Capital Budgeting Practices 86
Capital Budgeting Practices of Twelve Large Manufacturers
Marc Ross, University of Michigan,
reprinted from Financial Management (winter 1986) vol. 15, issue 4, pp 15-22
1. Introduction
Surveys of capital budgeting practices among lrge firms have indicated a widespread use
of discounted cash flow (DCF) methods, especially internal rate of return.
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 differences between theory and practice in the implementation of
DCF analysis.
Surveys have shown hat many firms use either a weighted average cost of capital or the
cost of a specific 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.
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 thee 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. I was supported by the John D. and Catherine T. MacArthur
Foundation. Data were gathered, in 1982-82, from 15 large firms, with three each from the steel,
paper, chemical, aluminum, and petroleum refining industries. Since the author did not
participate 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 is proprietary and the firms cannot be identified.
The author would like to express his pleasure in working with the project group at the Alliance to Save Energy:
Robin Miller, Bob Rauch, Mike Reid and Jim Wolf; Carliss Baldwin of the School of Business Administration,
Harvard University, for extensive comments on an early draft; and the editor of Financial Management for extensive
Two recent surveys of the literature are those by Scott and Petty [9] and Gurnani [5].
See the surveys by Gitman and Forrester [4] and Petty, Scott and Bird [6]. A survey of capital budgeting practices
is presented by Fremge [3].
Capital Budgeting Practices 86
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 generously provided. Moreover,
respondents stated that the capital budgeting process or energy conservation is essentially the
sane as for other discretionary projects of the same size.
B. The Sample Data
The firms typically categorize capital investments as either mandatory (regulations,
contracts, capitalized maintenance, replacement of antiquated equipment, product quality) or
discretionary (expanded markets, new businesses, cost cutting). Decisionmaking 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 contained some 400 projects: roughly 100
completed projects, almost all in 19890-81, and 300 projects either underway or prospective,
primarily intended for the period 1982-85.
Interviews at the firms showed that most firm' decision-making processes re 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 project) for four of the twelve firms under
consideration; i.e., they spanned all energy-conservation projects under consideration regardless
of project size. Complete records for project based at one or more plants were obtained at five
more firms. For the remaining firms only samples of the projects under consideration wee
Capital Budgeting Practices 86
Exhibit 1 Project Size and Decision-Making Authority
Project Size
Typical Boundaries
Primary Site for
Investment Decision
Very small
Up to $100,000
$100,000 to $1 million
$1 million to $10 million
Corporate investment committee
Over $10 million
CEO & board
Example of a Project Proposal
Decision making on smaller projects can be succinctly described by a hypothetical
example. Typical features that we observed are incorporated; the specifics would, of course,
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 would reduce excess air in
the combustion zone.
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 annul 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 and 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 a the edge of a cliff; a small mistake could be very damaging. Bill
selected a project 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.
His idea could have come from an energy-conservation audit of the plant, corporate energy conservation staff,
professional literature, or contacts with peers.
Capital Budgeting Practices 86
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 the 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 knows that other
alternatives would create a project in the $1 million to $10 million range, putting the final
decision with the Corporate Investment Committee (CIC). Paradoxically, while he knows that
the CIC is more generous in approving 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 tht
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 improving the manufacturing process (with respect to product qual,
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 organizations, 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 plan is relatively modern 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, ever where management does not expect the shutdown to
occur soon.
Using 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.
He assumes
that the heater is operated at design levels and that the energy saved per year is constant over the
Although 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 Budgeting Practices 86
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 if its 1.7 year payback.
The request for funds includes a two-page financial analysis prepared by a computer, a
brief technical description of the project and very brief comments on it possible impacts on
production and pollution. The request is sent to the plant manager. He has an overview 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 planning process, the plant manager knows that the total requested is inline with the
capital the division expects to allocate to this plant.
Decision makers 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 bean effective procedure for preventing
some plant managers from exaggerating the benefits of their projects. The vice president believes
the engineering estimate of capital costs and initial benefits to be unbiased. He has his own ideas
about rates of inflation, which leas 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
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
At the critical meeting on the project in question, it is learned that the requests for
mandatory projects are larger than usual.
Considering the funds remaining, if all discretionary
projects were ranked by their IRR, this particular project would not make it. On the other hand,
If 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.
Requests 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 plant level, and the reputation of the
plant and its management.
Capital Budgeting Practices 86
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.
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 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.
Exhibit 2 Distribution of 12 Firms by Measure of Investment Worth Used for Smaller
Measures Calculated Number of
Measure Primarily Relied Upon Number of
IRR, with both variable project life
and price escalation
Simplified IRR and
simple payback
IRR, with fixed life and/or escalation
Simple payback only**
Simple payback
*NPV and other DCF measures were also calculated but not referred to in discussion or in other documents.
