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This study empirically examines capital budgeting methods. Both discounted cash flow (DCF) techniques and nonfinancial measures are widely used. The impact of firm strategy affects both capital budgeting methods, as hypothesized.
This study empirically examines capital budgeting methods. Both discounted cash flow (DCF) techniques and nonfinancial measures are widely used. The impact of firm strategy affects both capital budgeting methods, as hypothesized.
This study empirically examines capital budgeting methods. Both discounted cash flow (DCF) techniques and nonfinancial measures are widely used. The impact of firm strategy affects both capital budgeting methods, as hypothesized.
Volume 20, Number 1, 2008 pp. 1329 DCF Techniques and Nonnancial Measures in Capital Budgeting: A Contingency Approach Analysis Shimin Chen The Hong Kong Polytechnic University ABSTRACT: This study empirically examines capital budgeting methods. Based on 115 responses from a cross-sectional survey and two approaches to contingency t, this study produces three basic ndings. First, both discounted cash ow (DCF) techniques and nonnancial measures are widely used in capital budgeting. However, DCF tech- niques are more important than nonnancial measures, and nonnancial measures ap- pear to serve as a partial substitute when DCF analysis is less efcient. Second, DCF techniques and nonnancial measures are not unconditionally appropriate. Although the impact of rm strategy on capital budgeting methods is not supported by the present results, the study shows that product standardization affects both capital bud- geting methods, as hypothesized. Firms with high product standardization tend to place more emphasis on DCF analysis, while rms with low standardization are more likely to focus on nonnancial measures. Third, an appropriate t under contingency theory between product standardization and the two capital budgeting methods is sig- nicantly associated with a rms satisfaction with the capital budgeting process. Keywords: capital budgeting; DCF techniques; nonnancial measures; contingency theory. INTRODUCTION T here have been many surveys of capital budgeting techniques over the past three decades (e.g., Graham and Harvey 2001; Kim et al. 1986; Klammer et al. 1991; Pike 1996; Ryan and Ryan 2002; Schall et al. 1978). Although there has been wide acceptance of discounted cash ow (DCF) methods, very little is known about the under- lying reasons for practice variations in the use of capital budgeting techniques. In particular, the extant literature reects two shortcomings. First, although it has been long recognized that DCF methods are not always appropriate (Haka 1987; Myers 1984), few studies have examined the circumstances in which the use of DCF methods may or may not be benecial. Second, existing surveys have mostly focused on quantitative nancial measures (Ittner and Larcker 2001). While both normative literature (Kaplan 1986; Myers 1984; Shank and Govindarajan 1992) and case/ eld studies (Carr and Tomkins 1996; Miller and OLeary 1997) suggest the importance of nonnancial considerations, studies based on cross- sectional surveys have generally ignored nonnancial measures. This is surprising, given calls for integrating nonnancial measures into management accounting systems during the 1990s (Kaplan and Norton 1992; Vaivio 1999). My thanks go to Steve Kaplan, the editor, and two anonymous reviewers for their valuable comments and sug- gestions that have helped improve this paper substantially. 14 Chen Behavioral Research in Accounting, 2008 This study attempts to address these two shortcomings. The study rst measures and compares the degree of DCF analysis and nonnancial consideration in capital budgeting. 1 Then, based on contingency theory (Fisher 1998), the study examines the extent to which the use of DCF techniques and nonnancial measures is associated with product standard- ization and rm strategy. Based on 115 responses from a cross-sectional survey, the study reports the following ndings. First, while both methods play a signicant role in capital budgeting, DCF techniques are more important than nonnancial measures. It appears that nonnancial consideration is used as a partial substitute when DCF analysis is less effective. Second, the study shows that product standardization is associated with both DCF tech- niques and nonnancial measures, as hypothesized. Firms with high product standardization tend to place more emphasis on DCF analysis, while rms with low standardization are more likely to focus on nonnancial measures. Third, an appropriate t, under contingency theory, between product standardization and the two capital budgeting methods is signi- cantly associated with a rms satisfaction with the capital budgeting process. The study contributes to the literature by constructing and providing preliminary evi- dence for a contingency-based theory for capital budgeting. The study extends prior capital budgeting research in three respects. First, the study examines the degree of DCF usage as opposed to documenting the use versus non-use of DCF methods in the literature (e.g., Kim et al. 1986; Klammer et al. 1991; Ryan and Ryan 2002). Second, this study measures nonnancial considerations in capital budgeting and compares the use of nonnancial mea- sures with DCF analysis. Third, the study employs two approaches to contingency t and identies specic conditions under which the use of DCF techniques or nonnancial mea- sures are more appropriate. The remainder of the paper is structured as follows. The next section provides a review of the relevant literature and development of hypotheses. The research methods and em- pirical results are then presented and discussed. The paper concludes with a summary of ndings and a discussion of the implications and limitations of the study. LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT DCF Techniques and Nonnancial Measures Survey evidence documents a trend of increasing use of DCF methods, with more recent studies reporting DCF usage by most, if not all, responding rms (e.g., Graham and Harvey 2001; Kim et al. 1986; Klammer et al. 1991; Pike 1996; Ryan and Ryan 2002; Schall et al. 1978). However, in an evaluation of the capital budgeting literature, Mukherjee (1987, 37) noted that much of the past effort has been spent on the what and not enough on the why of capital budgeting practices. One exception is the nding that larger rms tend to make more extensive use of DCF techniques than smaller rms (e.g., Pike 1996; Graham and Harvey 2001; Schall et al. 1978). Researchers have long recognized that DCF techniques are not unconditionally appro- priate (e.g., Haka 1987; Kaplan 1986; Myers 1984). Specically, the usefulness of DCF methods depends on a rms ability to estimate DCF parameters including: (1) a projects future cash ow; (2) the risk-adjusted discount rate; (3) the projects impact on cash ows generated from other assets; and (4) the projects impact on future investment opportunities (Myers 1984). The ability of managers to estimate these parameters is likely to vary de- pending on the environment in which rms operate (Haka 1987; Myers 1984). Firms in 1 A typical capital budgeting survey compares different DCF methods, such as net present value and internal rate of return, with so-called na ve methods, such as payback and accounting rate of return. This study combines DCF methods into one category and compares this with nonnancial considerations. DCF Techniques and Nonnancial Measures in Capital Budgeting 15 Behavioral Research in Accounting, 2008 stable environments with a limited number of products, simple cross-sectional relationships, and few growth opportunities are likely to nd DCF techniques more useful because of their ability to estimate the parameters. Alternatively, rms in complex and risky environ- ments may nd DCF methods less useful, as a result of their difculty in estimating the parameters. However, this type of reasoning has seldom been incorporated into studies to explain the variation in DCF usage. The use of nonnancial measures is often prescribed by scholars in accounting and nance as the other recommended approach to capital budgeting. For example, Myers (1984), in discussing the inability of DCF analysis to capture the benets of future growth and exibility, concludes that rational managers would simply bring these considerations into project evaluation, in addition to DCF analysis, as strategic factors dressed in non- nancial clothes. Both Klammer (1993) and Shank and Govindarajan (1992) suggest that strategic cost management be integrated into capital budgeting using methods such as value- chain analysis, cost-driver analysis, and competitive-advantage analysis. Additionally, case study evidence, although limited, offers support for the use of nonnancial considerations in capital budgeting. Carr and Tomkins (1996), drawing on 51 case studies in U.K., U.S., and German companies, nd that successful companies are more likely to use nonnancial strategic information in investment decisions. Miller and OLeary (1997) describe how Caterpillar redesigned its capital budgeting mechanisms to include substantial nonnancial considerations because of the inability of DCF analysis to incorporate the benets and costs of integrating diverse assets. However, as pointed out by Ittner and Larcker (2001), the case study evidence is less than conclusive due to the use of ambiguous measures and the lack of statistical tests. Also, no study has yet examined the use of nonnancial measures relative to DCF analysis. This study attempts to measure and compare the degree to which DCF techniques and nonnancial measures are used in capital budgeting. While the above literature review suggests the importance of both DCF analysis and nonnancial considerations, there are reasons to believe that each approach plays a different role in capital budgeting. According to nance theory, DCF analysis will lead to optimal investment decisions as long as a rm is able to estimate DCF parameters accurately (Haka 1987; Myers 1984). Nonnancial considerations are recommended as an alternative when the rm cannot adequately implement DCF analysis (Carr and Tomkins 1996; Kaplan 1986; Klammer 1993; Myers 1984; and Shank and Govindarajan 1992). This suggests a more important role for DCF analysis than for nonnancial considerations. In fact, recent surveys have reported increasing acceptance of DCF analysis (e.g., Graham and Harvey 2001; Ryan and Ryan 2002). However, most rms likely encounter some difculties in estimating DCF parameters, which is consistent with anecdotal evidence pointing toward widespread use of nonnancial considerations in capital budgeting (Burns and Walker 1997; Pike 1996). The above discussion suggests a substitution effect (a negative relationship) between the two capital budgeting methods. When managers have substantial condence in DCF analysis, then it would have less of a need for nonnancial measures. In contrast, nonnancial mea- sures are likely to become increasingly important in situations where managers lack con- dence in DCF analysis (Carr and Tomkins 1996; Kaplan 1986; Myers 1984). These basic expectations are summarized in the following hypotheses: H1a: DCF methods are more important than nonnancial measures in capital budgeting. H1b: There is a negative relationship between DCF methods and nonnancial measures. 16 Chen Behavioral Research in Accounting, 2008 In addition to the two baseline hypotheses, this study further examines why there is a variation in the use of DCF techniques and nonnancial measures among different com- panies. Specically, based on contingency theory (Chenhall 2003; Fisher 1998), this study proposes that product standardization and rm strategy affect the use of two capital bud- geting methods. Impact of Product Standardization and Firm Strategy Contingency theory prescribes no universally applicable management accounting sys- tems. The applicability of a specic system depends on a proper t between the system and its environment. Researchers have applied this theory to various aspects of management accounting systems (see reviews by Chenhall [2003] and Fisher [1998]). Particularly rele- vant to this paper are the studies that examine determinants of nancial versus nonnancial information usage (e.g., Chenhall and Langeld-Smith 1998; Chong and Chong 1997; Govindarajan and Gupta 1985; Hoque and James 2000; Simons 1990). Although these studies differ in specics, a central recurring theme is that nancial information plays a more important role when a rm operates in a stable