the proposed capital investment project and a short discussion of the gap between the theory and practice of capital budgeting

The British Accounting Review 47 (2015) 225–236

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The British Accounting Review

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Uncertainty, irreversibility and the use of ‘rules of thumb’ in capital budgeting

Francis Chittenden a, Mohsen Derregia b,* a Manchester Business School, Harold Hankins Building, Booth Street West, Manchester M13 9PL, UK b Libyan Investment Authority, 22nd Floor Tripoli Tower, Tripoli, Libya

a r t i c l e i n f o

Article history: Available online 21 December 2013

Keywords: Capital budgeting Real options Uncertainty Irreversibility

* Corresponding author. E-mail address: [email protected] (M. Derregia).

0890-8389/$ – see front matter � 2013 Published b http://dx.doi.org/10.1016/j.bar.2013.12.003

a b s t r a c t

Numerous studies of capital budgeting practice report continued use of simple techniques to evaluate decisions, a result that appears at odds with theory. Some theoretical de- velopments in the real options literature that highlight the influence of uncertainty and irreversibility on capital budgeting, however, suggest that these techniques may be used as proxies for more complex and theoretically correct evaluation. We survey the use of simple capital budgeting techniques to capture the effect of uncertainty and irreversibility on capital budgeting decisions in practice. We find that firms adjust payback time and discount rates in the presence of uncertainty and irreversibility and delay investment decisions. We also find that there are variations in responses received from firms by size, sector, and ownership. While most small and large firms find demand uncertainty important in delaying decisions, small firms find interest rate uncertainty significantly more important than large firms. Further, listed firms delay capital budgeting decisions less frequently than other firms. Irreversibility also affects the value of the option to abandon and the option to expand, and firms value flexibility, reversibility and first mover advantages.

� 2013 Published by Elsevier Ltd.

1. Introduction

The practical application of capital budgeting techniques is often seen as inconsistent with theoretical recommendations, and is characterised by the use of payback (PB) along with discounted cash flow (DCF) techniques and the adjustment of discount rates and cash flows in response to risk (Arnold & Hatzopoulos, 2000; Pike, 1988, 1996). Graham and Harvey (2001) find that many firms continue to use PB and adjust cash flows and discount rates in response to a variety of risk factors other than market risk. They also report that the use of PB is more widespread in smaller firms where it is as frequently used as net present value (NPV) and the internal rate of return (IRR). These results are contrary to the advice often found in finance and management accounting textbooks published in 1970s and 1980s, which, in line with the theory dominant at the time, recommends the use of DCF techniques and the Capital Asset Pricing Model (CAPM) (Scapens, 2006; Scapens & Sale, 1985). The theory explains PB’s inferiority to DCF techniques by highlighting its neglect of the time value of money and of cash flow beyond a cut-off date. It also explains why CAPM should be employed to find an appropriate discount rate that takes into account market risk for use with DCF techniques.

More recently, following the emergence of real options pricing theory in the 1980s, textbooks point out the importance of considering real options in capital budgeting and some of the problems posed by the ‘naïve’ use of DCF (for example, Brealey, Myers, & Allen, 2007; Dixit & Pindyck, 1994). The application of real options pricing theory in capital budgeting is reportedly

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limited (Alkaraan & Northcott, 2006; Brounen, de Jong, & Koedijk, 2004; Graham & Harvey, 2001), and does not appear to have challenged the dominance of NPV, IRR and PB. Several theoretical arguments and simulations, however, show that rules of thumb based on commonly used capital budgeting techniques, such as PB and DCF, can approximately capture the effect of uncertainty and irreversibility on capital budgeting decisions (e.g., Berry, Coad, Harris, Otley, & Stringer, 2009; Dixit & Pindyck, 1994; McDonald, 2000; Stark, 1990). Simulations by McDonald (2000) show that rules of thumb could serve as proxies for ‘rational economic considerations’ absent from the standard or ‘Naïve’ DCF.1 By simulating capital investment decisions and comparing results obtained using PB, discount rates and the Profitability Index, he finds that these rules proxy for optimal investment timing behaviour. He also finds the timing option is the most valuable amongst other options and it is the least sensitive to deviations from the optimal investment rule. Other simulations by Klumpes and Tippet (2004) use a real options model of an irreversible investment project to show that, given a discount rate of 10% and a variance parameter – a measure of uncertainty – increasing from 1 to 4, the optimal instantaneous cash flow increases making the PB time of their example fall from 3.7062 years to 2.6402 years. The simulated results they present further support the possibility that, in practice, shorter required PB time approximates the impact of higher uncertainty on irreversible decisions.

These results, in light of the theoretical arguments and simulations present in the literature, may be more consistent with theory than they appear. The focus on the application of techniques in the accounting and finance literature rather than the wider context of investment decisions that practitioners consider (Jones & Dugdale, 1994) may be exaggerating the gap between theory and practice. Firms can be using PB time and adjustment of discount rates in response to both uncertainty and irreversibility to take into account the value of the option to wait, in the absence of strategic and expiring options. The lack of evidence on this is a significant gap in the literature and this paper uses data obtained from a survey questionnaire to address the gap. It investigates the effect of uncertainty and irreversibility on the hurdles that projects need to clear when there is an option to wait. It also investigates the importance of several factors, such as, demand uncertainty and interest rate uncertainty in raising the value of the option to wait, and the frequency of the options to abandon, mothball, expand and contract in capital budgeting decisions. In investigating the above, the paper recognises that firms are not homogeneous in their need for, and in the way they carry out, capital budgeting (Scapens, 2006). This is based on evidence that, first, the use of capital budgeting techniques is usually related to the size of investment under consideration (Schall, Sundem, & Greijsbeek, 1978) and that firms vary in their need for capital and their capital intensity – a characteristic often associated with manufacturing firms (Abdel-Kader & Luther, 2008; Klammer, 1973). Firms, therefore, are unlikely to be facing a common degree of irre- versibility in their capital budgeting decisions. This will be reflected in their use of capital budgeting techniques and the effect of uncertainty on their decisions.