Of the five, one approximated the DCF calculation so it could be easily calculated, and all required use of a single
economic life for all projects and/or a single uniform price escalation.
** or a return on investment directly based on simple payback
Not surprisingly, perhaps, sensitivity analysis for various 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. However,
only a few of the firms studied 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.
The practice at most firms is thus to keep both the financial analysis of smaller projects,
and the process of communicating this analysis to decision makers, extremely simple [7].
Capital Budgeting Practices 86
Decisions are then based on the primary quantitative measure from the analysis supplemented by
informal adjustments made in the minds of decision makers. The analysis of large projects was
more detailed in the few cases we saw. For example, detailed DCF analyses were carried out,
often including sensitivity analyses with resect to parameters like the rates of price escalation.
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 de facto, 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 decentralized capital decision 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 followed 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 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.
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 thee
projects is very broad, but it has a few projects with IRRs that are close to the lowest IRR for an
For 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' studied were
Capital Budgeting Practices 86
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).
V. Hurdle Rate Results
Our information is consistent with the expectation that all twelve firms had de facto
hurdle rates for large projects close to the corporate cost of capital (about 15%).
Only four
firms gave this treatment to the smaller projects, however. For the other eight 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.
Exhibit 3 Investment Hurdle Rates by Project Size: Flexible-Budgeting and Capital-
Rationing Firms
Hurdle Rate Range*
Number in Sample
(firms, projects)
Budgeting Firms
Rationing Firms
Budgeting Firms
Rationing Firms
Size of Project
(4, 197)
(6, 96)
(4, 19)
(6, 73)
(3, 12)
Another 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
ther 1982 recession. These delays were not reflected in the data we collected.
Two of these firms showed us their methods of calculating cost of capital; they correspond closely to textbook
procedures. See, for example,
Van Horne [10].
Capital Budgeting Practices 86
*Internal rate of return, discounting nominal dollar flows
See Exhibit 1 for definitions.
** Based on a very small project sample; return on least profitable project is shown.
The firms studied thus fall into two classes:
i) firms with uniform de facto hurdle rates near the corporate cost of capital or all
discretionary projects, i.e., flexible-budgeting firms, and
ii) firms with de facto 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 decision making. 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
justified 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 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 new finding is that capital
rationing, as practiced, has an especially sever impact on smaller projects.
Not surprisingly, financial analysis of smaller projects at flexible-budgeting firms tends
to be more sophisticated 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-
5xIC, with r
~ 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
Capital Budgeting Practices 86
spending resulting from the difficulties that firms with poorer ratings face in raising capital, as
discussed subsequently.
Possible Rationales for Severe Capital Rationing for Smaller Projects
The high hurdle rates for smaller projects do not primarily reflect greater uncertainty abot
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
compensated 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 lest risky projects. This does not appear,
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 that the average cost of capital to the firm.
Under this explanation, capital rationing is imposed on firms from outside suppliers of
Top corporate management is preoccupied with many other responsibilities and assigns a low
priority to cost cutting. Also top management feels unable t decentralize or delegate open-
Capital Budgeting Practices 86
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 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
pubic offerings of industrial stocks by Asquith and Mullins [2].
Interviewees perceived the effect to be strongly differentiated, however, depending on the
general purpose of the investment: Debt can be raised by the capital-rationing firms without
unacceptably weakening their financial rating for certain major acquisitions. For added
investment to modernize existing plants, however, the cost of capital is perceived to be very
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 extraordinarily 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 postponed, 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 postponed, or neglected altogether, at
capital-rationing firms? There was enough information from six o 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 thee six firms. The highest fractions
in this range were associated with flexible-budgeting firms, or firms in very high energy-to-
value-added businesses sand the lowest fractions were associated with capital-rationing firms
Capital Budgeting Practices 86
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
postponed at 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 involvement of top management in decisions
on smaller projects.
i) Information on individual projects: Communication 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 intuitively 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 decision making 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
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 pricipal reasons why there were so many energy conservation projects: i) rapidly increased prices
for energy, ii) dramatic improvements in available energy-related technology 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, might be largely, but nor
completely used up 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.
Capital Budgeting Practices 86
cost is large enough to command the careful 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 it
would also 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.
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.
Ad hoc efforts are not
likely to succeed.
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 nominally 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 decision making (or 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.
Helpful software (ENVEST) has been developed by M. W. Reid at the Alliance to Save Energy.
Capital Budgeting Practices 86
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. Fremgen, "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 Used by
Major U.S. Firms," Financial 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 Corporations," 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 Practices in Large American firms: A
Retrospective Analysis and Synthesis," The Financial Review, 19 (May 1984), pp 111-123.
10. J.C. Van Horne, Financial Management and Policy, 5
ed., Englewood Cliffs NJ, Prentice
Hall, 1980.