and predictable environment, while nonnancial information is more important when the rm faces a dynamic and uncertain environment. Haka (1987) employs a similar contingency theory framework to examine DCF techniques. Based on 16 DCF rms and 16 matched non-DCF rms, the study pro- vides some supporting evidence by correlating the effectiveness of DCF adoption, measured as the difference in stock returns, with contingent variables including rm strategy, envi- ronmental predictability and diversity, information systems, reward structure, and degree of decentralization. Product standardization measures the product dimension of company technology (Brownell and Merchant 1990). Companies vary from low (one-of-a-kind) to high (com- modities) standardization. High standardization implies an optimal input / output relationship that is either known or can be learned through experience (Brownell and Merchant 1990). In such an environment, investment projects are likely to have features that management would be able to quantify accurately within the DCF framework. If DCF analysis can be implemented with condence, consideration of nonnancial factors will be less important. However, low standardization suggests product uniqueness, a complex manufacturing proc- ess, and reliance on research and development. In this type of capital budgeting environ- ment, management is more than likely to nd it difcult to estimate DCF parameters. Moreover, one could argue that, under this type of environment, nonnancial measures are relatively more effective at analyzing project benets related to new features, complex processes and technology, and future opportunities (Kaplan 1986; Klammer 1993; Myers 1984; Shank and Govindarajan 1992). This leads to the following hypothesis: H2a: The higher the level of a rms product standardization, the more the rm will emphasize (de-emphasize) DCF methods (nonnancial measures). Firm strategy is dened according to the Defender versus Prospector typology of Miles and Snow (1978). This typology has been frequently used in management accounting re- search (Chong and Chong 1997; Haka 1987; Simons 1990). 2 A Defender operates in rel- atively stable product markets, has a narrow product range, engages in little research and 2 Porters cost leadership versus product differentiation is the other frequently used measurement for strategy (e.g., Chenhall and Langeld-Smith 1998). While separately developed, there are similarities between a Defender and a Cost Leader and between a Prospector and a Differentiation rm (Simons 1990). DCF Techniques and Nonnancial Measures in Capital Budgeting 17 Behavioral Research in Accounting, 2008 market development, and competes primarily through cost leadership, quality, and service. Previous research has shown that Defender rms tend to use more objective nancial mea- sures (e.g., Govindarajan and Gupta 1985; Simons 1990). By the same logic, these rms are likely to nd DCF analysis suitable as a result of their ability to estimate DCF param- eters, and, thus, there is less need to consider nonnancial measures. In comparison, a Prospector competes primarily through new products and markets, which requires intensive and continuous efforts to search for new products and market opportunities. When making decisions in a Prospector rm, nancial considerations have been found not to be as im- portant as nonnancial factors such as maintaining product leadership and seeking future opportunities (Govindarajan and Gupta 1985; Simons 1990). Consequently, it is expected that the Prospector will nd DCF analysis less benecial and will emphasize nonnancial measures in capital budgeting. The following hypothesis summarizes the expected relation- ship between rm strategy and the two capital budgeting methods: H2b: The closer a rms strategy toward a Defender, the more the rm will emphasize (de-emphasize) DCF methods (nonnancial measures). While hypotheses H2a and H2b are consistent with the selection approach to contin- gency theory (Fisher 1998), this study also adopts the interaction approaches to examine the impact of t between a capital budgeting variable and a contingent variable on orga- nizational outcome. 3 Many contingency-based studies adopt this interaction perspective (e.g., Abernethy and Brownell 1999; Brownell and Merchant 1990; Govindarajan and Gupta 1985; Haka 1987; Hoque and James 2000). The literature has contained two types of outcome measures (satisfaction and performance), and the underlying logic is similar and intuitive: an organizational choice such as a capital budgeting method should be more successful if it ts the environment in which the rm operates, and this t should then generate a positive impact on satisfaction on part of managers involved in implementing this method and/ or on rm performance as a result of using this method. This study em- ploys a satisfaction measure because of the difculty in obtaining a performance measure that is directly related to capital budgeting. The following are the two sets of interaction approach hypotheses: H3a: An appropriate t of DCF methods or nonnancial measures with product standardization will be associated with a higher level of satisfaction in the capital budgeting process. H3b: An appropriate t of DCF methods or nonnancial measures with rm strategy will be associated with a higher level of satisfaction in the capital budgeting process. RESEARCH METHODS AND EMPIRICAL RESULTS Survey and Sample This study conducted a survey of capital budgeting techniques. The survey approach provided a basis to gather information about internal accounting practices on a large-sample basis. To enhance the level of condence in the survey results, two mechanisms were put 3 The impact of t on outcome can also be examined in terms of the system approach that emphasizes t among multiple contingent variables and multiple system design attributes (Fisher 1998). However, there has been a lack of consensus on how to dene an optimal subsample resulting from contingency t, which seems to prevent an effective implementation of the system approach in this current study. 