959. There was a clear tendency
for respondents to give less information for the earlier periods.

ANALYSIS OF RESULTS
In analyzing the results, I found that a major question is how to make
use of the industry detail available. One might speculate that the sam-
ple design and the pattern of nonresponses would act to eliminate most
of the potential interindustry differences, and this appears to be the case.
In the absence of strong hypotheses about the nature of industry dif-
ferences, x2 tests were performed on the responses to individual ques-
tions by industry. The mixed results, shown in table 2, do not provide
strong justification for more elaborate analysis by industry. Accordingly,
the analysis which follows will present and comment on the industry
detail only where it seemed especially appropriate.

Table 2
Significance of Differences in the Use of Capital
Budgeting Techniques By Industry
Significance
Industry and the Use of: * Levelt
Long-range capital budgeting ....... .......... 5.74 .45
Postauditing ................ ............... 5.46 .45
Full-time capital budgeting staff ...... ......... 9.38 .15
Formal method of considering risk ..... ....... 12.84 .05
Management science techniques ...... ......... 10.96 .10
Required profit rate-percentage of investments
meeting . ................................ 11.74 .08
Payback ................................... 4.76 .60
Accounting rate of return ....... ............. 7.51 .30
Discounting ................................ 5.27 .50
* The number of firms using and not using a technique was broken down for each in-
dustry with ten or more responses and a X2 calculated. The results of each of these X2s are
reported in this table.
t Significance at this level or greater based on six degrees of freedom.
390 The Journal of Business

Administrative Techniques
Five questions covered techniques which the literature frequently em-
phasizes in discussions of desirable capital budgeting systems. The per-
centage responses are summarized in table 3.

Table 3
Administrative Techniques Used
Percentage Using In: *
Technique 1970 1964 1959

Search for alternative investments...... 94 87 82

Formal long-range capital budget ...... 69 57 43
Postaudits of major projects .88...... 61 50
Standard forms for expenditure requests 97..... 90 84
Full-time capital budgeting staff .56...... 51 45
* Percentages shown are yes divided by yes + no multiplied by 100, disregarding non-
responses. Nonresponse rates were higher for earlier years. For these five questions, yes + no
answers ranged from 181 to 184 for 1970. For 1964 the corresponding range was 150-55 re-
spondents, and for 1959 it was 137-48.

Usage of all of these techniques has been growing and is now high
for most of them. Departures from 100 percent usage might be best ex-
plained as a result of careful reading of the question. It is hard to imagine
a respondent making no effort to search for alternative investments at
some point in the evaluation procedure, or having no long-range capital
budgeting plan, but the questions may have put such emphasis on the
formality with which these activities were conducted that some respon-
dents answered negatively. The low reported usage of a full-time capital
budgeting staff, reported as used by only a little more than half of the
respondents, can only mean that some amount of financial, engineering,
or other duties are often performed by even the most specialized indi-
viduals performing the capital budgeting function. This type of organi-
zation may well be consistent with a large and well-conducted capital
budgeting activity. It does not, however seem to give unqualified sup-
port to Terborgh's 1967 statement that most firms had specialized
staffs.4
In general, the usage rates reported here for earlier periods are
consistent with the findings of Istvan,5 Pflomn,6 and Terborgh7 on the
use of standard forms and postaudits.

4. George Terborgh, Business Investment Management (Washington, D.C.:

Machinery and Allied Products Institute and Council for Technological Advance-
ment, 1967), p. xx.
5. Donald F. Istvan, Capital Expenditure Decisions: How They Are Made
in Large Corporations (Bloomington: Bureau of Business Research, Indiana Uni-
versity, 1961), p. 29.
6. Norman P. Pflomn, Managing Capital Expenditures, Studies in Business
Policy 107 (New York: National Industrial Conference Board, 1963), p. 30.
7. Terborgh, p. xx.
391 Empirical Evidence of Budgeting Techniques

A relationship appears to exist between the presence of a full-time

staff and the use of a formal long-range capital budget. A x2 test showed
less than a 5 percent chance of this relationship occurring by chance.8
One might explain this association by pointing out that a full-time staff
is more likely to have the time, opportunity, ability, and interest to main-
tain a long-range capital budget.

Risk Analysis
It is likely that nearly every firm has some method of dealing with risk,
but only 39 percent of the respondents said they were using some spe-
cific formal method. Table 4 summarizes the percentage responses to

Table 4
Risk Analysis Techniques
Percentage Using In: *
Technique 1970 1964 1959

Raising requiredreturn ........ ............ 21 16 12

Shortening payback period ....... .......... 10 9 9
Determining probability distribution ......... 13 7 7
Measuring covariance of projects ..... ...... 3 2 1
Other ............... ................... 7 2 1
At least one of above ........ ............. 39 24 19
Two or more of above ........ ............ 14 7 5
Three or more of above ....... ............ 5 3 1
* Percentages shown are yes divided by yes + no multiplied by 100.

