Capital Budgeting Theory

CASIRJ Volume 11 Issue 8 [Year - 2020] ISSN 2319 – 9202
Capital Budgeting Theory
Author:
Dr. Suchita Shukla
Assistant Professor
(STEP HBTI)
Co-Author:
Devashish Shukla
PGDM 2nd Year
STEP HBTI
ABSTRACT
This research on the theory of financial management offers insight into the roles of stockholder
wealth maximization, the risk-return tradeoff, and agency conflicts as they apply to major topics
in finance. The current article investigates capital budgeting. Much literature addresses this topic,
with a number of articles challenging accepted theories, some investigating agency problems,
and a few empirically testing the relationships taught in most managerial finance classrooms.
Keywords: capital budgeting; agency theory; stockholder wealth maximization; discounted cash
flows
INTRODUCTION:
This research is designed to combat the tendency of most current managerial finance books to
cover the technicians of financial management while neglecting the conceptual connections of
that bulb-and-light content to the stockholder wealth maximization, risk and return, and agency
constructs; to that end, the research offers brief articles to supplement the introductory finance
course. To date, the series has offered an introductory article as well as essays covering financial
analysis, leverage, the valuation of stocks and bonds, and capital structure.
It is now time to turn to the topic of capital budgeting to address questions such as:
1-Why is capital budgeting important?
2- What approaches to capital budgeting exist?
3- What theories prevail?
4- What agency conflicts do financial managers face?
5- What aspects of capital budgeting have researchers investigated, and what are their findings?
As with past articles, we review the mechanical and conceptual framework commonly presented
in books, look at how risk and return and agency problems interface with stockholder wealth
maximization, review the literature related to capital budgeting, and conclude by offering advice
to the financial manager for tackling the important assignment of implementing the firm‘s capital
budgeting process.
International Research Journal of Commerce Arts and Science

http://www.casirj.com Page 75
A.MECHANICAL AND CONCEPTUAL REFRESHER

In this research, the returns to investors covered in ―Part IV Valuation‖ were converted to the
cost components of the weighted average cost of capital (WACC) of ―Part V Capital Structure,‖
and now, at least in theory, financial managers use the (minimized) WACC to judge the
acceptability of long-term projects requiring capital investment. The allocation of long-term
capital is called capital budgeting, and while accepting or rejecting any single project probably
would have little impact on the short-term survival of the firm, these judgments in the aggregate
determine stockholder wealth in the long term. This makes the topic crucial to stockholder
wealth maximization.
The most widely employed models include two that would be considered by many to be
antiquated (or at least unsophisticated)—the payback period and ―urgency and persuasion‖—
and two that rely on discounted cash flows—internal rate of return and net present value. The
payback period considers the number of years of returns required to recover the initial
investment (the shorter, the more desirable with a maximum number of years often considered in
the accept/reject decision); neither the timing of the cash flows nor the ultimate profitability of
the project matters. Proponents of this approach argue that it is simple and addresses risk
appropriately for many projects. Urgency (the machine breaks and therefore must be replaced)
and persuasion (the most convincing manager, or the one with the greatest power, gets the capital
budgeting dollars) do not measure up in an economic sense, because ultimate profitability,
timing of cash flows, and other economic variables play no formal role. Still one would be
remiss in not mentioning these oft-used approaches. The internal rate of return (IRR) and net
present value (NPV) models consider both the timing of cash flows and the ultimate profitability
of the project, and thus these discounted cash flow models warrant a bit more description and
elaboration.
The IRR model uses the initial outlay and the expected future cash flows to solve for the
discount rate that would equate the two, the internal rate of return in present value terms.
Acceptability of projects then depends on whether or not that internal rate of return equals or
exceeds the ―hurdle rate‖ (typically, the WACC, but more on that later). Projects can be ranked
from highest to lowest IRR, with the highest being considered superior. The reinvestment rate
assumption constitutes a drawback of this approach, as it assumes that every time a cash inflow
occurs it can be reinvested to earn the IRR for the remainder of the project‘s life. Sometimes this
is an unrealistic assumption, especially for high-IRR projects. Thus many contend that the NPV
approach is superior, as described blew.
In contrast to the IRR model, its close cousin the NPV approach assumes AS the discount rate
for future cash flows the hurdle rate (or WACC) in determining the total present value of those
future cash flows. From this value the outlay is subtracted to calculate the net present value with
the following decision rule: If the NPV is greater than or equal to zero, accept the project.
Essentially, if the project‘s risk aligns with the risk of the firm‘s assets, a zero NPV would
maintain the value of the firm; positive NPV projects would increase firm value. A variant on
this model, the NPV index approach would ―standardize‖ projects of different size by dividing
the NPV by the outlay required, with projects ranked from highest to lowest based on the size of
this index.
Because of their general reliance on estimated future cash flows, each of the models above can
be effective only insofar as those projections are accurate. These represent the returns, and
financial managers‘ability to estimate them constitutes a big part of the risk profile. The
following section addresses the relationships among risk, return, agency conflicts, and
stockholder wealth maximization
THEORETICAL CONSTRUCTS AND CAPITAL BUDGETING