18 Chen Behavioral Research in Accounting, 2008 in place. First, established survey instruments were adopted, as far as possible, for variable measurement. Second, the questionnaire incorporated comments from several academic col- leagues with expertise in survey research and those received from a eld test in two large manufacturing rms. This eld test provided an assurance that the questionnaire was rea- sonably understandable for respondents. The sample consisted of about 600 publicly traded manufacturing rms in the U.S., identied from the Disclosure Database. 4 As in most capital budgeting surveys (e.g., Graham and Harvey 2001; Klammer et al. 1991; Pike 1996; Ryan and Ryan 2002), the questionnaire was sent to the CFOs of sample rms in a personalized letter. 5 About a dozen companies returned the questionnaire, citing their corporate policy of no survey participa- tion. The survey resulted in 115 usable responses, 6 a response rate of approximately 20 percent based on the number of potential respondents. Although a 20 percent response rate is not very high, it is commensurate with many capital budgeting surveys, including more recent ones (e.g., Graham and Harvey 2001; Ryan and Ryan 2002). Several tests were conducted to assess potential nonresponse biases. First, the respond- ing and nonresponding rms were compared in terms of industry distribution, size, and protability. The responding rms all came from manufacturing industries based on two- digit SIC codes, except for those producing textile products (SIC code 22). No single industry dominated the responding rms, and the largest industry group included 16 rms producing industrial and commercial machinery and computer equipment products (SIC code 35). A Chi-square test (p-value 0.8676) of homogeneity does not suggest any signicant differences in industry distribution. The total assets of the responding rms averaged about $5,450 million, which is signicantly higher than those of the nonrespond- ing rms, according to the t-test (p-value 0.0178). Thus, relative to the mailing sample, the sample used in this study was biased toward larger rms. The average return on assets (ROA) of the responding rms was 6.62 percent, which is not signicantly different from that of the nonresponding rms, based on the t-test (p-value 0.7959). Second, the 23 rms that responded three weeks after the survey were identied as late respondents 7 and were compared with the 92 early respondents for all variables measured in this study, in addition to size and protability. No signicant difference was found between the early and late responding groups. Finally, the responding rms were divided into equal groups by their median assets. The resulting groups were compared and two signicant differences were observed. Consistent with previous studies (Graham and Harvey 2001; Pike 1996; Schall et al. 1978), the larger responding rms placed more emphasis on DCF techniques than did the smaller rms. Second, product standardization was higher for the group con- taining the larger rms. Consequently, total assets were included in this study as a control variable, to minimize the potential bias of size. 4 The sample was determined based on three criteria: (1) two-digit SIC Codes (2039) were used to select publicly traded manufacturing rms; (2) all rms had been listed for at least ten years; and (3) mailing information, including CFO name, must be available. 5 A relevant issue is whether a capital budgeting survey should be conducted at the corporate level to measure overall practice, or at lower levels to capture diversied practices within the rm. Almost all published capital budgeting surveys are conducted at the corporate level. One probable reason is that capital budgeting practice may, indeed, be fairly uniform within a rm as a result of top-management involvement. 6 The survey was sent to the CFO of each rm, but about half of the respondents were CFOs, treasurers, or controllers, and the other half were assistant treasurers or controllers, or managers of capital budgeting depart- ments. Most of them had graduate-level education and had been in their positions for more than three years. 7 The respondents were asked to respond within two weeks of receiving the survey. DCF Techniques and Nonnancial Measures in Capital Budgeting 19 Behavioral Research in Accounting, 2008 TABLE 1 Descriptive Statistics (n 115) Variable Mean Median S.D. Minimum Maximum DCF 4.017 4.100 1.067 1.000 5.000 Nonnancial 3.616 4.000 1.156 1.000 5.000 Standardization 2.461 2.000 0.882 1.000 4.000 Strategy 2.921 2.920 0.461 1.670 4.420 Satisfaction 3.487 4.000 0.842 1.000 5.000 Specic measures for each variable are contained in the Appendix. DCF average score of discounted cash ow techniques used in three categories of capital budgeting projects; Nonnancial average score of nonnancial measures used in three categories of capital budgeting projects; Standardization product standardization, with a high score indicating high standardization; Strategy company strategy, with a high (low) score indicating a Prospector (Defender) strategy; and Satisfaction satisfaction with capital budgeting process. Variable Measurement Capital Budgeting Techniques As shown in the Appendix, two questions were asked to measure the importance of DCF techniques and nonnancial measures. The questions were repeated three times for three types of investment projects: (1) equipment replacement; (2) expansion of existing products; and (3) expansion into new products. Klammer et al. (1991) used similar classi- cations in their multi-year capital budgeting surveys. To ensure consistent understanding, the survey instrument described DCF methods as nancial-based techniques, including net present value, internal rate of return, and the protability index, and nonnancial techniques as considerations of rm strategy, growth potential, and competition in capital budgeting. As reviewed in the previous section, the literature has called for integrating nonnancial considerations into the capital budgeting process, but does not produce a standard denition for what constitutes a nonnancial method. Instead, researchers often suggest taking several common nonnancial aspects into consideration, including company strategy, growth po- tential, and the impact of competition (e.g., Kaplan 1986; Klammer 1993; Myers 1984; Shank and Govindarajan 1992). Consequently, these three aspects were explicitly cited in the questionnaire to describe nonnancial techniques. Participants responded using a ve-point scale anchored by 5 for extremely important and 1 for not important. Since respondent ratings for the three investment categories were highly correlated, a weighted average index was constructed for both DCF techniques and nonnancial measures using the ratio of capital expenditure in each investment category to total capital expenditure as a weighting factor. 