# Capital Budgeting

**Topics:**Net present value, Capital budgeting, Investment

**Pages:**28 (5777 words)

**Published:**March 26, 2013

Vol. 39 (2010), pp. 39 - 50

Capital Budgeting Management Practices

in Japan

— A

Focus on the Use of Capital Budgeting Methods* —

Tomonari Shinoda†

Capital budgeting is one of the most important factors in the process of corporate decision-making. Data from numerous previous studies show that managers prefer the simple payback period method (non-discounted payback model) over the net present value method (discounted cash flow model), which academics consider as superior. In particular, almost all investigative research in Japan has shown that the managers of Japanese firms tend to prefer a non-discounted cash flow model, such as a simple payback period method. This interesting gap between business practice and academic theory has long been a puzzle to the academic community.

From October, 2008, to January, 2009, I conducted a survey in the form of a questionnaire sent to 225 people in charge of capital budgeting at firms listed on the Tokyo Stock Exchange, with a focus on capital budgeting practices. This paper presents the results of the questionnaire survey and evaluates the capital budgeting practices in Japanese firms. The results show that Japanese firms manage their decision-making by a combination of payback period method and net present value method. While most financial managers utilize multiple tools in the capital budgeting process, these results reflect a better alignment of views between academia and business.

JEL Classitication: M10, M40, M41, G31

Keywords: Capital Budgeting, Simple Payback Period Method, Discounted Payback Period Method, Premium Payback Period Method, Accounting Rate of Return, Net Present Value Method, Internal Rate of Return Method, Real Options

1. Introduction

Corporate capital budgeting decision models are used by corporate managers in the process of critically important decision-making about capital budgeting. There are a variety of capital budgeting methods: the net present value (NPV) method, the internal rate of return (IRR) method, the simple payback period (SPP) method, the discounted payback period (DPP) method, the accounting rate of re-

*

This research was supported by KAKENHI (Grant-in-Aid for Young Scientists (B), No. 20730298) provided by MEXT/JSPS. † Graduate School of Economics and Business Administration, Hokkaido University, Kita 9, Nishi 7, Kitaku, Sapporo, Hokkaido, 060-0809 Japan, Email: shinoda@econ.hokudai.ac.jp

40

Econ. J. of Hokkaido Univ., Vol. 39 T . Shinoda

turn (ARR) method, such as ROI, and the real option (RO) method1） .

Almost all academic articles and textbooks recommend that managers should

use the most appropriate and exact methods to ensure the highest return for the least risk in order for their firm to maximize shareholder value. Academic literature, in particular that devoted to finance theory, has therefore indicated that discounted cash flow models, such as NPV, are desirable for decision-making concerned with capital investment because an increase of NPV is connected directly with increased corporate value.

While managers have, over the long term, used various capital budgeting models, the use of such models has not always been in agreement with finance theory. In particular, the payback period method is said to be theoretically irrelevant and mistaken because the simple payback period (SPP) method ignores the time value of money and cash flows beyond the cutoff date: the cutoff is usually arbitrary. Even if we use the discounted payback period (DPP) method, which was modified in order to eliminate the limitations imposed by ignoring the time value of money, we cannot resolve the difficulty of ignoring cash flows beyond the cutoff date2）Even .

so, some previous surveys in Japan have indicated that Japanese managers have most frequently used SPP and have rarely used NPV or IRR.

This study re-examines the capital budgeting decision-making methods used by managers of...

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