Capital Budgeting Theory

Danielson and Scott (2006) found out that US firms with less than 250 employees take decisions on potential investments using much less sophisticated methods than those suggested by capital budgeting theory. It is observed by the authors that discounted cash flow methods are usually used less frequently than subjective assessments, payback period and accounting rate of return. Small businesses have owners with very less formal education and their teams have incomplete management teams. Hence, a lack of financial sophistication is sighted as the reason of so many small firms in the US differing so largely in practice from accepted financial theory. Many small firms also place a constraint on the number of capital budgeting analyses a firm may

Payback method is another method which is most popular among the firms. Payback method ignores time value of money which is considered a major flaw. It considers the length of time it takes to recover money and ignores cash received after the recovery period. Notwithstanding the above two serious flaws, the payback method is easy and simple to understand. Another reason is that more often a team of experts is set up to see whether a project is worth pursuing or not. A team consists of individuals with varied background and training. When varied backgrounds are concerned, it is considered worthwhile to discuss a process which is easily understood by many individuals. Hence, payback method is preferred by them. Payback method is concerned with short term profitability. American managers are more concerned with short term profitability as they value money earned at the earliest. They consider money earned at a later stage as not something to which a great value can be attached with. According to them economy is continuously changing and conditions at a later stage cannot be predicted with certainty. In addition, it is observed that near future conditions are at a better control under them than far future conditions. This is due to the fact that hedging, insurance and other techniques can be better applied to change near future

A logit regression model was used to check the probability that foreign subsidiaries would adopt capital budgeting strategies which are thought of as sophisticated given the firm specific and company specific factors. It is observed by the authors that capital budgeting process for the multinational enterprises involves many factors which are rarely encountered by domestic firms engaged in capital budgeting. It was determined that ownership arrangement and financial leverage were significant factors related to application of sophisticated capital budgeting techniques. Other significant points determined by the author was that the age of the firm, size of the assets and publicly traded securities were positively related to the sources used to determine discount rates. The authors suggested that more emphasis should be placed and more research should be done on the entire capital budgeting process to come up with thorough understanding on the relation among different variables and sophistication of the capital budgeting