8 Table 1 contains descriptive statistics for the DCF and the nonnancial index. The actual scores achieved matched the theoretical minimum and maximum values (1 and 5). 8 The Cronbachs alpha values of 0.8656 for the DCF index and 0.8851 for the nonnancial index suggested a high reliability for each variable. Further, a factor analysis of the three sub-ratings for DCF methods or non- nancial measures resulted in a one-factor solution in each case. Both the DCF and the nonnancial factor scores were highly correlated with the indexes (r 0.963 and r 0.897). Summated scores (indexes), rather than factor scores, were used to facilitate interpretation of the survey results based on the original ve-point scale, given the single factor solution for each index (Hair et al. 1998, 119120). 20 Chen Behavioral Research in Accounting, 2008 The relatively high mean scores suggest widespread use of DCF techniques and nonnancial measures. Contingent Variables The survey adopted existing instruments for both product standardization and rm strategy. The respondents indicated the level of product standardization based on a four- point, fully anchored single-item measure used by Brownell and Merchant (1990). A score of 1 suggested the lowest level of product standardization (each unit custom-made) and 4 represented the highest product standardization (products completely standardized). The theoretical and actual minimum and maximum values were found to be the same, and the mean score of 2.461 is reported in Table 1. To measure rm strategy, respondents were asked about the extent to which they agreed with 12 statements concerning their rm strategy. These 12 statements described the un- derlying characteristics of Prospector versus Defender, based on Miles and Snows (1978) typology. The more strongly a rm agreed with these statements, the closer it was perceived to position itself toward the Prospector end of the strategic continuum. Similar instruments and/ or classications have been used in other accounting studies (Abernethy and Brownell 1999; Chong and Chong 1997; Haka 1987; Simons 1990). Since factor analysis resulted in one common factor, an average of the 12 questions was computed as the measure for strategy. 9 Although the theoretical range was from 1 to 5, the actual range was narrower, from 1.67 to 4.42, as shown in Table 1. While product standardization and rm strategy are two well-recognized contingent variables in the literature (Chenhall 2003; Fisher 1998), they are not necessarily indepen- dent. A signicantly negative correlation of 0.258 (p-value 0.005) between the two variables is consistent with the notion that product standardization and rm strategy share some common characteristics. However, such a relationship is unlikely to have posed a serious threat in this study. Fisher (1998) suggests including multiple contingent variables and addressing correlations among them. Satisfaction In a single question, respondents were asked directly to rate their rms overall satis- faction with the capital budgeting process, from 1 (not satised) to 5 (extremely satised). This approach was employed because of the lack of any established multiple-item measure for this variable (Shields 1995). Similar one-item questions have also been used in other studies to measure satisfaction with product-costing and performance measurement (Howell et al. 1987; Swenson 1995). As shown in Table 1, the mean value of 3.487 and the standard deviation of 0.842 suggest a sufcient level of variation in this variable. Hypothesis Testing Results Table 2 contains the results of testing the two baseline hypotheses (H1a and H1b) about the use of DCF methods versus nonnancial measures. Panel A compares the mean values of the two capital budgeting indexes. As predicted in H1a, both the parametric and the nonparametric tests show that DCF techniques are signicantly more important than non- nancial measures. Panel B shows a signicantly negative correlation between the two capital budgeting methods, which provides supporting evidence for H1b. While both DCF 9 The correlation between the summated and factor scores was very high at 0.915. There were two additional reasons for choosing the summated score. First, a summated score facilitates interpretation (Hair et al. 1998, 119120). Second, testing the interaction approach hypothesis becomes statistically simpler using the original, rather than standardized, measurement scale (Hartmann and Moers 1999). DCF Techniques and Nonnancial Measures in Capital Budgeting 21 Behavioral Research in Accounting, 2008 TABLE 2 Capital Budgeting Methods: Mean Comparison and Correlation (n 115) Panel A: Pairwise Comparison Mean Difference t-test t-(p-value) a Wilcoxon Rank Test z-(p-value) a DCF versus Nonnancial 0.401 2.492 (0.014) 2.568 (0.010) Panel B: Correlation Pearson Spearman DCF versus Nonnancial 0.203 (0.029) a 0.186 (0.047) a a Two-tailed signicance. DCF average score of discounted cash ow techniques used in three categories of capital budgeting projects; Nonnancial average score of nonnancial measures used in three categories of capital budgeting projects; and Mean Difference the difference between the mean scores of DCF and Nonnancial in Table 1. techniques and nonnancial measures are important for capital budgeting, there is a partial substitution effect between the two, as hypothesized. 10 To examine variations in the use of DCF techniques and nonnancial measures, cor- relation and regression analyses were conducted. As shown in Panel A of Table 3, rms with high product standardization appear to make more use of DCF methods, but rms with low product standardization place more focus on nonnancial measures. While the relationship between product standardization and nonnancial measures is signicant using both the Pearson and Spearman correlations (two-tailed p-values 0.05), the rela- tionship between product standardization and DCF techniques is insignicant (two-tailed p-values 0.10). 