Capital Budget

Topics: Discounted cash flow, Net present value, Capital budgeting Pages: 20 (6920 words) Published: January 6, 2013

Morris G. Danielson*
St. Joseph’s University Philadelphia, PA

Jonathan A. Scott Temple University Philadelphia, PA

June 2006

We acknowledge the helpful comments of Jacqueline Garner, William Petty, and participants at the 2005 Financial Management Association and Eastern Finance Association Conferences.

Corresponding author: Erivan K. Haub School of Business, Saint Joseph’s University, Philadelphia, PA 19131; Phone: (610) 660-1606; E-mail:


THE CAPITAL BUDGETING DECISIONS OF SMALL BUSINESSES Abstract This paper uses survey data compiled by the National Federation of Independent Business to analyze the capital budgeting practices of small firms. While large firms tend to rely on the discounted cash flow analysis favored by finance texts, many small firms evaluate projects using the payback period or the owner’s gut feel. The limited education background of some business owners and small staff sizes partly explain why small firms use these relatively unsophisticated project evaluation tools. However, we also identify specific business reasons— including liquidity concerns and cash flow estimation challenges—to explain why small firms do not exclusively use discounted cash flow analysis when evaluating projects. These results suggest that optimal investment evaluation procedures for large and small firms might differ. [G31]

This paper analyzes the capital budgeting practices of small firms. The U.S. Small Business Administration estimates that small businesses (which they define as firms with fewer than 500 employees) produce 50 percent of private GDP in the U.S., and employ 60 percent of the private sector labor force. Many small businesses are service oriented, but according to the 1997 Economic Census over 50 percent are in agriculture, manufacturing, construction, transportation, wholesale, and retail—all industries requiring substantial capital investment. Thus, capital investments in the small business sector are important to both the individual firms and the overall economy. Despite the importance of capital investment to small firms, most capital budgeting surveys over the past 40 years have focused on the investment decisions of large firms (examples include Moore and Reichardt, 1983, Scott and Petty, 1984, and Bierman, 1993). An exception is Graham and Harvey (2001), who compare the capital budgeting practices of small and large firms. Even their small firms are quite large, however, with a revenue threshold of $1 billion used to separate firms by size. Indeed, less than 10 percent of their sample report revenues below $25 million. Thus, Graham and Harvey’s results do not directly address the investment decisions of very small firms.1 There are several reasons small and large firms might use different criteria to evaluate projects. First, small business owners may balance wealth maximization (the goal of a firm in capital budgeting theory) against other objectives—such as maintaining the independence of the business (Ang, 1991, Keasey and Watson, 1993)—when making investment decisions. Second, small firms lack the personnel resources of larger firms, and therefore may not have the time or

The Federal Reserve Board of Governor’s Survey of Small Business Finance serves as the data source in many studies of small business finance. The firms in the Board of Governor’s Survey tend to be much smaller than the firms in the Graham and Harvey (2001) sample; in the 1993 Board of Governor’s survey, 83 percent of the firms report revenues under $1 million. The firms in the Graham and Harvey sample, therefore, are much larger than firms typically included in studies of small business finance.


the expertise to analyze projects in the same depth as larger firms (Ang, 1991). Finally, some small firms face capital constraints, making project liquidity a prime concern...
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