the questions on risk analysis. Many firms which did report using a
formal method tended to use more than one. In addition, some of the
management science techniques covered in the next section undoubtedly
included risk appraisal features, although the questions were not asked
in such a way as to permit determination of a nonduplicating total of
firms using at least one management science or other formal method of
risk analysis. If we make the relatively conservative assumption that all
firms reporting the use of probability theory are making formal risk
analyses, ignoring the possibility that some of the other management
science techniques are being used for the same purpose, the nondupli-
cating total of table 4 becomes 45 percent of respondents using some
formal risk analysis method.9
Industry groups responded differently to the risk questions. Over
70 percent of firms in Petroleum Refining and over 50 percent of those
in Chemicals reported using at least one method. In the remaining indus-
try groups, less than 40 percent of the firms did so.
8. A series of X2 tests was made comparing the usage and nonusage of two
capital budgeting techniques. These tests were designed to test the association of
individual techniques.
9. A x2 test indicates that there is a strong relationship between risk analysis
and management science techniques.
392 The Journal of Business

Management Science Techniques

Out of the many techniques associated with the approaches of manage-
ment science and operations research, the questionnaire asked about
eight. Percentage responses are summarized in table 5. Again, firms re-

Table 5
Management Science Techniques Used
Percentage Using In: *
Technique 1970 1964 1959

Game theory ............... ............. 3 2 0

Linear programming ......... ............. 17 8 5
Nonlinear programming ........ ........... 4 3 1
Computer simulation ......... ............. 28 7 4
Probability theory ...................... 32 8 5
Decision theory ............ .............. 9 4 3
Per/critical path ............ ............. 28 13 4
Utility theory .............. ............. 4 1 0
At least one of the above ....... ........... 51 22 13
Two or more of the above ................. 32 11 7
Three or more of the above ....... ......... 21 4 3
* Percentages shown are yes divided by responding firms multiplied by 100, disregarding
nonresponse. For this question, total responding firms are 184 in 1970, 157 in 1964, and
149 in 1959.

porting any use often report the use of several of these techniques. And
once again, firms in the Petroleum Refining industry reported the heaviest
use: 85 percent of such firms say they used one or more of these methods.
No other industry group reported usage greater than the all-industry
average.

Project Evaluation Methods

Two questions covered the proportion of projects for which profit con-
tribution estimates were made and on which minimum profitability
standards were imposed. Recognizing that considerations of cost and the
value of information would lead a sophisticated firm to avoid these pro-
cedures for some sorts of projects, it still seems likely that movement
away from the lowest and toward the highest proportions indicates in-
creased sophistication during the period covered by this survey. The
results, as reported in table 6, show such movement. Even among the
relatively sophisticated respondents of this survey, however, it remains
true that about a quarter of the firms say they make profitability esti-
mates for a quarter or less of their capital outlays and nearly a tenth say
they impose minimum profitability standards on only a few of their
proposals.
Respondents cited a variety of projects as not subject to estimates
of profit contribution. Most frequently, these were governmentally re-
quired projects such as those for safety or pollution control, replacement
393 Empirical Evidence of Budgeting Techniques

proposals, particularly in emergencies, and projects for employee morale,

such as paving parking lots and the purchase of newer office furniture.
Lumping respondents who said that "most" and "some" projects
had to meet minimum profitability requirements in 1964, we obtain re-
sults that are very similar to those obtained by Christy.10
When asked to designate their primary standard of project evalu-
ation, a number of firms gave more than one answer. The percentages
given in the lowest section of table 6 count only the most sophisticated

Table 6
Project Evaluation Techniques
Percentage Using In: *
Technique 1970 1964 1959

profit contribution analysis required:

For over 75% of projects ...... ......... 53 53 50
For 25%-75% of projects ...... ......... 41 40 34
For less than 25% of projects ...... ...... 6 7 16
Total ............ ................... 100 100 100
Minimum profitability standards required:
For most projects ......... ............. 77 65 58
For some projects ......... ............. 13 23 20
For few projects ......... .............. 10 12 22
Total ............ ................... 100 100 100
Most sophisticatedprimary evaluation standard:
Discounting (rate of return or present
worth) ............... .............. 57 38 19
Accounting rate of return ....... ......... 26 30 34
Payback or payback reciprocal ..... ...... 12 24 34
Urgency ................ .............. 5 8 13
Total ............ ................... 100 100 100
* Percentages shown are yes divided by yes + no multiplied by 100.

method designated by each respondent, where "Urgency" is taken as the

least sophisticated and any discounted net cash flow method is taken as
the most sophisticated. The results show a clear majority using dis-
counting methods in 1970.
The method of eliminating multiple answers entails an obvious bias
in the direction of more sophisticated standards. For the current period,
about one-third of the firms reporting the use of discounting as their
most sophisticated primary method reported that they used more than
one primary method. Furthermore, an additional 25 percent of the
firms that used discounting as a primary method reported use of some
nondiscounting method as a secondary standard. Thus, only about 25
percent of the respondents say they are using discounting standards ex-
clusively, although 67 percent make some use of discounting methods.