11 These results provide some support for H2a. However, the univariate results do not support the hypothesized effect of rm strategy on capital budgeting methods, as stated in H2b. While the Pearson correlation shows a signicant relationship between strategy and DCF method, the coefcient does not possess the predicted sign. Regression analysis was also conducted. Panel B of Table 3 contains two regressions with the same independent variables, including product standardization, rm strategy, and total assets, but separate dependent variables, DCF techniques or nonnancial measures. Given the substitution effect between the dependent variables, rather than treating the two regressions independently, they were estimated jointly using a general linear model pro- cedure that takes interdependency in the dependent variables into consideration. Overall, 10 Although the negative correlation supports a substitution effect, the relatively small correlation coefcient sug- gests a partial substitution, at best. An examination of the survey responses reveals that some rms rely on both DCF analysis and nonnancial consideration to a large degree, indicating a complementary relationship. Future research may examine why the two types of capital budgeting techniques are substitutive in some rms but complementary in others. 11 While two-tailed p-values are reported throughout the tables, one-tailed p-values may be used to interpret the results where predictions are directional. In this connection, some of the insignicant results become marginally signicant. 22 Chen Behavioral Research in Accounting, 2008 TABLE 3 Capital Budgeting Methods, Product Standardization, and Company Strategy: Correlations and Regressions (n 115) Panel A: Correlations Standardization Pearson Spearman Strategy Pearson Spearman DCF 0.145 (0.123) a 0.141 (0.133) 0.167 (0.074) 0.092 (0.328) Nonnancial 0.243 (0.009) 0.186 (0.046) 0.058 (0.536) 0.082 (0.385) Panel B: Multivariate Regressions with DCF and Nonnancial as Dependent Variables Independent Variables Multivariate Tests Hotelling-t F-(p-value) DCF as Dependent Variable t-(p-value) a Nonnancial as Dependent Variable t-(p-value) a Standardization 0.089 4.919 (0.009) 0.260 2.291 (0.024) 0.319 2.547 (0.012) Strategy 0.048 2.615 (0.078) 0.491 2.268 (0.025) 0.013 0.056 (0.956) Assets 0.035 1.912 (0.153) 0.000 1.901 (0.060) 0.000 0.137 (0.891) Adjusted R 2 0.071 0.034 a Two-tailed signicance. DCF average score of discounted cash ow techniques used in three categories of capital budgeting projects; Nonnancial average score of nonnancial measures used in three categories of capital budgeting projects; Standardization product standardization with a high score indicating high standardization; and Strategy company strategy with a high (low) score indicating a Prospector (Defender) strategy. controlling for size, the regression analysis in Panel B of Table 3 provides qualitatively similar results as that in Panel A. The hypothesized effects of product standardization on both DCF analysis and nonnancial considerations were supported according to both the multivariate Hotellings t-test and individual t-tests in each equation. Although rm strategy was signicant in the DCF regression, the sign of the coefcient was not in the predicted direction as hypothesized in H2b. Consequently, the multivariate regressions provide sup- port for H2a, but not for H2b. To test the interaction approach hypotheses (H3a and H3b), Table 4 presents a mod- erated regression analysis of whether the interaction term between one capital budgeting variable and one contingent variable signicantly explains satisfaction with the capital bud- geting process. This moderated regression analysis was originated by Southwood (1978), recently reviewed by Hartmann and Moers (1999), and has been frequently applied in contingency-based accounting studies (e.g., Abernethy and Brownell 1999; Brownell and Merchant 1990; Govindarajan and Gupta 1985). Since there were two capital budgeting and two contingent variables, Table 4 contains four separate regressions, with satisfaction as the dependent variable. In addition, total assets are included in each regression as a DCF Techniques and Nonnancial Measures in Capital Budgeting 23 Behavioral Research in Accounting, 2008 TABLE 4 Impact of Fit on Satisfaction: Moderated Regression Analysis (n 115) Independent Variables DCF t-(p-value) a Independent Variables Nonnancial t-(p-value) a Panel A: Standardization DCF 0.411 2.295 (0.024) Nonnancial 0.327 1.421 (0.158) Standardization 1.363 4.588 (0.000) Standardization 0.465 1.575 (0.118) Assets 0.000 1.046 (0.298) Assets 0.000 1.159 (0.249) DCF * Standardization 0.299 4.280 (0.000) Nonnancial * Standardization 0.165 2.076 (0.040) Adjusted R 2 0.256 Adjusted R 2 0.056 F-Test (p-value) 10.818 (0.000) F-Test (p-value) 2.685 (0.035) Panel B: Strategy DCF 1.027 2.397 (0.018) Nonnancial 0.278 0.649 (0.518) Strategy 1.471 2.291 (0.024) Strategy 0.241 0.411 (0.682) Assets 0.000 0.858 (0.393) Assets 0.000 1.321 (0.189) DCF * Strategy 0.275 1.814 (0.072) Nonnancial * Strategy 0.054 0.379 (0.706) Adjusted R 2 0.172 Adjusted R 2 0.069 F-Test (p-value) 6.920 (0.000) F-Test (p-value) 3.102 (0.018) a Two-tailed signicance. DCF average score of discounted cash ow techniques used in three categories of capital budgeting projects; Nonnancial average score of nonnancial measures used in three categories of capital budgeting projects; Standardization product standardization with a high score indicating high standardization; Strategy company strategy with a high (low) score indicating a Prospector (Defender) strategy; DCF * Standardization interaction between DCF and Standardization; DCF * Strategy interaction between DCF and Strategy; Nonnancial * Standardization interaction between Nonnancial and Standardization; and Nonnancial * Strategy interaction between Nonnancial and Strategy. control variable. To test the interaction approach hypotheses, we examined both the value and the signicance of the interaction term in each equation. 