As has been the case with every topic in this series, risk and return, agency costs, and
stockholder wealth maximization play critical roles in capital budgeting. Often agents are
tempted to amplify expected returns and disguise risk in their attempts to secure a piece of the
capital budgeting pie; as expected, this does not always serve to enhance stockholder wealth.
This section highlights some of the most problematic elements of these theoretical themes.
In considering the risk aspect of capital budgeting, managers should apply the models outlined in
the previous section to projects that lie within the general risk profile of the firm‘s business. If
the risk associated with a project vying for capital investment is greater than normal, the project
should be subjected to a quicker payback period or a higher hurdle rate than the WACC for the
discounted cash flow approaches. Similarly, if the project is exceptionally routine and perhaps
even less risky than the norm, the manager should employ less challenging hurdles.
Unfortunately, the risk of projects is quite difficult for external parties to police, as no required
disclosure rules apply. This can open the door for agency conflicts, as managers underestimate
risk and accept projects that should be rejected.
The return dimension of capital budgeting comes with its own special challenges. Estimating
future cash flows, their timing, and the level of their uncertainty comprises the biggest challenge
for most managers, yet this receives relatively little attention in the textbook setting (or falls in a
chapter separated from the capital budgeting models, increasing the likelihood that professors
will not devote time to both or the likelihood that students will not quite get to it!).
Among the people-related complexities and items typically carrying agency costs are the
following, each of which will be treated in turn:
1- Finding the personnel required for all acceptable projects
2-Weighing the costs and benefits of centralization versus decentralization
3-Creating the self-discipline to perform post-audits
4- Recognizing sunk costs
5- Including all real economic costs (cannibalization of similar product lines, pollution and other
externalities)
6- Recognizing (and controlling) information asymmetry

