A Survey of Capital Budgeting Techniques Used by Major U.S.

Firms
Author(s): Lawrence J. Gitman, John R. Forrester and Jr.
Source: Financial Management, Vol. 6, No. 3 (Autumn, 1977), pp. 66-71
Published by: Wiley on behalf of the Financial Management Association International
Stable URL: http://www.jstor.org/stable/3665258
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 Forecasting and Evaluation.
Practices and Performance

A Survey of Capital Budgeting Techniques

Used by Major U.S. Firms*

Lawrence J. Gitman and John R. Forrester, Jr.

Lawrence J. Gitman is Associate Professor of Finance at the

University of Tulsa. He is author of a number of articles, books,
and papers on various aspects of financial management.
John R. Forrester, Jr., is Administrator of the Richardson
Heights Baptist Church in Richardson, Texas. He received an
M.B.A. from the University of Tulsa, after which he was employed
as an officer of the First National Bank of Tulsa.

* The capital budgeting decision process remainsSample Selection, Response, and

one of the key decision areas confronting the contem- Characteristics
porary financial manager, since its results help mold
the firm's future opportunities. Academicians have The large business firms utilized in this study were
preached the use of the more sophisticated approaches selected on the basis of two factors: 1) stock price
to capital budgeting analysis and have suggested thatgrowth, and 2) total dollars of capital expenditures
certain adjustments for risk be made. Support for the All of the sample firms came from a list of 600 com-
use of quantitative risk-adjustment was provided by panies which experienced the greatest stock price
the findings of Petty and Bowlin in their Winter 1976 growth over the 1971-1976 period as reported in
Financial Management article [7] concerned with the Forbes [12, pp. 186-206]. The sample was in effect
use of quantitative methods by financial managers. limited to those firms having exhibited the type of
This article surveys the level of sophistication used in growth which would be expected to accompany in
capital budgeting by the nation's leading firms. Where creased levels of capital expenditure. The firms also
possible, the findings of this study are related to com- appeared in a list of the 500 companies having made
parable previous studies. the greatest dollar capital expenditures during 1969 as

*The cost of preparation, distribution, and other clerical chores required by this study was funded through a University of
Research Grant.

66

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L. J. GITMAN AND J. R. FORRESTER, JR./CAPITAL BUDGETING TECHNIQUES 67

reported in Forbes [11, pp. 111-118]. These 1969 data average size of $3,375,000. All of the respondents indi-
were used since they reflected the behavior of firms cated that a minimum outlay of $10,000 or more was
during an inflationary or expansionary period. Ques- required in order to justify formal analysis of a pro-
tionnaires personally addressed to the chief financial posed project: because of the response choices given
officer of the firm were mailed in June, 1976, to 268 (See Exhibit 4), this result may be a bit misleading
firms appearing on both lists [10]. since the questionnaire's minimum was $10,000. Of
One hundred and ten responses were received, with projects formally analyzed, two-thirds of the respon-
103 completed questionnaires (38.4% of the 268 dents have an acceptance rate of over 75%. This sug-
firms). To become more familiar with the character- gests that projects are not formally analyzed unless
istics of the respondents, a few questions were asked they are expected to meet the firm's acceptance
pertaining to the firm and its chief financial officer. criteria.
Job titles of those primarily responsible for capital
budgeting analysis as well as the completion of the Exhibit 3. Size of Annual Capital Budget
questionnaire were: Vice President of Finance, Responses
Size of Annual
Treasurer, Director of Planning, Director of Capital Number Percent
Capital Budget
Programs, or Director of Facilities Management. As
Less than $10 million 0 0.0
can be seen in Exhibits 1 and 2, the firms responding
$10 to $50 million 11 11.2
primarily were manufacturing firms with total assets $50 to $100 million 23 23.5
in excess of $100 million. More than $100 million 64 65.3

Total Responses 98 100.0

Exhibit 1. Industry Classification of Respondents
Responses
Exhibit 4. Project Size for Formal Analysis
Classification Number Percent
Responses
Distributor 4 3.9
Manufacturer of Durables 35 34.0 Project Size Number Percent
Manufacturer of Non-durables 41 40.0
Greater than $10,000 31 31.3
Service Company 23 22.1
Greater than $50,000 27 27.3
Total Responses 103 100.0 Greater than $100,000 23 23.2
Greater than $500,000 12 12.1
Greater than $1,000,000 6 6.1
Exhibit 2. Asset Size of Respondent Firms
Total Responses 99 100.0
Responses
Asset Size Number Percent
Exhibit 5. Percent of Projects Ac
Less than $100 million 0 0.0
$100 to $500 million 10 9.7 Percent „~Percent ~Responses
$500 to $1 billion 22 21.4 Accepted Number Percent
More than $1 billion 71 68.9 Less than 10% 4 4.1
10 to 25% 1 1.0
Total Responses 103 100.0
25 to 50% 5 5.1
50 to 75% 20 20.6
75 to 90% 34 35.1
Capital Budgeting Statistics More than 90% 33 34.1