Second, small firms tend to be more sensitive to uncertainty and more financially constrained (Ghosal & Loungani, 2000). This implies that delay of investment decisions may also be caused by lack of funds as well as uncertainty and irreversibility. Third, the separation of ownership and control may lead managers of listed firms to be less sensitive to uncertainty when making capital budgeting decisions (Antle & Eppen, 1985; Antle & Fellingham, 1990). The paper considers potential differ- ences between firms in their response to uncertainty and irreversibility and in their use of rules of thumb resulting from size, sector, and ownership effects.

The paper proceeds as follows. In section two we review the academic literature on the potential of adapting capital budgeting techniques to account for the price of risk associated with both uncertainty and irreversibility. Section three de- scribes the research methodology utilised. Section four presents results of the fieldwork on the use of simple capital budgeting techniques as ‘rules of thumb’ to account for uncertainty and irreversibility. In this section we also explore the factors that drive the value of options to expand or contract, abandon, delay or mothball projects and the differences between firms’ response to uncertainty and irreversibility on the basis of size, sector and ownership. Finally, in section five the con- clusions are presented.

2. Background

This section is organised in three parts. The first part deals with the potential for common capital budgeting techniques to approximate the value of the option to wait. In the second part, the pricing of risk in real options is compared with the CAPM approach and the potential for rules of thumb to take into account the price of risk is explained. In the third and final part, characteristics of firms that may lead to variations in the use of capital budgeting techniques and in the response of firms to uncertainty and irreversibility in capital budgeting decisions are discussed.

2.1. Capital budgeting and the option to wait

Real options pricing theory considers the capital budgeting decision structure to be flexible in that it is not a now-or-never decision, with firms having the option to wait or delay decisions (e.g., Brennan & Schwartz, 1985; Dixit & Pindyck, 1994; McDonald & Siegel, 1986; Pindyck, 1991). It also considers other options, e.g., flexibility, expansion, mothballing, contraction,

1 The use of ‘naïve’ here follows Dixit and Pindyck (1994) who point out that DCF techniques can be adjusted to deal with irreversibility and uncertainty. But, as often presented in textbooks, ‘naïve’ DCF techniques ignore the role of irreversibility and uncertainty in the value of real options that decision makers have when evaluating investment projects, and during and after implementation of projects.

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and abandonment to be relevant tothe evaluation of capital investment opportunities and need tobe valued whenever present. In models of the option towait, uncertaintyabout payoffsand irreversibilityof decisions are crucial in determining its value (e.g. Dixit & Pindyck, 1994; McDonald & Siegel, 1986; Trigeorgis, 1996). Further, given that uncertainty increases with time, firms would prefer investments with quick payoffs (Dixit & Pindyck,1994). Since raising the hurdle a project faces by increasing the discount rate or shortening the PB time can lead to similar decisions (Narayanan, 1985), firms may raise the discount rate or shorten the PB time to ensure that sufficient payoffs are received in the near and less uncertain future. With an option on the timing of an irreversible investment (in the absence of strategic value and expiring options), uncertainty would increase the value of the option to wait.2 This makes it necessary for the PB time to become shorter or the discount rate to rise to ensure that the decision takes into account the increase in the value of the option. Conversely, if assets were reversible, then uncertainty would encourage investment, given the possibility of high payoffs and the ability to roll back a decision (Pindyck, 1991).

There is sufficient evidence from surveys of capital budgeting practice to suggest, when looked at retrospectively in light of the above results, that firms may be employing rules of thumb in ways consistent with real options pricing theory. For example, Block (1997) finds that the PB time used by small US firms averages 2.81 years, which he reports is much shorter time than the useful life of many of the assets evaluated. The practice of raising the discount rate or shortening the PB time in response to risk has been widely reported in the literature. Schall et al. (1978) report that of the 120 respondents using PB with either NPV or IRR, 8% adjust only the required PB period, 42% only adjust the required rate of return, 32% adjust both and 18% adjust either. Gitman and Forrester (1977) report that 44% of respondents increase the required rate of return and 13% decrease the minimum PB period. Further, the assessment of risk is often done subjectively (Klammer, 1972). However, the role of irreversibility, which is arguably important in capital budgeting decisions, is absent from studies of capital budgeting practice. A natural progression from the above, to address the gap in the literature, is to investigate if the adjustments to PB time and discount rates are in response to uncertainty and to irreversibility and lead to delayed decisions.

2.2. Pricing risk and real options

The CAPM and real options pricing models offer methods for pricing risk that differ in their approach to non-systematic risk. The CAPM deals with non-systematic risk through portfolio theory and diversification and offers a method for pricing systematic risk. By contrast, real options models regard both systematic and non-systematic risk (and the degree of irre- versibility) to be important to the investment decision. Graham and Harvey (2001) investigate the use of CAPM and use a list that comprises the factors proposed by Fama and French (1992), momentum (Jegadeesh & Titman,1993), and macroeconomic factors in Chen, Roll, and Ross (1986) and Ferson and Harvey (1991,1993). The results show that in practice CAPM is often used in conjunction with assessing specific risk factors that are of concern to firms depending on their exposure, a result that is consistent with Jagannathan and Wang (1996) and Jagannathan, Kubota, and Takehara (1998).