Managers often can find a number of acceptable projects and secure funding for them but cannot
launch them due to constraints associated with personnel. Projects require managerial expertise
and time to oversee them; sometimes the projects outnumber the available managers. This can
result in theoretically indefensible capital rationing. New managers should be hired to carry out
the projects, surmounting this constraint. In reality, projects often are rejected despite the fact
that the benefits of the related growth would accrue to the stockholders.
Capital budgeting can occur in a centralized setting in which top management controls the
allocation of investment dollars or in a decentralized setting in which divisional managers vie
against one another for capital project funding. While the former alleviates agency costs, it also
results in less commitment from divisional managers than the approach in which they become
responsible for finding and approving specific projects. The challenge is to find the appropriate
balance between the benefits of decentralization (responsiveness to customers, suppliers, and
employees, faster decision making, increased motivation, etc.) and the potential costs of such
independence (suboptimal decision making, focus on the subunit, duplication of output and
activities, etc.) [Horngren, 2012, pp. 777-78].
Textbooks often comment that firms do a better job of finding, funding, and running projects
than they do in judging after the fact whether or not the estimates that led to acceptance were
realized. This review process is referred to as a ―post audit,‖ and (theoretically) it should be
used as an instrument to ensure learning over time— accepting better and better projects and
improving future estimates. Post-investment audits help protect against managerial tendencies to
promote projects by over-stating potential cash flows. Such audits can also ―help alert senior
management‖ to ―implementation problems‖ (weak project management, poor quality control,
or inadequate marketing‖) [Horngren, 2012, p. 756]. Some of the literature indicates that these
audits do, in fact, take place [See Klammer, Wilner, and Smolarski, 2002, as cited in Koch,
Mayper, and Wilner, 2009, for a report on the extent of this activity.]. Perhaps because no formal
cash flow reporting for individual projects is required, those of us external to the firm simply do
not see this post audit information. A final weakness of the audit process is the apparent
disconnect between the use of discounted cash flow to accept projects and the use of accrual-
based accounting, including losses on sale, to judge managerial performance. This tempts
managers to make capital budgeting decisions based on (inappropriate) measures.
Any person who has taken an introductory course in economics is familiar with the term ―sunk
costs‖— costs that are irrelevant to decisions because they cannot be changed and will not differ
among future alternatives. However, in reality, managers can fixate on a past decision and allow
this to interfere with judgments related to capital budgeting. For example, consider the manager
who has underestimated demand and purchased a semi-automatic machine that is more costly to
run for the production levels that have materialized. Replacing the machine with an automatic
counterpart might make good sense (might pass all the discounted cash flow hurdles) but would
require recognizing a ―Loss on Sale‖ from the old machine, which would dampen current
earnings per share. Though not a ―cash flow‖ and not relevant to the current proposal to
purchase a better, faster, more efficient machine, the manager in all likelihood will take actions
to avoid the ―loss,‖ perhaps even hiding the issue entirely by not proposing a machine purchase
at all. This ―two-wrongs-does-not-make-a-right‖ behavior will fail to maximize shareholder
wealth, though it may well lead to a better bonus for the manager if bonuses are a function of
earnings per share in the division.
One way external parties can detect the existence of ill-advised investments is by monitoring free
cash flow—the residual remaining after subtracting from operating cash flows the capital
investments and payments to those financing them (interest and dividends). Good financial
managers will recognize their duty to return excess funds to the stockholders who can invest
them in other companies earning suitable returns on their projects. Of course, this requires a tacit
admission by the financial managers that they have failed to find such projects, a dilemma for
most humans. As this section has suggested, the academic approaches and those of practitioners
don‘t always coincide, and the following section offers coverage of some pertinent capital
budgeting literature that underscores that fact.
CAPITAL BUDGETING IN THE LITERATURE
The capital budgeting literature is vast, but several articles since 2000 give a good idea of how
researchers have treated some of the ideas presented in the current paper. This section groups
those articles into two categories: Capital budgeting approaches and principal-agent challenges.
Capital Budgeting Models
While some researchers focus on the cost of capital input into the discounted cash flow (DCF)
capital budgeting models, others debate the relative strength of the different models themselves.
Because the estimation of the cost of capital determines project acceptability in the DCF models,
mistaken estimations can cause poor accept-reject decisions. The Capital Asset Pricing Model
(CAPM) takes center stage in the literature as one technique for estimating the cost of the equity
component of the weighted average cost of capital, but the model has received much criticism
over the past decades [See Laux, 2010 (d) and Laux 2011 for coverage of some of this literature.]
In ―Toward an Implied Cost of Capital,‖ Gebhardt, Lee, and Swaminathan [2001] offer a model
to the financial manager for approximating the firm‘s cost of capital. The authors suggest that a
firm‘s cost of capital ―…is a function of its industry membership, B/M ratio, forecasted long-
term growth rate, and the dispersion in analyst earnings forecasts‖ (p. 135). Jagannathan and
Meier [2002] question whether we even need CAPM for capital budgeting, contending that
capital rationing exists to such an extent that misestimates of the WACC based on CAPM don‘t
really matter—most projects actually undertaken have internal rates of return in excess of that
measure anyway.
Academics consider the NPV approach superior, and Ryan and Ryan [2002] find that, over time,
practitioners have come to agree. However, discounted cash flow models, while considered more
sophisticated than those that do not consider the time value of money, still have their detractors.
Adler [2006] argues that the assumptions of DCF capital budgeting models are so unlikely to
hold in reality that business schools do a disservice by even teaching them. Capital budgeting
projects tend to be so complex that data are not available for the most essential parameters
required by DCF models. Adler cites the following limitations: ―…narrow perspective,
exclusion of non-financial benefits, over-emphasis on the short-term, faulty assumptions about