12 12 Lower-order variables (capital budgeting and contingent variables) were included in each model, but the main effects are not interpretable, and hypothesis testing depends on the interaction term due to the interval scale of variable measurement (Hartmann and Moers 1999; Southwood 1978). Furthermore, multicollinearity does not affect either the value or the signicance of the interaction term, and a t-test is equivalent to a partial F-test of incremental R 2 , as a result of adding the interaction term. 24 Chen Behavioral Research in Accounting, 2008 Panel A of Table 4 contains the results of the impact on satisfaction of t between product standardization and each capital budgeting variable. The interaction terms are sig- nicant, with the expected signs. It appears that when product standardization is high, an emphasis on DCF methods leads to higher satisfaction with the capital budgeting process; when standardization is low, an emphasis on nonnancial measures is associated with higher satisfaction. These results provide support for H3a. However, results for strategy, as shown in Panel B of Table 4, are mixed. While, as hypothesized, the marginally signicantly negative interaction term in the DCF regression suggests that an emphasis on DCF methods by Defenders (Prospectors) leads to higher (lower) satisfaction, there is no evidence to support the impact of t between strategy and nonnancial measures. Therefore, H3b is conrmed for DCF methods, but not for nonnancial measures. Additional Analysis While the selection and interaction approaches both supported the hypothesized rela- tionships between product standardization and capital budgeting techniques, the study found no evidence for the impact of rm strategy, except in the case of the interaction effect between strategy and DCF methods. Based on subsamples, an additional analysis was car- ried out in an attempt to reconcile the results between testing the selection and interaction hypotheses. The analysis followed a simple logic: since the selection approach hypothesizes a correlation between a contingent variable and a capital budgeting variable, and the inter- action approach predicts a positive impact of this correlation on satisfaction, empirically, we should then observe a stronger relationship between the contingent and capital budgeting variables for higher than for lower satisfaction rms. To carry out this analysis, the 115 sample rms were divided into two groups: 65 high-satisfaction rms, with a satisfaction score of 4 or 5, and 50 low-satisfaction rms, with a score below 4. The multivariate regression models in Panel B of Table 3 were then estimated separately for each subsample. As presented in Table 5, two interesting ndings emerged from this analysis. First, it was found that the hypothesized relationships between product standardization and DCF methods or nonnancial measures (H2a) exist only for the high-satisfaction subsample, which is consistent with the moderated regression results in Table 4. Second, the strategy variable was found to be insignicant in both the high- and the low-satisfaction samples, thus eliminating any confusion caused by the separate application of the selection and interaction approaches. In sum, this analysis provided additional evidence that product standardization is related to both capital budgeting techniques, and that an appropriate t between them leads to higher satisfaction with the capital budgeting process. CONCLUSIONS AND DISCUSSIONS This study provides preliminary evidence for a contingency-based theory for capital budgeting. The study advances the literature in three ways. First, instead of determining use or non-use of DCF techniques as in most capital budgeting surveys, this study examined the degree of DCF usage. Second, this study measured and compared the use of nonnancial considerations to DCF analysis. Although both play an important role across all rms, the study found that DCF techniques are overall more important than nonnancial considera- tions. Consistent with theoretical discussion and anecdotal evidence, nonnancial measures appear to be used as a partial substitute for DCF analysis when DCF techniques are less effective. Third, this study applied contingency theory as a basis to explain variations in the use of both DCF techniques and nonnancial measures. While the results generally do not support the rm strategy variable, the study found consistent evidence for the hypoth- esized role of product standardization on the capital budgeting methods. It appears that DCF Techniques and Nonnancial Measures in Capital Budgeting 25 Behavioral Research in Accounting, 2008 TABLE 5 Impact of Fit on Satisfaction: Additional Evidence Based on Subsamples Independent Variables Multivariate Tests Hotelling-t F-(p-value) DCF as Dependent Variable t-(p-value) a Nonnancial as Dependent Variable t-(p-value) a Panel A: Multivariate Regressions for High-Satisfaction Firms (n 65) Standardization 0.405 12.13 (0.000) 0.389 3.445 (0.001) 0.527 3.377 (0.001) Strategy 0.024 0.729 (0.487) 0.265 1.199 (0.235) 0.086 0.280 (0.780) Assets 0.047 1.423 (0.249) 0.000 1.698 (0.095) 0.000 0.003 (0.997) Adjusted R 2 0.144 0.131 Panel B: Multivariate Regressions for Low-Satisfaction Firms (n 50) Standardization 0.002 0.049 (0.952) 0.000 0.003 (0.998) 0.063 0.302 (0.764) Strategy 0.026 0.593 (0.557) 0.403 1.078 (0.287) 0.043 0.110 (0.913) Assets 0.090 2.036 (0.142) 0.000 1.762 (0.085) 0.000 0.452 (0.653) Adjusted R 2 0.046 0.059 a Two-tailed signicance. The 65 high-satisfaction rms scored 4 or 5 in satisfaction with their capital budgeting process, while the 50 low-satisfaction rms reported a satisfaction score of 1, 2, or 3. DCF average score of discounted cash ow techniques used in three categories of capital budgeting projects; Nonnancial average score of nonnancial measures used in three categories of capital budgeting projects; Standardization product standardization, with a high score indicating high standardization; Strategy company strategy, with a high (low) score indicating a Prospector (Defender) strategy; and Satisfaction satisfaction with capital budgeting process. rms with high product standardization tend to place more emphasis on DCF analysis, while rms with low standardization tend to focus more on the use of nonnancial mea- sures. Also, a stronger t between product standardization and the two capital budgeting methods has a signicantly positive effect on satisfaction with the capital budgeting process. The ndings of the study have implications for future research. This study shows that both DCF techniques and nonnancial measures are widely used in practice and