Simulations by Jagannathan and Meier (2002) show that accurate estimates of the cost of capital may not be critical for capital budgeting decisions. They show that in the presence of an option to wait, assuming organisational and managerial capital is rationed, a hurdle rate that is higher than the cost of capital used in NPV calculations could account for the value of the option to wait. Empirical evidence finds that companies often use hurdle rates that are substantially higher than the historical average rate of return on debt or equity observed over several decades. Poterba and Summers (1995) in a survey of all Fortune 1000 companies report that respondents, who are, as in several other surveys, mostly manufacturing firms, use an average hurdle rate of 12.2% in real terms.3 Their results show wide variations in the levels of hurdle rates used within companies, with the average difference between the highest and the lowest rates at 11.2%.4

The incorporation of specific risk factors into CAPM (Jagannathan & Wang, 1996; Jagannathan et al., 1998) reveals that some of these factors, not only market risk, influence the cost of capital. Several empirical studies use secondary data to investigate the impact of specific risk (uncertainty) on investment levels as evidence of firms valuing their option to wait, assuming that manufacturing firms make irreversible decisions. Some of the factors considered are: demand uncertainty (Guiso & Parigi, 1999); profit uncertainty (Ghosal & Loungani, 2000); interest rate uncertainty measured by the premia on long-term bonds (Ferderer,1993); and market value volatility (Leahy & Whited,1996). The survey questionnaire employed for this paper examines the link between the pricing of risk to both uncertainty and irreversibility by exploring their impact on the discount rate and PB time employed in decisions. Further, several factors that can influence the timing of investment decisions, such as interest rate levels and availability of funding are also surveyed.

The presence of strategic and/or expiring options could reduce the value of the option to wait. Evidence presented by Poterba and Summers (1995) show that strategic projects face lower than average discount rates. It is expected that firms do not always raise the hurdles irreversible projects face under uncertainty. This paper is primarily concerned with investigating

2 When considering capital budgeting decisions that are strategically important (i.e. have strategic value) or opportunities that are expiring, the value of the option to wait may be reduced. Further, flexible (multi use) capital assets can mitigate the effect of uncertainty by reducing irreversibility.

3 Jagannathan and Meier (2002) state that surveys of capital budgeting often receive a majority of responses from manufacturing firms. Examples of such surveys are Klammer (1972), Poterba and Summers (1995), and Block (1997). Graham and Harvey (2001) target the fortune 500 firms and members of the Financial Executives Institute and their respondents are 40% manufacturing – the highest proportion of respondents from a single industry.

4 Long-term equity risk premium measures published by Ibbotson Associates in the US find that between 1926 and 2000 the estimated annualised return is 11.3% and the estimated risk free rate of interest is 3.6%, giving a risk premium of 7.3%. In the UK, Barclays Capital and Credit Swiss First Boston find that between 1916 and 2000 the respective figures are 12.2%, 5.5%, and 6.4%.

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the link between uncertainty and irreversibility on the one hand, and the hurdles facing projects on the other. However, we also report on the importance firms attach to the valuation of flexible assets, first mover advantages and reversibility of assets.

The option to wait is one of several options that may typically be encountered in capital budgeting decisions. The relative importance of some other options, which compete with the option to wait, can also be influenced by the degree of irre- versibility in decisions. For example, if an investment is irreversible, the option to contract will have little value since it derives its value from the ability to at least partly reverse a decision, while the presence of reversibility reduces the value of the option to wait. The survey examines the frequency, and the role that irreversibility (or conversely, reversibility) plays in creating the value of the options to expand, contract, mothball, and to abandon.

2.3. Firm characteristics and capital budgeting

The literature on capital budgeting reports that manufacturing and capital intensive firms have more use for capital budgeting. Empirical studies have pointed out that the use of capital budgeting techniques is often related to the size of investment under consideration (Schall et al.,1978) and the capital intensity of firms (Klammer,1973).5 Capital intensive firms are more likely to experience a need to buy capital assets, possibly because the assets are specialised (irreversible).6 Capital budgeting decisions may also be affected by the separation of ownership and control (Antle & Eppen,1985; Berry et al., 2009), which occurs more often in listed rather than unlisted firms. This may lead to less sensitivity to uncertainty and irreversibility as managers in their capacity as agents seek to control more resources and assets, without having to bear the full conse- quences of bad decisions. Further, there are variations in the way some specific risk factors affect firms, for example, Graham and Harvey (2001) report that small firms are more affected by interest rate risk than large firms. Small firms are also more likely to experience capital rationing, which can lead to delayed capital decisions and needs to be distinguished from the effect of uncertainty and irreversibility. Large firms, on the other hand, generally have better access to finance and higher confidence in their future prospects, reflected in less sensitivity to uncertainty (Ghosal & Loungani, 2000).

Often empirical research into capital investment expenditure focuses on manufacturing firms. Examples of such empirical studies are numerous (see Chirinko, 1993; Hubbard, 1998 for literature reviews). But few studies investigate the use of capital budgeting by non-manufacturing firms; one of these is Graham and Harvey (2001), who find that they do use capital budgeting techniques. Other studies report that some small firms do not engage in capital budgeting as judged by their lack of use of capital budgeting techniques, for example, Block (1997) and Arnold and Hatzopoulos (2000). It is not clear, however, whether the use of capital budgeting is related to firms’ capital intensity, size, or sector. These results motivate this paper to investigate firm characteristics associated with the use and non-use of capital budgeting and the role played by asset specificity (irreversibility).