the status quo, inconsistent treatment of inflation, and promotion of dysfunctional/cheating
behavior‖ (p. 4). In short, strategy lies at the heart of long-term investment, and strategy involves
a level of complexity that cannot be reduced to mere financial numbers. If one desires to cut
content in the financial management curriculum, Adler suggests we start by cutting this topic.
Two commentaries on this very article, however, recommend that we not throw the baby out
with the bathwater. Wouters [2006] and Weil and Oyelere [2006] see value in the framework
offered by DCF modeling. Both argue that DCF models should be used in conjunction with other
strategic investment decision models. Two other supporters of the NPV approach, Berkovitch
and Israel [2004] bemoan the fact that, while this approach could lead to optimal decisions, it is
dominated by other models such as IRR and the profitability index. Thus, ―while firms use
NPV to measure the addition to firm value from prospective projects, ‗classical‘information and
agency considerations prevent it from implementing the optimal capital budgeting outcome‖ (p.
239).
When interest rates are uncertain, the net-present-value threshold required to justify an
irreversible investment is increasing in the length of a project‘s payback period. Therefore, slow-
payback projects should face a higher hurdle than fast-payback projects, just as investment
folklore suggests. This result suggests that the widely disparaged use of payback for capital
budgeting purposes can be an intuitive response to correctly perceived costs and benefits. (p. 1)
This section presenting conceptual and theoretical literature would not be complete without
recognizing the contributions of Stewart Myers to the area of capital budgeting. As outlined in
Allen, Bhattacharya, and Rajan [2008], among the ground-breaking ideas related to capital
budgeting, Myers offered the value additively concept(investments should be treated separately
from one another and not in a portfolio context). This represented a meaningful departure from
earlier work by Markowitz suggesting that corporate diversification would contribute to higher
firm value and shareholder wealth. Allen et al. reflect that, in his work, Myers recognized some
of the same deficiencies of the DCF model pointed out by Adler [2006] and Boyle and Guthrie
[2006]: ―What is missing from simple DCF analysis is the ability to model the flexible
responses of corporate managers and other decision-makers when new information becomes
available‖ [Allen et al., p. 16]. This implies that (1) models such as the payback period have
some usefulness when used in tandem with DCF, and (2) human intervention as new information
surfaces can enhance capital budgeting decisions. This second observation provides the
foundation for the following section addressing literature associated with the behavioral aspects
of capital budgeting.
Agency Theory In The Capital Budgeting Literature
While all capital budgeting models discussed above generate a numerical output used to make
long-term investment decisions, numbers cannot tell the whole story, because people generate
the numbers. This human aspect leads to ―gaming‖ the system in pursuit of control, power,
benefits, and other coveted outcomes that can obstruct shareholder wealth maximization. In