that their use appears linked, in part, to contingent-based variables. These results suggest that future capital budgeting studies should examine not only traditional DCF analysis but also non- nancial considerations in relation to rms operating environment. While this study presents new evidence about capital budgeting methods, several meth- odological limitations should be noted when evaluating the ndings of this study, some of which offer directions for future research. First, the relatively low response rate is still a cause for concern, even though the nonresponse analysis did not reveal any signicant bias, except for the effect of size. Second, measurement errors inherent in survey studies cannot be ruled out. There can be no direct control over whether respondents interpret the survey questions in the manner intended. The use of the single-item measurement for satisfaction and the broad-based denition for nonnancial measures are a particular concern. Although 26 Chen Behavioral Research in Accounting, 2008 the instrument for measuring product standardization was adopted from the literature, the single-question measure makes the assessment of reliability impractical. Third, in addition to the two contingent variables, other contextual factors may also affect DCF techniques and nonnancial measures. Analyzing multiple contingent factors simultaneously, especially those that make conicting demands on different capital budgeting techniques, will further improve our understanding. Fourth, it is perplexing that the impact of the strategy variable on DCF analysis was found to be contrary to the hypothesized effect. While the survey instrument was based on the literature, the Miles and Snow typology (1978) may not fully reect different aspects of competitive strategy. Given the importance of rm strategy in contingency-based management accounting literature (Chenhall 2003; Fisher 1998), future studies should pay particular attention to the relationship between strategy and capital bud- geting techniques. Finally, a cross-sectional survey at the corporate level that queries man- agers with nance or accounting backgrounds, such as CFOs, although common in the literature, may not be sufcient to deal with heterogeneity in both investment projects and operating environments. A more focused study of capital budgeting practice at lower levels may produce additional insights. APPENDIX SURVEY QUESTIONS USED IN THIS STUDY 1. Techniques used in the project selection phase of capital budgeting are often re- ferred to as either nancial or nonnancial. Within nancial-based techniques, net present value (NPV), internal rate of return (IRR), and the protability index (PI) are usually called discounted cash ow models. Nonnancial-based capital bud- geting techniques include consideration of company strategy, growth potential, or competition. A particular company may use only one of these techniques or may combine them to provide information for decision making. For each of the follow- ing three categories of investment, please circle the number indicating the relative importance of each type of the techniques listed below. A technique is considered extremely important if it is always relied upon by managers. If the technique is not used or has no signicance in capital budgeting decisions, it is considered not important. Not Extremely Important Important For Replacement Projects: Discounted Cash Flow models (NPV, IRR, or PI) . . . . . . . . . . . . . . 1 2 3 4 5 Nonnancial techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 3 4 5 For ExpansionExisting Products: Discounted Cash Flow models (NPV, IRR, or PI) . . . . . . . . . . . . . . 1 2 3 4 5 Nonnancial techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 3 4 5 For ExpansionNew Products: Discounted Cash Flow models (NPV, IRR, or PI) . . . . . . . . . . . . . . 1 2 3 4 5 Nonnancial techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 3 4 5 DCF Techniques and Nonnancial Measures in Capital Budgeting 27 Behavioral Research in Accounting, 2008 Please estimate the average proportion of total capital expenditures you made in the last ve years that should be classied within these three investment categories: Replacement Projects ExpansionExisting Products ExpansionNew Products Total 100% 2. Please circle the number that indicates your rms overall satisfaction with your capital budgeting process. Not Extremely Satisfied Satisfied The level of your satisfaction . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 3 4 5 3. Please circle the number that characterizes your rms product standardization. 1 Each unit is custom-made. 2 Products differ but have common components. 3 Products are basically alike, with only minor differences, e.g., models, add- on features. 4 Products are completely standardized. 4. Please circle the number that indicates your agreement with the following state- ments about your companys strategy in comparison with those of your leading competitors. Please note that none of the specic strategies is inherently good or bad. Strongly Strongly Disagree Agree You dene your business market very broadly . . . . . . . 1 2 3 4 5 Your customer base changes frequently . . . . . . . . . . . . . . 1 2 3 4 5 You monitor external environment very widely . . . . . . 1 2 3 4 5 Your product mix often changes . . . . . . . . . . . . . . . . . . . . . . 1 2 3 4 5 You actively create changes in your customer base . . 1 2 3 4 5 You compete primarily on innovation rather than low cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 3 4 5 Your rm grows in spurts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 3 4 5 You actively seek growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 3 4 5 You do not constrain the design of your products to your production capacities . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 3 4 5 Your production employees skills are not specialized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 3 4 5 You always seek exible instead of low-cost production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 3 4 5 Your R & D spending as a percentage of sales is very high . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 3 4 5 28 Chen Behavioral Research in Accounting, 2008 REFERENCES Abernethy, M. 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