3. Methodology

3.1. Design

The research for this paper requires data on the use of capital budgeting techniques by individual firms, and on the levels of uncertainty and irreversibility facing them. If the data were available, a large sample data analysis would have facilitated the use of powerful statistical tests. However, such firm-level data are not readily available and so our data is collected using a survey questionnaire (a copy of the questionnaire is available from the authors upon request). The questionnaire is developed on the basis of the theoretical and empirical literature reviewed in Section 2 above, and on the basis of interviews with 49 finance directors (FDs) of non-sample firms. The interviewees included finance directors and chief executive officers of UK headquartered multinational corporations and UK small firms, including listed and unlisted firms from the service and manufacturing sectors.7 The interviews were employed to discuss capital budgeting practice and to refine the design of the survey questionnaire. The involvement of the interviewees is also used to reduce the potential for firms to misunderstand the survey questions and as a robustness check for the survey questionnaire results. Consistency between the information gained from the interviews and the survey responses makes it less likely that the research results are biased.

In carrying out the research measures were taken to deal with a number of important issues that are relevant to survey research as discussed by Wallace and Mellor (1988) and Moore and Reichert (1983). The first measure was the imposition of a restriction on the time given to firms to respond to the survey, limiting it to 4 weeks in total with a reminder sent after two weeks to non-respondents. The second measure was to test for differences in responses with and without late replies using

5 There is evidence that capital budgeting is limited to large ticket items (Copeland, 2002; Schall et al., 1978). This does not necessarily imply that the decisions are not economically justified, but to save management time they are approved without going through the formality of capital budgeting at board level. Capital intensive firms need to make more capital investment decisions and thus have more use for capital budgeting. On the other hand, companies making decisions about small ticket items do not need to spend valuable time analysing such decisions but often buy items because they are needed, e.g., as a result of regulatory requirements.

6 Williamson (1975, 1979) and Klein, Crawford, and Alchian (1978) argue that asset specificity increases the transaction costs and it is less costly for firms to own such assets. Asset specificity implies that such assets have limited residual value as opposed to generic assets (Gompers, 1995).

7 To define small firms this paper uses a commonly used UK definition of Small and Medium Enterprises, these being firms that have two of these: sales of no more than £25m, fixed assets of no more than £12m and number of employees no more than 250.

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c2, which revealed no significant differences at the 5% level. The third measure was employing c2 tests to assess whether there are significant differences between the composition of respondents and the target population, which includes listed and non-listed firms, service and manufacturing, and small and large businesses. This approach follows the suggestion of Moore and Reichert (1983) and is employed by Graham and Harvey (2001) to deal with non-response bias. No significant differences on the basis of size, sector, and ownership are found at the 5% level.

The survey questionnaire uses multiple-choice questions and scales to facilitate statistical tests on responses, including tests for significant differences in the distribution of responses on the basis of size, sector, and ownership. The questionnaire also requests that respondents add answers in writing should alternative answers be more appropriate. It first seeks to establish whether firms use similar capital budgeting techniques to those reported in the literature. Past surveys of US, UK and other European countries find that firms continue to use methods that do not always fit with what theory recommends (for example, UK studies by Pike (1996) and Arnold and Hatzopoulos (2000), and Brounen et al. (2004) studying European firms).

The survey then asks whether firms adjust the discount rate and/or the PB time used in their capital budgeting decisions in response to uncertainty and irreversibility. If irreversibility and uncertainty explain the use of short PB time and high discount rates as proxies for the value of the option to wait, then the higher the uncertainty when considering an irreversible in- vestment in fixed assets, the shorter the PB time and/or the higher the discount rate. To assess the irreversibility firms face, asset specialisation (specificity) is used. The interviews conducted to develop the questionnaire reveal that firms find it most difficult to reverse decisions when assets are specialised and easiest to reverse decisions when they are generic with numerous users. This is very much in line with Williamson’s (1988) distinction between general assets that can be hired, rented or leased, and specific assets that generate high transaction costs if not internalised.

The survey asks firms whether the time it takes an investment to breakeven is important to the investment decision. Firms are also asked about the frequency of delaying investment decisions and to rate the importance of several factors that can potentially lead to such delay. Further, the research looks at the frequency of the options to abandon, mothball, expand, and contract, and considers the relative importance of these options when fixed assets are reversible and when they are irreversible.

3.2. Research sample and response

To form a sample of firms to survey, two databases, Datastream for listed firms and FAME for unlisted businesses, were used. The firms selected had to have complete financial records for at least 5 years. This period was chosen to ensure that firms were survivors that had existed long enough to have considered capital budgeting decisions under a range of different economic conditions. Firms were selected to include small and large, manufacturing and service, and listed and unlisted firms, to facilitate comparison of their responses.8 To identify the sectors to which listed companies belong, contribution to sales by Standard Industrial Classification Code (SIC) was used. Many companies do not have a single activity that makes up their total turnover, with companies being active in more than one manufacturing or service SIC and in combinations of manufacturing and service SICs. For listed firms, if two thirds or more of a company’s sales come from activities that are defined by the SIC code as belonging to a single sector, then the firm is assigned to that sector. Firms that are active in both service and manufacturing sectors are defined as mixed. For unlisted firms, identification of sector is based on the SIC code reported in FAME but the data on sales by sector are requested from respondents since they are not reported by FAME.