addition, managers are subject to risk aversion (or risk taking) behaviors that can impede their
ability to achieve this assumed goal. The literature offers a look at several of these aspects.
Corporate socialism and the free rider problem represent themes in three articles. In ―Green
with Envy: Implications for Corporate Investment Decisions,‖ Goel and Thakor [2005]
investigate how the utility gained by managers when their consumption exceeds that of their
reference group affects investment in centralized versus decentralized capital budgeting systems.
Centralized environments can lead to corporate socialism (wherein CEOs award projects to
satisfy disgruntled managers), and envy can lead to overinvestment as it ―creates a natural
propensity for managers to overinvest so as to hoard resources and deny them to others in the
organization‖ [Goel and Thakor, 2005, p. 2260]. Of course, both outcomes reduce firm value.
Although authors Scharfstein and Stein [2000] also believe that corporate socialism exists, they
explain it differently, and once again the CEO and managers play the role of the primary culprits.
The CEO, in an attempt to get the manager to turn away from wasteful rent-seeking behavior to
more productive work, allocates more non-cash resources than capital budgeting models would
dictate—an action not easily tracked by stockholders whose wealth is being reduced. In addition,
the greatest inefficiencies occur ―when there is a great deal of divergence in the strength of the
divisions‖ (p. 2540). Finally, de Motta [2003] suggests that ―…corporate headquarters‘
informational advantage, while improving the allocation of resources, might have adverse
consequences for managerial incentives [because] each division manager takes the external
perception of the whole firm as a public good and is tempted to free ride‖ (p. 1212); with no
external eyes evaluating his/her own division, the divisional manager has no incentive to
maximize the value of the whole firm—others will do this for him or her. Thus, the centralize-
versus-decentralize choice assumes some importance. So, too, does information asymmetry, as
external investors lack access to divisional profitability and therefore cannot judge managerial
efficiency at that level.
Two articles hone in on the issue of decentralization. Baldenius [2003] argues that
decentralization promotes empire building, a negative activity that can be offset by applying a
higher required rate of return for capital budgeting projects. In short, ―…the hurdle rate is
always higher under delegation than under centralization‖ [Baldenius, 2003, p. 911, italics
deleted]. Thus, the author makes a case for alternative forms of hurdle rates. Marino and
Matsusaka [2005] find that both centralized and decentralized schemes have their drawbacks.
―Processes that delegate aspects of the decision to the agent [decentralization] result in too
many projects being approved, while processes in which the principal retains the right to reject
projects [centralization] cause the agent to strategically distort his information about project
quality‖ (p. 301); the latter results in ―an inefficiently large capital allocation‖ as well (p. 320).
Finally, emotions provide the focus of a number of articles investigating capital budgeting
behavior. In ―The Impact of Affective Reactions on Risky Decision Making in Accounting
Contexts‖ [2002], Moreno, Kida, and Smith contend that emotions, even when based on data,
counteract (and can even overcome) classical prospect theory, which says that decision makers
tend to be risk averse in settings with potential gains but risk taking in loss settings. This
―normal‖ setting only applies in the absence of other decision-relevant characteristics. Because
managers are human and are ―likely to reject decision alternatives that elicit negative reactions
and accept alternatives that elicit positive reactions‖ (p. 1333), their affective reactions
(evaluations, moods, and emotions) can ―negate prospect theory‘s predictions, resulting in risk
taking in gain contexts and risk aversion in loss contexts‖ (p. 1336), sometimes resulting in the
choice of alternatives with lower economic value.
Risk-taking/risk-avoidance also relates to a manager‘s job security and compensation. Bernardo,
Cai, and Luo [2004] focus on the compensation mechanism that best promotes truthfulness in
information that managers provide in capital requests. They suggest that ―compensation
schemes such as shares in the firm…or stock options…are likely to provide powerful incentives
for managers to report truthfully their private information and allocate efficiently the resources
under their control‖ (p. 758). Dutta [2003] investigates the problem of managerial mobility and
suggests that the owner can counteract the manager‘s urge to go elsewhere by reducing the
hurdle rate required to approve investment projects for these mobile managers. ―Green with
Envy…‖ (cited above) also highlights some findings related to compensation: ―…the average
compensation of managers in a conglomerate exceeds the average compensation of similar
managers in single-segment firms [and] the cross-sectional variation in wages among managers
in a conglomerate is less than that across managers in separate single-segment firms; that is,
there is wage compression in conglomerates‖ (p. 2261). The implication is that envy raises its
ugly head in a more pronounced fashion in the conglomerate environment, and perhaps because
it is harder to monitor individual performance in that environment, all managers partake (in
roughly even manner) in the higher wages. The bottom line, of course, is that all of this imperils
stockholder wealth maximization in the capital budgeting arena.
This literature review charts a difficult course for the financial manager with respect to capital
budgeting activities. How can managers combat the uncertainties and human frailties associated
with this important activity?
What advice can we offer financial managers who find themselves on the journey? The next
section outlines some potentially enlightening questions.
THE BOTTOM LINE: CAPITAL BUDGETING ADVICE FOR THE FINANCIAL