A portion of the questionnaire was devoted to deter- Total Responses 97 100.0

mining various statistics describing the respondent
firms' capital budgeting activities: Exhibits 3, 4, and 5
provide these data. Capital budgets of over $100
Capitol Budgeting Proced
million were in the majority, and the number of proj- Respondents were asked to indi
ects formally analyzed averaged 238 per respondent firms utilize a central review committee. The re-
per year. These data indicate that the responding firms sponses to this "yes-no" question indicated that a
were actively engaged in capital budgeting evaluation great majority of the firms do: 76 of 101 respondents
and analysis. An open-ended question relating to proj- indicated that their firms utilize the committee, while
ect size elicited a wide range of responses with an the other 25 indicated they did not.

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68 FINANCIAL MANAGEMENT/FALL 1977

The respondents were asked to choose one of a
number of possible areas to identify which division or
department has the responsibility for analyzing capital
expenditure proposals - Finance, Operations, Plan-
ning, or Production. The responses to this question are
shown in Exhibit 6. Total responses (123) exceed the
number of respondents, because a number of respon-
dents picked more than one choice, since the responsi-
bility for capital budgeting analysis in their firm was
shared between two or more departments. Exhibit 6
clearly indicates that in the majority of firms the
responsibility for analyzing capital budgeting projects
is that of the Finance or Planning Departments.
flows is the most critical stage. These results confirm
those of Fremgen [2, pp. 24-25] who in his 1973 study
found that most firms believed that the definition and
estimation of project cash flows were both the most
difficult and most critical parts of the capital budget-
ing process.
Capital Budgeting Techniques
One of the goals of this study was to determine the
capital budgeting techniques most commonly used by
the nation's leading business firms: by comparing the
findings with the results of previous studies, the prog-
ress of business firms toward the use of more sophisti-

Exhibit 6. Division of Department Responsibility cated techniques was assessed. Another area of inter-
est was the cost of capital or cutoff rate utilized by
Division or
Responses these firms.
Department Number Percent Several capital budgeting techniques are available
Finance 74 60.2 for use in evaluating projects. Net Present Value,
Operations 16 13.0 Benefit/Cost Ratios (or Profitability Index), and the
30 24.4
Planning Internal Rate of Return (or Discounted Rate of
Production 3 2.4
Return) are quite "sophisticated," since they ex-
Total Responses 123 100.0
plicitly consider the time value of money. Although
there are numerous "unsophisticated" capital bud-
The capital budgeting process cantechniques,
geting be viewedthe best as
knowncon-
are the Rate of
sisting of four stages: 1) project definition and estima-
Return (or Average Rate of Return) and the Payback
tion of cash flows; 2) project analysis and selection;
Period. The respondents were asked to 3)
indicate the
project implementation; and 4) project review. Ex-
primary and secondary technique used, given a choice
hibit 7 indicates that the most
of difficult aspect
the three sophisticated of unsophisticated
and two the
capital budgeting process involves defining
techniques mentioned. projects
Their responses are summar-
and estimating their cash flows.
ized inThis result
Exhibit 8. is not
From the total numbersur-
of responses
prising since specification of cash
to the questionflows
on primaryinvolves
technique in use (112), it
numerous forecasts and tax-related decisions. Since
can be seen that some respondents consider more than
what is viewed as "most difficult" might not be con-
one technique to be a primary tool.
sidered "most important," the respondents were asked
which stage of the capital budgeting process is most
Exhibit 8. Capital Budgeting Techniques in Use
critical. The responses, also shown in Exhibit 7, indi-
Primary Secondary
cate that project definition and estimation of cash Number Percent
Number Percent
Technique
Internal (or Discounted)
Rate of Return 60 53.6 13 14.0
Exhibit 7. Most Difficult and Most Important Stages
Rate of Return (Average
of Capital Budgeting Process Rate of Return) 28 25.0 13 14.0
Net Present Value 11 9.8 24 25.8
Responses 10 8.9 41 44.0
Payback Period
Most Difficult Most Critical Benefit/Cost Ratio
(Profitability Index) 3 2.7 2 2.2
Stage Number Percent Number Percent
Total Responses 112 100.0 93 100.0
Project Definition and
Cash Flow Estimation 65 64.3 53 52.0
Financial Analysis and The results indicate a strong preference for sophis-
Project Selection 15 14.9 34 33.3
ticated capital budgeting techniques as the primary
Project Implementation 7 6.9 9 8.8
Project Review 14 13.9 6 5.9 tool of analysis, and the use of internal rate of return
101 100.0 102 100.0
as the dominant technique, confirming the findings of
Total Responses
Fremgen [2] and Petty, Scott, and Bird [8, pp.