The number of listed firms targeted by the postal questionnaire is 183, and the number of unlisted firms sent a survey questionnaire is 472. To improve the chances of obtaining a high response rate, personal letters were sent to FDs of these companies followed by reminders to those who agreed to participate but were late in returning the questionnaire (after two weeks, to adhere to a four week response window). The response rate for listed firms is 40% (74 firms), and for unlisted firms, the number of replies received is 166, giving a response rate of 35%. Table 1 provides information on respondents. To assess whether the respondents are the FDs of the companies targeted, reply-paid envelopes and reply slips were provided for the FDs to reply to the letter requesting their participation. Those who had agreed to participate were also asked for their business card in order to forward to them the findings and contact them to clarify responses once the study is complete. These two factors indicate that FDs make up at least 91% of respondents.

4. Results

4.1. Use of capital budgeting techniques

The capital budgeting techniques in use by respondents are shown in Table 2. It is clear that PB is the most widely used technique in evaluating investment opportunities for the 152 firms that use capital budgeting techniques. More than 89% of these report using PB either on its own or with other techniques, while 6 firms report using real options. Ten firms report using one or more of the following: commercial judgement without any formal techniques; investing on the basis of need,

8 It is important to note that the definition of small firms in this paper differ from the small firms in Graham and Harvey (2001) who describe firms with sales under $100 million to be “very small”. The UK company population is much smaller than the US population and it is not possible to have a large enough sample using the Graham and Harvey (2001) definition, something that would have aided comparison.

Table 1 Postal survey respondents by sector, size, ownership and financial profile.

Numbers of respondents

Listed Unlisted

Manufacturing Services Mixed Manufacturing Services Mixed

SME 4 8 2 11 100 7 Large 26 25 9 18 28 2 Total 30 33 11 29 128 9

Listed

£’000s Manufacturing Services Mixed

Min Max Mean Min Max Mean Min Max Mean

SME Total assets 3048 21,100 9434 3662 12,606 7955 3349 15,289 9319 Fixed assets 628 8800 3336 73 5112 2066 2868 14,588 8728 Turnover 675 8762 5160 138 10,418 6147 341 4043 2192

Large Total assets 6044 17,206,000 1,786,205 12,906 13,662,000 1,287,965 24,432 13,556,000 1,839,984 Fixed assets 1103 10,142,000 1,072,257 6301 11,103,000 957,417 18,054 11,503,000 1,491,222 Turnover 11,780 9,041,000 1,542,332 13,963 11,238,000 1,385,808 33,838 23,653,000 2,881,210

Unlisted

£’000s Manufacturing Services Mixed

Min Max Mean Min Max Mean Min Max Mean

SME Total assets 271 8172 2581 141 28,410 1621 231 8568 3557 Fixed assets 6 5025 1254 0 24,049 671 101 6474 2297 Turnover 401 9905 3223 352 11,181 2805 299 7733 3707

Large Total assets 6323 90,049 27,260 3583 36,467 17,713 14,762 16,019 15,391 Fixed assets 1082 45,921 12,876 71 26,116 7099 9456 10,519 9988 Turnover 13,768 109,613 42,875 11,742 85,220 36,781 17,016 19,514 18,265

Note:alldataisin£’000sintheListedCompany ‘Max’columns,thelargestcompaniesreportdatain£’Millionsandasaresultthehundredsarepresentedaszeros.

Table 2 Techniques used for capital budgeting.

Techniques Number of firms Percentage

PB 28 18.4% PB with NPV and IRR 93 61.2% PB with NPV and AARR 11 7.2% PB with ROI and NPV 4 2.6% NPV 5 3.3% NPV and IRR 8 5.3% IRR 3 2.0% Total 152 100%

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investing to meet health and safety regulations, and using intangible improvements resulting from investment as a basis for making decisions. The remaining respondents, numbering 88, state that they do not employ capital budgeting techniques. Many of these firms state that they obtain the assets they need but do not use the conventional set of evaluation techniques, such as PB and DCF techniques.9

The activity, ownership, and size of businesses reporting the use of capital budgeting techniques can be seen in Table 3. The composition of these respondents reveals that small firms operating in the service sector comprise the vast majority of businesses that do not use capital budgeting. Virtually all large firms state that they use capital budgeting techniques with some exceptions in the service sector, and most listed businesses of all sizes also do. This is in contrast to the minority of small service firms who use capital budgeting techniques. The proportion of fixed assets to total assets employed by many of the smaller service firms is very low (20% or less), indicating that they are investing very little in fixed assets. The small value of the assets does not merit the same level of analysis and economic justification needed by capital intensive firms (Copeland, 2002; Schall et al., 1978).

Observing the capital intensity of the respondents using data from Datastream and FAME, 47 firms have a proportion of fixed assets to total assets of 10% or less, 35 firms with a proportion of more than 10% but less than 20%, and 82 firms have a proportion of more than 50%. Of the 47 with a proportion of 10% or less, only 6 were manufacturing, while only 7

9 Arnold and Hatzopoulos (2000) and Block (1997) report that some small firms do not use capital budgeting techniques, and Copeland (2002) states that not all investment decisions are analysed using capital budgeting techniques because many investments are in response to regulations or are small in value.

Table 3 Composition of firms using or not using capital budgeting techniques.

Using Listed Unlisted

Manufacturing Service Mixed Manufacturing Service Mixed

SME 3 6 2 6 35 3 Large 26 25 9 16 19 2

Not using Listed Unlisted

Manufacturing Service Mixed Manufacturing Service Mixed

SME 4 3 0 4 66 3 Large 0 0 0 0 8 0

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manufacturing firms and 2 mixed firms were amongst the 35 firms with a proportion between 10% and 20%. Amongst the 82 firms with a proportion of fixed assets to total assets of more than 50%, 27 were manufacturing and 13 mixed. These statistics suggest that manufacturing firms tend to be more capital intensive than service firms – a commonly held view in studies of capital budgeting (e.g. Klammer, 1972; Schall et al., 1978).

