The Misapplication of Capital Investment Appraisal Techniques

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The misapplication of capital investment appraisal techniques Drury, Colin, Tayles, Mike. Management Decision. London: 1997. Vol. 35, Iss. 2; pg. 86

Abstract (Summary)
An examination of the surveys of capital budgeting practices that have been undertaken during the past 20 years in both the UK and US reveals a trend towards a continuing increase in the use of more sophisticated capital budgeting techniques. In a longitudinal survey of capital budgeting practices of large UK companies between 1975 and 1992, substantial increase in the usage of discounted cash flow (DCF) and risk appraisal techniques was reported. Despite the increased usage of the more theoretically sound discounting techniques, several writers in both the UK and US have claimed that companies are underinvesting because they misapply or misinterpret DCF techniques. It has been asserted by several writers that firms are guilty of rejecting worthwhile investments because of the improper treatment of inflation in the financial appraisal. Many firms are understating NPVs and IRRs because of the incorrect treatment of inflation and the use of excessively high discount rates. Concern has also been expressed by various commentators that many companies are failing to invest in advanced manufacturing technologies (AMT) as fully as they should. Financial appraisal techniques have been cited as a major reason for the under-investment in new manufacturing technology. DCF procedures should not be ignored or relegated in importance merely because they might be used incorrectly. Instead, decision-makers should recognize potential problems and be careful to ensure that the financial appraisal is performed correctly.

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Copyright MCB UP Limited (MCB) 1997

Colin Drury: Professor, University of Huddersfield, Huddersfield, UK

Mike Tayles: Lecturer, University of Bradford, Bradford, UK

ACKNOWLEDGMENT: Financial support for undertaking the survey was provided by the Chartered Association of Certified Accountants

An examination of the surveys of capital budgeting practices that have been undertaken during the past 20 years in both the UK and USA reveals a trend towards a continuing increase in the use of more sophisticated capital budgeting techniques. In a longitudinal survey of capital budgeting practices of large UK companies between 1975 and 1992 Pike (1996) reported a substantial increase in the usage of discounted cash flow (DCF) and risk appraisal techniques. In 1975 32 per cent and 44 per cent respectively used net present value and internal rate of return. The corresponding percentages in 1992 were 74 per cent and 81 per cent. Pike also reported that whereas in 1975 most firms adopted one of two investment appraisal techniques (typically payback and accounting rate of return), by 1992 the most common method was to use a combination of four different methods (net present value, internal rate of return, payback and accounting rate of return). Pike attributes these movements as being due to the widespread adoption of computer-based spreadsheet models which can be easily programmed to generate different financial measures and the need to explore the many faceted aspects of investment performance.

Despite the increased usage of the more theoretically sound discounting techniques, several writers in both the UK and USA have claimed that companies are underinvesting because they misapply or misinterpret DCF techniques. For example Marsh et al. (1988,p. 23) studied three UK organizations, observing that although all three companies used DCF techniques "we noted many errors in the way it was applied". Such claims, however, have been made on the basis of observations in a small number of companies or anecdotal evidence, without any supporting statistical evidence. In this article we report on a recent survey that we have conducted which suggests that many UK companies are indeed guilty of...
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