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L. J. GITMAN AND J. R. FORRESTER, JR./CAPITAL BUDGETING TECHNIQUES 69

162-165]. A 1972 study by Klammer [4, pp. 387-395] Capital Rationing

showed that the use of sophisticated techniques in-
Respondents were asked to indicate "yes or no" on
creased from 19 percent of the firms in 1959 to 38 per-
whether their firm made a competitive allocation of a
cent in 1964, and to 57 percent in 1970. The 1973
study by Fremgen [2, pp. 20-22] also confirmed this
fixed budget to competing projects. Of the 100
responses to this question, 52 indicated "yes" while
trend. This study supports these earlier findings and
the remaining 48 responded "no." Hence, about half
suggests that the use of sophisticated techniques is
of all large firms operate in a capital rationing en-
continuing to increase (57 percent of firms in 1970, 66
vironment in which they attempt to allocate a fixed
percent of responses in 1976). Petty, Scott, and Bird
budget on a competitive basis. The principal causes of
[8, p. 170] also show that "almost one-half of the
capital rationing are presented in Exhibit 10. Nearly
respondents expressed that the firm has moved to
70 percent of the respondents indicated that the major
more quantitative and formal analysis."
Exhibit 8 indicates that the most popular secon- cause of capital rationing was a limit placed on
borrowing by the internal management. This con-
dary (or supplementary) technique used is the pay-
firms the finding of Fremgen [2, pp. 23-24] who dis-
back period. The popularity of this technique has
closed that "the most prevalent cause of capital ra-
prevailed for years. In Fremgen's 1973 study, the pay-
tioning is a limitation on borrowing." When the other
back period was found to be the most popular tech-
causes of borrowing limitations imposed by outside
nique. Although Fremgen did not specifically ask for
secondary techniques, it is apparent from his study agreements (10.7 percent) or external management
that the use of payback was secondary to the use of the
(3.2 percent) are added, the total of 83 percent sug-
gests that capital rationing results from some type of
internal rate of return as has been suggested by
debt limitation.
numerous authors such as Gitman [3, pp. 290-291].
The use of net present value as a supplementary tech-
nique was reported by nearly 26 percent of the respon-
Exhibit 10. Major Cause of Capital Rationing
dents, but only 9.8% used it as a primary technique, Responses
which suggests that it is not utilized by most firms in a Cause Number Percent
primary role but does find favor as a secondary tool of Debt Limit Imposed by
analysis. Outside Agreement 10 10.7
Respondents were asked to indicate which of a Debt Limit Placed by Management
number of possible cost of capital values best de- External to the Organization 3 3.2
Limit Placed on Borrowing by
scribed that of their firm. The responses to this ques-
Internal Management 65 69.1
tion are summarized in Exhibit 9. At the time they Restrictive Policy Imposed upon Retained
responded, most of the firms had a cost of capital of Earnings for Dividend Payout 2 2.1
10 to 15 percent or more. 83.1 percent of the firms had Maintenance of a Target Earnings Per
Share or Price-Earnings Ratio 14 14.9
costs of capital between 10 and 20 percent. Although
this finding does not enhance our knowledge of the Total Responses 94 100.0
techniques being used, it does provide a general idea
about the requirements for project acceptance even
though these findings may only apply to a particular
Risk and Uncertainty
point in time.
The final aspect of the capital budgeting process
investigated was the treatment of risk and uncer-
Exhibit 9. Cost of Capital or Cutoff Rate tainty. The literature of capital budgeting emphasizes
Responses the importance of giving some consideration to the
Rate
differing risks associated with different projects. Two
Number Percent
questions were included in the questionnaire on
Less than 5% 0 0.0
whether the firms explicitly consider risk and uncer-
5 to 10% 9 9.5
10 to 15% 57 60.0
tainty, and, if so, what methods they use. Of 100
15 to 20% 22 23.1 respondents, 71 percent indicated they gave explicit
More than 20% 7 7.4 consideration to risk and uncertainty, while 29 per-
Total Responses 95 100.0 cent said "no." This suggests that a great majority of
large firms give explicit consideration to risk and un-

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70 FINANCIAL MANAGEMENT/FALL 1977

certainty, and it confirms Fremgen's 1973 study [2,

268 major companies experiencing high stock price
growth and known to make large capital expendi-
pp. 22], which found 67 percent of the firms respond-
ing affirmatively. tures. Based upon the 103 usable responses received,
The respondents were asked to indicate which of the findings were analyzed on the basis of five major
four possible techniques they used to adjust for risk
areas.