Further to the non-use of capital budgeting techniques by some firms, responses reveal that not all firms surveyed consider owning land, buildings, plant and machinery to be necessary for their business to function. While a clear majority of manufacturing firms, 83%, state that fixed assets are necessary, only 56% of service companies do (Table 4). Those of mixed activities provide intermediate responses in line with the mix of activities that make up the businesses. This informs us that it is possible for a small proportion of manufacturing firms and many service firms to carry out their mission without making substantial capital investment, possibly because they are part of the ecology of newer organisational forms researched by Smith, Morris, and Ezzamel (2005). One hundred and seventy one firms report leasing, renting, or hiring fixed assets, while 67 firms state that they do not, and 2 firms do not answer the question.

When examining differences in responses on the basis of sector, size and ownership, some differences between firms that regard owning fixed assets as essential to their activity (as shown in Table 5) and those that do not are revealed. Significant differences at the 1% level are found between the two groups for both sector (c2 ¼ 9.638) and size (c2 ¼ 11.461), but not for ownership.10 Manufacturing businesses and large firms are both over represented in the companies finding it necessary to own fixed assets. This implies that manufacturing businesses of all sizes, both listed and unlisted, tend to need to own fixed assets significantly more than service firms, and large listed and unlisted service firms need to own fixed assets significantly more than small service firms.

Respondents rate future prospects as important to the decision to own fixed assets but not asset specialisation (Table 6).11

Differences in responses emerge when compared on the basis of sector, size and ownership. Being in a strong position is substantially more important for unlisted firms, which implies that unlisted companies avoid investment in capital assets whenever possible until they are more confident about their future, i.e. facing less uncertainty. Tests reveal no statistically significant difference at the 5% level on the basis of size or sector when it comes to agreeing that being in a strong position leads to more investment in capital assets. This suggests that separation of ownership and control may be a factor in determining confidence of respondents about the future and listed firms appear less sensitive to uncertainty.

Although the overall responses do not suggest that specialisation is a factor in companies’ decisions to own fixed assets, on the basis of sector there are significant differences at the 1% level between service and manufacturing firms (Table 6). Manufacturing firms find asset specialisation to be important in the decision to own fixed assets. Comparing responses of listed and unlisted firms on specialisation reveals no significant difference at the 5% level. There are no significant differences at the 5% level between small and large businesses. The results demonstrate that manufacturing firms tend to need more specialised (irreversible) assets than service firms. Firms relying on generic, widely used assets, can use leasing, renting and hiring instead of buying and these assets tend to be less specialised/more reversible (Williamson, 1988).

4.2. Irreversibility, uncertainty, and the use of rules of thumb

The survey asks firms to rate the importance of the time taken by an investment to breakeven to the investment decision. Respondents rate this as quite important with the mean response at 3.76 on a scale from 1 to 5, mode and median both at 4 and standard deviation of 1.183. This is significantly more important than a neutral response at the 1% level. There is a general agreement amongst firms here, as there are no significant differences between respondents by size, sector, or ownership.

To clarify that the replies are not merely a reflection of firms preferring short-term projects, an additional question asks how firms respond to uncertainty. 113 Firms report raising the required rate of return and/or reducing the PB time. Of these,

10 The tests of significance are carried out using Kruskal–Wallis non-parametric test, and, for robustness, the results are confirmed using the Mann- Whitney non-parametric test and the standard test. 11 Importance is determined by the statistical significance of a difference test between the ‘neutral’ expected mean, 3 on a Likert scale from 1 to 5, and the actual mean, given the standard deviation.

Table 4 Is owning fixed assets necessary for the business to function?

Number of firms answering ‘no’

Percentage ‘no’ Number of firms answering ‘yes’

Percentage ‘yes’

Manufacturing 10 17% 49 83% Services 71 44% 90 56% Mixed activity 7 35% 13 65% Total 88 36% 152 64%

Table 5 Is owning fixed assets necessary for the business to function? Composition of firms by yes or no answer.

No Listed Unlisted

Manufacturing Service Mixed Manufacturing Service Mixed

SME 1 3 1 2 52 2 Large 7 8 4 0 8 0

Yes Listed Unlisted

Manufacturing Service Mixed Manufacturing Service Mixed

SME 3 5 1 9 48 2 Large 19 17 5 18 20 5

Statistics for differences in distribution of responses

On the basis of size On the basis of sector On the basis of ownership

c2 11.461 (0.001)** 9.638 (0.002)** 0.823 (0.364)

*Statistically significant at the 5% level, **statistically significant at the 1% level.

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47 were manufacturing, 13 were mixed and 53 service firms. Clearly, the majority of manufacturing firms respond to un- certainty by reducing the PB time or raising the required rate of return. Service and mixed firms responding in this way tend to be relatively capital intensive, with the mean proportion of fixed to total assets ratio at 50% and a similar mode and median. In addition to the 113 firms, 39 firms do not respond to uncertainty in this way but add that they reduce the projects’ cash flow forecasts.

Beside altering the PB time and raising the hurdle rate to deal with uncertainty, firms are asked whether they use scenario analysis, sensitivity analysis, decision trees, or any other techniques. One hundred and fifty seven report using scenario analysis, 41 use sensitivity analysis, 80 use both with 11 additionally using decision trees, 1 firm uses scenario analysis with decision trees, and 5 use decision trees. Thirty-six firms use no techniques at all. It is clear from these figures that many firms not using any traditional capital budgeting techniques employ techniques of risk appraisal. This indicates that uncertainty about the payoffs from decisions is still important and firms assess its impact on decisions.