MANAGER
In navigating their way through the choppy seas of capital budgeting, financial managers might
benefit by employing the following questions (and suitable answers) to help them set the
compass:
ur capital budgeting models?
(Yes)
than the weighted average cost of capital? (Yes)

hole, or if not, have we
adjusted the discount rate accordingly? (Yes)
CC
or above? (No)
If the financial manager can answer these questions honestly and let the answers drive proper
action, the stockholders‘chances for maximized long-run wealth should be enhanced.
THIS SERIES CONTINUES
This article has raised some hard questions about the capital budgeting assignment. In fact,
capital budgeting has implications for another major assignment, dividend policy, because
whatever is not invested in long-term projects will be retained or paid out as dividends. Thus,
dividend policy naturally assumes its rightful position as the next topic in this series.
REFERENCES
 Adler, Ralph W. 2006. Why DCF Capital Budgeting is Bad for Business and Why
Business Schools Should Stop Teaching it. Accounting Education: An International
Journal, Vol. 15, No. 1: 3-10.
 Allen, Franklin, Sudipto Bhattacharya, and Raghuram Rajan. 2008. The Contributions of
Stewart Myers to the Theory and Practice of Corporate Finance. Journal of Applied
Corporate Finance, Vol. 20, No. 4: 8-19.
 Arnold, Glen C. and Panos D. Hatzopoulos. 2000. The Theory-Practice Gap in Capital
Budgeting: Evidence from the United Kingdom. Journal of Business Finance &
Accounting, Vol. 27, Nos. 5 and 6: 603-626.
 Baldenius, Tim. 2003. Delegated Investment Decisions and Private Benefits of Control.
The Accounting Review, Vol. 78, No. 4: 909-930.
 Berkovitch, Elazar and Ronen Israel. 2004. Why the NPV Criterion does not Maximize
NPV. Review of Financial Studies, Vol. 17, No. 1: 239-255.
 Bernardo, Antonio E., Hongbin Cai, and Jiang Luo. 2004. Capital Budgeting in
Multidivision Firms: Information, Agency, and Incentives. Review of Financial Studies,
Vol. 17, Issue 3: 739-767.
 Block, Stanley. 2005. Are There Differences in Capital Budgeting Procedures Between
Industries? An Empirical Study. Engineering Economist, Vol. 50, Issue 1: 55-67.
 Boyle, Glenn and Graeme Guthrie. 2006. Payback without apology. Accounting and
Finance, Vol. 46: 1-10.
 De Motta, Adolfo. 2003. Managerial Incentives and Internal Capital Markets. The
Journal of Finance, Vol. LVIII, No. 3: 1193-1219.
 Dutta, Sunil. 2003. Capital Budgeting and Managerial Compensation: Incentives and
Retention Effects. Accounting Review, Vol. 78, Issue 1: 71-93.
 Gebhardt, William R., Charles M. C. Lee, and Bhaskaran Swaminathan. 2001. Toward an
Implied Cost of Capital. Journal of Accounting Research, Vol. 39, No. 1: 135-176. .

Capital Budgeting Theory

Uploaded by

Copyright:

Available Formats

Capital Budgeting Theory

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Capital Budgeting Theory

Uploaded by

Copyright:

Available Formats

CASIRJ Volume 11 Issue 8 [Year - 2020] ISSN 2319 – 9202

Capital Budgeting Theory

International Research Journal of Commerce Arts and Science

A.MECHANICAL AND CONCEPTUAL REFRESHER

THEORETICAL CONSTRUCTS AND CAPITAL BUDGETING

International Research Journal of Commerce Arts and Science

exclusion of non-financial benefits, over-emphasis on the short-term, faulty assumptions about

International Research Journal of Commerce Arts and Science

THE BOTTOM LINE: CAPITAL BUDGETING ADVICE FOR THE FINANCIAL

than the weighted average cost of capital? (Yes)

You might also like