10. Christy, p. 12.

394 The Journal of Business

Beyond all this, one can make no further statement, from these data,
about how and to what extent firms use any of these techniques.
Even with the bias just discussed, it is clear that use of one or the
other of the discounted cash flow methods has been gaining over time
and that payback methods have been declining in popularity. Previous
surveys usually showed payback as the most widely used standard."
This is not strongly contradicted by the present survey responses for the
two earlier periods, when we consider sample differences, normal errors
of recall of earlier periods, and our method of eliminating multiple an-
swers. The advanced theory of the 1950s has increasingly become the
practice of the early 1970s.

11. Ibid.
 395 Empirical Evidence of Budgeting Techniques

APPENDIX
No. of Respondents
Questions and Answers Current 1964 1959
AdministrativeTechniques

Are alternativesto major investment pro-

posals specifically searched for and con-
sidered?
Yes ............................. 171 130 112
No ........... .................. 10 20 25
NR* ............................. 3 34 47
Is a long-rangecapitalbudget formallypre-
pared?
Yes ............................. 126 86 60
No ............................. 57 65 79
NR ........... .................. 1 33 45
Does your firm carry out postaudits of
major projects?
Yes ............................. 162 92 71
No ............................. 22 60 71
NR ........... .................. 0 32 42
Are standardforms generallyused for bud-
get and appropriationrequests?
Yes ............................. 177 141 124
No ........... .................. 6 15 24
NR ........... .................. 1 28 36
Is at least one member of your staff as-
signed full time to capital budgeting?
Yes ............................. 103 78 64
No ............................. 81 76 79
NR ............................. 0 30 41

Newer Techniques

Does your firm have a formal method of

considering risk?
Yes ............................. 71 36 26
No ............................. 112 113 111
NR ........... .................. 1 35 47
What method is used?
a) Raising the requiredreturn ....... 38 24 17
b) Shorteningpayback period ....... 18 13 12
c) Determining probability
distribution ....... ........... 33 11 9
d) Measuringcovarianceof projects . . 5 3 1
e) Other ........................ 13 3 1
* NR = no response.
 AP P ENDIX (Continued)
No. of Respondents
Questions and Answers Current 1964 1959
Newer Techniques
Managementscience techniques:
a) Game theory ....... ........... 6 3 0
b) Linear programming ..... ....... 31 13 7
c) Nonlinear programming..... ..... 8 4 2
d) Computersimulation ..... ....... 51 11 4
e) Probability theory ...... ........ 58 13 8
I) Decision theory ....... ......... 17 7 4
g) Pert/critical path ...... ......... 51 20 6
h) Utility theory ....... ........... 7 1 0

ProjectEvaluationTechniques
What is the approximatepercentage(based
on dollar value) of capital projects for
which your firm makes an estimate of
profit contribution?
100 ............................. 21 16 15
75-100 ............ ............. 72 62 45
50-75 .............. ............ 57 41 30
25-50 .............. ............ 16 19 11
0-25 .............. ............ 10 10 20
NR ............................. 8 36 63
Does your company require proposals for
capital investment to meet minimum
standardsof profitability?
Most ............................. 140 103 85
Some ............................. 24 36 29
Few ............................. 17 20 33
NR .............................. 3 25 37
What form does your primary standard
take?t
Urgency ..............5........... 5 8 13
Payback-before tax ...... ......... 26 24 25
Payback-after tax ...... .......... 34 27 25
Payback reciprocal-before tax ....2 2 2
Payback reciprocal-after tax ....... 4 3 3
Average accounting rate of return-on
total investmentbefore tax ..... ... 26 19 20
Average accounting rate of return-on
total investment after tax ..... .... 27 23 23
Average accounting rate on return-on
averageinvestmentbefore tax ...... 8 3 3
Average accounting rate of return-on
averageinvestmentafter tax ....... 11 7 6
Minimumrate of discountedcash flow . - 55 32 14
Discountedpresentvalue of cash flow . . 53 27 10
t Some respondents indicated more than one primary standard.
397 Empirical Evidence of Budgeting Techniques

A P P E NDIX (Continued)
No. of Respondents
Questions and Answers Current 1964 1959
Project Evaluation Techniques
What form does your secondary standard
take?t
Urgency ............. ............ 11 6 6
Payback-before tax ...... ......... 12 8 6
Payback-after tax ....... ......... 35 24 21
Payback reciprocal-before tax ...... 0 0 0
Payback reciprocal-after tax ....... 1 1 1
Average accountingrate of return:
On total investmentbefore tax 2 3 2
On total investmentafter tax ...... 8 6 1
On averageinvestmentbefore tax 4 2 1
On average investmentafter tax . 6 5 3
Minimumrate of discountedcash flow 11 3 2
Discountedpresentvalue of cash flow . . 13 6 4
t Some respondents indicated more than one secondary standard.