survey and analysis of capital budgeting methods
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COURSE TITLE: SEMINOR IN FINANCE COURSE CODE: MPH 622
Presentation on
Survey and Analysis of Capital Budgeting Methods
Written by: Lawarance. D. Schall, Gary L. Sundem and William R. Geijsbeek, Jr.
University of Washington and Finance Manager, The Boeing Company
Published in: Journal of Finance, Vol. XXXIII, No. 1, March 1978
10th April, 2011
Article Outline
I. Background
II. Survey sample and findings
A. Sample
B. Results
III. Analysis of results
IV. Conclusions
Presentation Outline
Background & Objectives
Motivation of the study
Research Methodology
Major Findings
Conclusions
Comments
Background
Istvan (1961), Klammer (1972) and Fremgren (1973)
and Lawarance, et.al (1977) are the only previous
works concentrated towards the gradual sophistication
of capital budgeting techniques in the area of finance.
The insight of the study emerges from the mutual needs
of such kind of works from both the academicians’ and
practitioners’ area of interest.
The study thus try to entitle the needful blend.
Back…..
Objectives
i) To find the most popular CBTs employed in
practices.
ii) To explore the computation of discount rates and
cash flows, and
iii) To identify the method of estimation and
adjustment of project risk.
Research Gap:
The need of further assessment of CBTs, as
suggested by the trend of limited previous works.
The growing concern over the use of CBTs in
practices.
Implications of the results.
Motivation
Population: large US firms which are included on the COMPUSTAT tape.
Selection of sample (424 firms) constitute 3 condition; i) net plant assets exceeding $200 million,
ii) capital expenditures exceeding $20 million, or
iii) net plant assets exceeding $150 million and capital expenditures exceeding $10 million.
Since the inability of 17 firms, only 407 firms were entertained for the survey.
Major financial officers are the respondents .
Response rate was 46.4%.
Methodology
Method… Variables:
Payback period (PBK)
Accounting rate of return (ARR)
Internal rate of return (IRR)
Net present value (NPV)
Cost of debt
Cost of equity
Weighted average cost of capital (WACC)
Growth and dividend payout ratio, and
Risk-free rate
Tools : The study uses the naïve methods for
analysis which includes frequency distribution,
range and percentile.
Major findingsModel Percentage Remarks
PBK 74% Most popular
ARR 58%
IRR 65%
NPV 56%
The most popular
techniques is PBK (74%).
Percentage of resp. firms using each possible combination of CBTs
Model Used% of firms
using models
PBK, ARR, IRR, NPV 17
PBK, ARR, IRR 14
PBK, ARR, NPV 9
PBK, IRR, NPV 9
ARR, IRR, NPV 2
PBK, ARR 8
PBK, IRR 8
PBK, NPV 7
IRR, NPV 7
ARR, NPV 4
ARR, IRR 2
IRR 6
ARR 4
NPV 2
PBK 2
101*
The use of IRR or NPV or
both techniques constitute
over 86% and only 16% use
one or both without using
ARR and PBK.
Percent of the 140 firms that use a discount rate using each cost of capital method
Use measure exclusively
Use measure in combination with others
Total % Using
Cost of debt 7% 10% 17%
Cost of equity 1 8 9
WACC 31 16 47
A measure based upon past experience 14 6 20
Expectations w.r.t. Growth and Dividend payout 8 9 17
Return from a Rf asset plus a premium associated with the risk 3 5 8
Another rate 12 4 16
WACC is one of the most popular discount rate and it is used by
about 51% of the US firms.
And, the remaining use a variety of methods.
Distribution of COC for the 69 firms using an after-tax COC
% COC No of firms % of firms
7.0 - 7.9 3 4
8.0 - 8.9 3 4
9.0 - 9.9 2 3
10.0 - 10.9 30 43
11.0 - 11.9 4 6
12.0 - 12.9 11 16
13.0 - 13.9 0 0
14.0 - 14.9 5 7
15.0 - 15.9 8 12
16.0 - 16.9 2 3
17.0 + 1 1
69 99
After tax discount rate is used
by major firms (88%) and the
average rate 11.4%.
Before tax average discount rate
14.3%.
The most common method of
predicting cash flow is predicting
net income (NI) first and then
adjust of non-cash flow items.
Risk assessment (189 firms)
Assessment method Percent
Quantitative 36
Subjective 60
Do not assess 4
Majority (60%) of the respondents
use the subjective judgment for risk
assessment.
Only 4% of the respondents do not
assess the risk.
Individual project risk assessment (43 firms)
Assessment method Percent
Probability of cash flow 25
Sensitivity analysis 10
Covariance of CF with others 4
Subjective evaluation 57 +
Over 57% firms use subjective
evaluation, followed by probability of
cash flow.
Sensitivity analysis also used by
10% of the firms.
Klammer (1972) and Fremgren (1973) on study of CBTs shows the increasing trend of its use for the investment decision making. Former showed 39% and later 67% of the decision based use CBTs. Lawarance, et.al (1977) found 78%as the increasing parameter of popularity. On top of the previous works, the study suggest that 86% of the firms use more than one CBTs.
After-tax WACC is the most common method of determining a required rate of return.
Project risk is usually assessed subjectively, and
The level of sophistication in CBTs is positively related to the size of the firm’s capital budget and negatively related to risk.
Conclusions
The study use the simpler methods of analysis so that readers can easily understand the theme.
The findings could impart the understanding about the importance of CBTs and its pervasive use from the very beginning.
The results of the study are very much useful to the learners and beginners (practitioners), and
The study was conducted by the authors from the academic and practitioner field of finance, thus it is an interesting blend of two opponents.
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