Responses to the survey concur with the theoretical role irreversibility plays in capital budgeting decisions. One hundred and seventy-nine businesses stress that investing in ‘hard-to-sell’ fixed assets requires that stricter conditions be satisfied. Of these, 95 see reducing the PB time as a tool to account for irreversibility, and 93 raise the required rate of return. Forty of these respondents use both, but other firms state that they only buy such assets if it is absolutely necessary. These responses demonstrate that, in practice, irreversibility of investments leads to higher capital budgeting hurdles.

Table 6 Descriptive statistics for reasons for owning assets.

Unimportant ¼ 1 Very important ¼ 5

N Median Mean Mode Std. deviation

Specialisation 240 2 2.16** 1 1.328 Prospects 240 4 3.95** 5 1.203

Statistics for differences in distribution of responses to ‘specialisation’

On the basis of size On the basis of sector On the basis of ownership

c2 2.222 (0.136) 30.204 (0.000)** 1.782 (0.182)

Statistics for differences in distribution of responses to ‘prospect’

On the basis of size On the basis of sector On the basis of ownership

c2 2.974 (0.085) 0.918 (0.338) 16.392 (0.000)**

See notes to Table 5. Significance of mean response is determined by comparing it to the expected response.

Table 7 How often do you consider these when evaluating a new investment?

Not often ¼ 1 Very often ¼ 5

N Median Mean Mode Std. Deviation

Abandonment 238 3 2.89 2 1.399 Mothballing 238 2 2.45** 2 1.286 Expansion 238 3 3.23** 4 1.096 Contraction 238 3 2.75** 3 1.21

See notes to Tables 5 and 6.

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4.3. Factors driving the value of the option to wait, and frequency of real options

In response to questions relating to the frequency of some commonly analysed real options, respondents state that in investment evaluation the option to expand is the most frequently considered, followed by abandonment, contraction, and mothballing (Table 7). The value of some real options is influenced by the degree of reversibility of the assets in question, however. One hundred and twelve firms report considering the consequences of abandonment to be most relevant when investments are hard to reverse. In such circumstances the abandonment option is the least valuable. The option to reduce the size of the investment at the evaluation stage and mothballing are second and third in importance. When an investment is seen as easy to reverse, 66 firms consider increasing the size of the investment at the evaluation stage, indicating that they experience less concern about the consequences of lower than expected payoffs.

The results reveal that the hurdle a proposal has to clear is raised in the presence of uncertainty and irreversibility. Most respondents state that delaying investment decisions to wait for clearer future prospects happens ‘sometimes’. A summary of the frequency of responses is shown in Table 8 below. Significant differences in the frequency of delay exist between listed and unlisted firms at the 1% level, with listed firms delaying investment decisions less often. This may reflect the higher levels of confidence (less uncertainty) that listed firms have in their market position. It is also possible that managers of listed firms are less cautious because they enjoy the benefits of controlling more corporate resources but bear less of any negative conse- quences of decisions than their unlisted counterparts (Antle & Eppen, 1985; Antle & Fellingham, 1990).

Respondents are asked to rate the importance of a number of variables in delaying investment decisions (Table 9). The replies put demand uncertainty as the most important factor responsible for delaying investment decisions. This is followed by the lack of internal funding, high interest rates and interest rates uncertainty. There are no significant differences between respondents on the importance of demand uncertainty, but there are significant differences on the importance of interest rate uncertainty, high interest rates and lack of internal funding. Small firms find high interest rates and interest rate uncertainty significantly more important than large firms at the 1% level, and lack of internal funding more important at the 5% level. These results reflect the higher sensitivity of smaller firms to the cost of capital and their reliance on internally generated funds.

The real options pricing theory presents a number of models in which firms face valuable strategic and expiring options and uncertainty does not lead to delayed investment decisions (Dixit & Pindyck,1994; Trigeorgis,1996). The survey asks firms about the value of first mover advantages, flexibility, and reversibility of assets. As can be seen from Table 10, the respondents’ valuation of these is significantly higher than neutral at the 1% level.

The option to wait implies that delayed investment decisions are revisited when uncertainty falls. Most firms revisit a delayed investment decision, if it is delayed because of uncertainty. Two hundred and three firms confirm that they wait for uncertainty to clear then revisit a delayed project. Some hand written replies state that delayed projects are kept under review, while others state that the decision to revisit a delayed project depends on how many alternative investment projects there are. The large number of firms revisiting projects demonstrates that even firms not using capital budgeting techniques,

Table 8 Frequency of delaying investment decision.

Listed Unlisted

Never Rarely Sometimes Often Never Rarely Sometimes Often

SME Services 0 1 4 3 4 25 61 9 Manufacturing 0 0 1 3 2 0 7 2 Mixed 0 0 2 0 0 0 1 6

Large Services 0 3 14 7 0 12 10 4 Manufacturing 0 5 17 4 0 6 12 0 Mixed 0 1 6 2 0 0 2 0

Statistics for differences in distribution of responses

On the basis of size On the basis of sector On the basis of ownership

c2 0.001 (0.974) 0.176 (0.675) 9.374 (0.002)**

See notes to Table 5.

Table 9 Most important factors in delaying investment decisions.

