capital budgeting

Topics: Net present value, Capital budgeting, Internal rate of return Pages: 29 (9954 words) Published: October 28, 2014
3 : Literature Review in Capital Budgeting Studies

3.1

Introduction

3.2

Literature Review : Foreign Studies

3.3

Literature Review : Indian Studies

3.4

Conclusion

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Chapter 3 : Literature Review in Capital Budgeting Studies

3.1

Introduction:

A number of researchers in finance and accounting have examined corporate capital budgeting practices. Many of these articles survey corporate managers and report the frequency with which various evaluation methods, such as payback, internal rate of return (IRR), net present value (NPV), discounted payback, profitability index (PI), or average return on book value are used. The best known field studies about the practices of corporate finance are Gitman and Forrester’s (1977) study of Capital Budgeting Techniques Used by Major U.S. Firms, Porwal’s (1976) study on Capital Budgeting Techniques and Profitability and Graham and Harvey’s (2001) study on capital budgeting, cost of capital, and capital structure. It is believed that the findings of this study in the context of India are useful to academia and practitioners in learning how corporate India operates, developing new theories, and identifying areas where finance theory is not implemented.

What are the capital budgeting tools and techniques being practiced by the industry and how popular are they? Do firms use methods that help to maximize the firm value? The review of empirical surveys and studies help to find answers to these questions. The changes in capital budgeting procedures over the decades have been well documented in prior studies. The research of Canada and Miller, Fremgen, Gitman and Forrester, Kim and Farragher, Stanley Block all indicate that increasingly sophisticated capital budgeting procedures have been put in practice.

However, a generalization that more sophisticated practices take place across all industries is subject to investigation and challenge. This consideration is important because an analyst within a given industry may be intending on following industry norms but misled by general observation that relate to the studies cited above. Just as there are different valuation procedures or financing norms between industries, there may also be different capital budgeting procedures.

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Rosenblatt and Jucker (1979) and Scott and Petty (1984) summarize several of these surveys. They show that from 1955 to 1978 the use of techniques which recognize the time value of money (i.e., IRR, NPV, PI and discounted payback) by sample firms rose from .09 to around .80. However, many survey authors express surprise that a greater percentage of the respondents did not use techniques which discounted future cash flows. A number of textbooks have similar concerns.

I have divided my literature review into two parts:
1.

Foreign Studies

2.

Indian Studies

3.2

Literature Review: Foreign Studies

Klammer, Thomas P. (1972) surveyed a sample of 369 firms from the 1969 Compustat listing of manufacturing firms that appeared in significant industry groups and made at least $1 million of capital expenditures in each of the five years 1963-1967. Respondents were asked to identify the capital budgeting techniques in use in 1959, 1964, and 1970. The results indicated an increased use of techniques that incorporated the present value (Klammer, 1984).1& 2

Fremgen James (1973) surveyed a random sample of 250 business firms that were in the 1969 edition of Dun and Bradsheet’s Reference Book of Corporate Management. Questionnaire were sent to companies engaged in manufacturing, retailing, mining, transportation, land development, entertainment, public utilities and conglomerates to study the capital budgeting models used, stages of the capital budgeting process, and the methods used to adjust for risk. He found that firms considered the Internal Rate of Return model to be the most important model for decision-making. He also found that the majority of firms increased their...
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