and uncertainty and to indicate any other techniques The first section presented basic statistics d
used. Responses to the four choices are shown in Ex-ing respondent firms. The second section
hibit 11. Other responses included: sensitivity analy-
budgeting procedures disclosed that most firm
sis, simulation, and risk models. A few respondents central review committee which chooses prop
use more than one technique (103 responses from 100that the responsibility for analysis normally
respondents). The most popular technique (43 per-
the Finance or Planning Departments. The
dents also indicated that the most difficult and most
cent of responses) involves adjusting the minimum
rate of return upward. important stage of the process involves the definition
and estimation of cash flows. The third section showed
Exhibit 1 1. Methods Used to Adjust for Risk that sophisticated techniques for primary analysis
and Uncertainty were most popular, particularly the internal rate of
Responses return. For secondary analysis, the use of the pay-
back period was indicated by a large number of
Method Number Percent
respondents. It was found that most firms at the time
Increase the Minimum Rate of
of the survey used costs of capital or cutoff rates of 10
Return or Cost of Capital 44 42.7
to 20 percent; the majority of responses were in the 10
Use Expected Values of Cash
Flows (Certainty-Equivalents) 27 26.2 to 15 percent range. The fourth section showed that
Subjective Adjustment of Cash Flows 19 18.5 most firms make capital expenditures on a competi-
Decrease Minimum Payback Period 13 12.6 tive basis to allocate a fixed budget. It was found that
Total Responses 103 100.0 the major cause of capital rationing was a debt limit
which was imposed internally by management. The
final section found that most firms give explicit con-
The popularity of the risk-adjusted rate of return is sideration to risk and uncertainty, and that the use of
not surprising since it is one of the easiest approaches risk-adjusted discount rates and/or certainty equiva-
available for risk adjustment. Petty, Scott, and Bird lents to adjust for risk is quite popular.
[8, p. 170] recognized the use of this technique in their In summary, it is evident that the major firms in the
1975 survey and contended that more sophisticated U.S. are utilizing many of the tools of analysis pre-
risk-adjustment techniques would not be employed sented in the financial theory for analyzing capital
until risk can be measured more precisely and one can budgeting projects. And, as indicated in previous
show its effect on the firm's cost of capital. The sec- studies (Fremgen [2] and Petty, Scott, and Bird [8]),
ond favored approach was expected values, and the firms are continuing to move forward in the adoption
third most popular technique was the subjective ad- of more sophisticated tools of analysis.
justment of cash flows. As one might expect from a
reading of capital budgeting texts [1, 6, 9], the use of References
either risk-adjusted discount rates or certainty equiva-
1. Harold Bierman, Jr., and Seymour Smidt, The Capita
lents is quite common (approximately 69 percent of Budgeting Decision, 3rd ed., New York, Macmillan,
the responses) among the nation's leading business 1971.
firms. These results again seem to confirm those of 2. James M. Fremgen, "Capital Budgeting Practices: A
Fremgen [2, pp. 22-23], who found both of these tech- Survey," Management Accounting (May 1973), pp.
niques to be quite popular. 19-25.

3. Lawrence J. Gitman, Principles of Managerial Finance,

Summary and Conclusions New York, Harper and Row, 1976, Ch. 13, 14.
4. Thomas Klammer, "Empirical Evidence of the Adop-
This article has presented the findings of a survey tion of Sophisticated Capital Budgeting Techniques,"
of capital budgeting techniques sent to a sample of Journal of Business (July 1972), pp. 387-397.

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L. J. GITMAN AND J. R. FORRESTER, JR./CAPITAL BUDGETING TECHNIQUES 71

5. James C. T. Mao, "Survey of Capital Budgeting:
Theory and Practice," Journal of Finance (May 1970),
pp. 349-360.
6. Jerome Osteryoung, Capital Budgeting: Long Term
Asset Selection, Columbus, Ohio, Grid, 1974.
7. J. William Petty and Oswald D. Bowlin, "The Finan-
cial Manager and Quantitative Decision Models,"
Financial Management (Winter 1976), pp. 32-41.
8. J. William Petty, David F. Scott, Jr., and Monroe M.
Bird, "The Capital Expenditure Decision-Making Pro-
cess of Large Corporations," The Engineering Econ-
omist (Spring 1975), pp. 159-172.
9. David G. Quirin, The Capital Expenditure Decision,
Homewood, Illinois, Irwin, 1974.
10. Standard and Poor's, Inc., Register of Corporations,
Directors, and Executives, Vol. 1, New York, Standard
and Poor's, Inc., 1976.
11. "The 500 Biggest Corporations by Capital Expendi-
tures," Forbes (May 15, 1970), pp. 111-118.
12. "Who's Where in the Stock Market," Forbes (January
1, 1976), pp. 186-206.
13. Ronald B. Williams, "Industry Practice in Allocating
Capital Resources," Managerial Planning (May/June
1970), pp. 15-22.

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