Unimportant ¼ 1 Very important ¼ 5

N Median Mean Mode Std. deviation

High interest rates 240 3 2.76** 2 1.295 Interest rate uncertainty 240 2 2.59** 2 1.227 Demand uncertainty 240 4 4.19** 5 0.989 Lack of internal funding 240 4 3.45** 5 1.422 Lack of external funding 240 3 2.89 2 1.368

Statistics for differences in distribution of responses to ‘high interest rates’

On the basis of size On the basis of sector On the basis of ownership

c2 17.445 (0.000)** 2.342 (0.126) 10.747 (0.001)**

Statistics for differences in distribution of responses to ‘interest rate uncertainty’

On the basis of size On the basis of sector On the basis of ownership

c2 11.916 (0.001)** 0.549 (0.459) 8.473 (0.004)**

Statistics for differences in distribution of responses to ‘demand uncertainty’

On the basis of size On the basis of sector On the basis of ownership

c2 0.040 (0.842) 1.212 (0.271) 0.983 (0.332)

Statistics for differences in distribution of responses to ‘lack of internal funding’

On the basis of size On the basis of sector On the basis of ownership

c2 5.597 (0.018)* 0.547 (0.282) 1.489 (0.222)

Statistics for differences in distribution of responses to ‘lack of external funding’

On the basis of size On the basis of sector On the basis of ownership

c2 0.174 (0.676) 0.938 (0.333) 0.455 (0.500)

See notes to Tables 5 and 6.

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which tend to be less capital intensive, delay investment decisions under uncertainty. Such firms, while the assets they purchase are likely to be small relative to their size and do not require a sophisticated analysis to make a decision, have a choice about the timing of investments.

5. Conclusion

The continued use of simple capital budgeting techniques in ways that appear contrary to theoretical recommendations is a practice that has been reported by many surveys of capital budgeting practice. It has long been argued, however, that firms cannot continue to make bad decisions and survive. Friedman (1953) explains this by likening practitioners to a good pool player who knows how to knock the billiards balls into one another just right, but he or she may not be able to solve a differential equation. The survey employed for this paper has explored the possibility that intuition underlying the observed practice is not at odds with theory, and we find the practical relevance of the option to wait is in line with theoretical pre- dictions and simulations. Firms respond to the presence of uncertainty and irreversibility by raising the hurdles projects have to clear, and most respondents state that they delay projects to wait for clearer prospects (less uncertainty) sometimes. This is an important result, that represents a useful contribution to our understanding of capital budgeting practices, as it offers an explanation for the use of hitherto inexplicably high discount rates and short PB times reported in the literature. These are not associated with risk alone, but also irreversibility. Further, firms are also aware of the value of first mover advantages, flexibility, and reversibility of assets.

Table 10 How valuable are these factors in making investment decisions?

Low value ¼ 1 High value ¼ 5

N Median Mean Mode Std. deviation

Flexible use fixed assets 240 4 3.52** 4 1.150 Reversible fixed assets 240 3 3.30* 3 1.232 Moving first into a new market 240 4 3.52** 5 1.216

See notes to Tables 5 and 6.

F. Chittenden, M. Derregia / The British Accounting Review 47 (2015) 225–236 235

In evaluating uncertainty, firms commonly resort to scenario analysis, either alone or together with sensitivity analysis, with a minority of firms using decision trees. Overall, firms identify demand uncertainty, lack of internal funding, interest rate uncertainty and levels as important in delaying investment decisions. However, the number of firms using such techniques to evaluate uncertainty exceeds the number of firms using capital budgeting techniques, with firms concerned about uncer- tainty even when they make small capital investments. This is consistent with the observed decline in capital expenditure across firms in times of economic uncertainty.

Analysis of responses shows that there are some significant differences between firms on the basis of size, sector, and ownership. The lack of internal funding, interest rate uncertainty and interest rate levels are significantly more important in delaying decisions for small firms than for large firms. Further, listed firms are less sensitive to uncertainty and delay decisions less frequently, which may be due to the separation of ownership and control. Other variations in responses between small and large, listed and unlisted, and service and manufacturing can to a large extent be explained by capital intensity and asset specialisation (irreversibility). It is firms with frequent and substantial capital budgeting decisions that have more use for capital budgeting techniques. But, although manufacturing firms most commonly face such decisions, the use is not limited to them. Large service firms are more capital intensive than small and have more use for capital budgeting techniques.

Survey research has it limitations, and these limitations may lead to doubts about the validity of the results. We have attempted to deal with these limitations as best as we could. In addition to taking measures to limit non-response bias, by basing the survey questionnaire design on existing literature and developing it in interviews with practitioners, we have sought to limit the chance of respondents misunderstanding the questions. Further, we have used the interviews, numbering 49, as a further check on the validity of the survey. Even so we must acknowledge the possibility that the financial directors responding believe that capital investment decisions in their businesses are made in a more rigorous way than is actually the case. Other senior staff may see capital budgeting as a ritual to support decisions already taken. This may provide a partial explanation for our results. Formal capital budgeting techniques, required by financial policies, are evolving through adap- tations that capture commercial judgements. This survey has demonstrated that, although firms engage in practice that is at odds with how theory should be applied, the intuition underlying the practice is not always at variance with theory. It has also shown the important role irreversibility plays in capital budgeting decisions under uncertainty.

Acknowledgement

The authors thankfully acknowledge the financial support for this research provided by the Institute of Chartered Ac- countants in England and Wales and the support received from Gillian Knight and Clive Lewis of the Institute. The authors are also grateful to two anonymous referees and the editors for their constructive comments and suggestions that have resulted in improvements to this manuscript. Any errors remain the responsibility of the authors.

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