capital budgeting

Chapter 2

Literature Review

2.1

Introduction

This chapter critically reviews the existing literature in some areas of business that
impact investment appraisal decisions. These areas include capital budgeting,
corporate governance, capital markets, accounting practices, and investment
appraisal methods. To discuss these concepts and their interrelationships, some
relevant theories are discussed including the following: agency theory, stakeholder
theory, stewardship theory and resource dependence theory. The capital market
variables include interest rates (cost of capital) and agency costs, which impact on
corporate governance, which in turn have an impact on capital budgeting decisions
(Ruiz-Porras and Lopez-Mateo 2011). There are two main sources of capital –
equity and debt (Whitehead 2009). Debt is an external source of capital which bears
a specified interest rate. It is mainly supplied by capital markets including commercial banks, investment banks and other financial institutions such as insurance
companies, superannuation funds, etc. The company (the borrower) and the financial institution (the lender) enter into a contract which specifies the interest rate to
be charged and other restrictive debt conditions which have to be observed during
the life of the debt. Through the interest charges and other conditions imposed on
the borrower (investor), capital markets influence the firm’s corporate governance,
agency costs and capital budgeting decisions. Therefore, making capital budgeting
decisions without considering capital market interactions ignores one of the major
factors that influence investment appraisal decisions.

2.2

Capital Budgeting

Making a capital budgeting decision is one of the most important policy decisions
that a firm makes. A firm that does not invest in long-term investment projects does
not maximise stakeholder interests, especially shareholder wealth. Optimal decisions
B. Kalyebara and S.M.N. Islam, Corporate Governance, Capital Markets,
and Capital Budgeting, Contributions to Management Science,
DOI 10.1007/978-3-642-35907-1_2, # Springer-Verlag Berlin Heidelberg 2014

15

16

2 Literature Review

Goal of the Firm
Maximise shareholder wealth

Investment Decision

Short-term Investments

Financing Decision

Dividend Decision

Long-term Investments

Investment Appraisal Decisions:
capital budgeting

Fig. 2.1 Investment appraisal and goal of the firm

in capital budgeting optimise a firm’s main objective – maximising the shareholders’
wealth – and also help the firm to stay competitive as it grows and expands. These
decisions are some of the integral parts of overall corporate financial management
and corporate governance. A company grows when it invests in capital projects, such
as plant and machinery, to generate future revenues that are worth more than the
initial cost (Ross et al. 2011; Shapiro 2005).
Aggarwal (1993) states that capital budgeting decisions are important because of
their long-term financial implications to the firm, and therefore they are crucial. The
effects of capital budgeting decisions extend into the future, and the firm endures
them for a longer period than the consequences of operating expenditure. Some of
the definitions of capital budgeting includes the following: Seitz and Ellison (1999)
define capital budgeting as ‘the process of selecting capital investments’.
According to Agarwal and Taffler (2008) capital budgeting decisions possess the
distinguishing characteristics of exchange of funds for future benefits, investment
of funds in long- term activities and the occurrence of future benefits over a series of
years.
This study uses the term capital budgeting synonymously with investment
decision making and investment appraisal. Therefore, capital budgeting may be
defined in many ways, but in a nutshell, it is the decisions made by an organisation
to allocate capital resources most efficiently in long-term activities in the hope that
aggregate future benefits exceed the initial investment so as to maximise
shareholders’ wealth and other stakeholders’ interests. Figure 2.1 shows how
investment appraisal is related to other financial decisions and the goal of the firm.

2.2 Capital Budgeting

17

A firm’s decision to invest in long-term assets has an impact on the rate and
direction of its growth. A wrong decision can prove disastrous for the long-term
survival of the firm. The purchase of unwanted long-term capital assets results in
unnecessary capital allocation and heavy operating costs to the firm (Aggarwal
1993).
Heavy operating costs may render an organisation unsustainable. Again, the fact
that the firm needs to raise and commit ‘large sums of money’ in long-term capital
projects, makes capital budgeting decisions most important, requiring careful
planning and implementation (Brealey et al. 2011). Further, once wrong capital
budgeting decisions are made, they are not easily reversible and if the firm insists
and reverses them, they are costly. Therefore, a company’s future direction and the
pace of future growth start with capital budgeting decisions which involve investing
in viable long-term assets to generate future revenue. Hence, capital budgeting is
the most critical decision of any organisation that plans to grow, adequately
compete and thrive for a long time. Sub-optimal capital budgeting decisions don’t
maximise stakeholders’ interests in the long run, in particular the share prices or
market capitalisation. Share prices are reflected on the capital markets. Since share
prices listed on the stock exchange (capital market) are impacted on by various
factors and keep changing continuously, then the capital budgeting decisions should
be able to factor in those issues which impact on the capital markets.
It is a common occurrence that in the early years of most capital projects, the
cash outflow exceeds the cash inflow, which means is there is a deficit because of
large entry charges. Therefore, the organisation needs to have good financial
management to have other means of sourcing cash to cover this deficit until cash
from capital projects start coming in. The risk of making negative net cash inflows
in the early years is exacerbated if a firm invests in sectors with inherent high
business risk, such as the e-commerce sector and the airline industry. These sectors
significantly use IT which is changing quickly and have relatively high competition.
Schniederjans et al. (2004) acknowledge that investments in IT should not be
evaluated using the traditional capital budgeting methods. They should be looked
at on a case by case basis. An optimal investment solution in IT requires the use of
more than one investment techniques, because of the multidisciplinary impacts and
multiple objectives. The techniques should be able to integrate multiple objectives
Schniederjans et al. (2004). Similarly, capital investments in the airline industry
need capital budgeting models which can factor in financial and managerial flexibility, multiple objectives and corporate governance principles.
The returns of capital investments can be measured in terms of extra net cash
inflow and share price maximisation. The cash flows are the most important liquid
resources for any business because other resources can be bought if the cash inflows
exceed cash outflows. Share prices quoted on stock exchanges are next to cash in
terms of liquidity because they can be converted into cash very quickly if the
company is listed on the stock exchange. Viable capital investments earn a return in
excess of its cost to increase the overall value of the organisation, in other words,
the investment should have a positive NPV or the NPV should be greater than zero
to add to the value of the firm.

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2 Literature Review

2.2.1

Significance of Capital Budgeting in Corporate Financial
Management

Corporate financial management includes investing, financing, working capital and
dividend decisions (Brealey et al. 2011; Myers and Pogue 1974). Capital budgeting is
an integral part of corporate financial management. It requires simultaneous consideration of all of the above types of decisions. It entails planning for the firm to achieve
its objective. Decisions in different departments may be decentralised, and they
should all be well coordinated to achieve the goal of the firm. Good corporate
financial management should include the following, among others:
• Investment decisions: Allocating capital resources to projects with the highest
NPV.
• Financing decisions: Sourcing capital from the cheapest source first – pecking
order theory.
• Working capital: Managing working capital within business operations to
promptly meet its obligations as they fall due. Working capital is calculated by
subtracting current liabilities (due rent, telephone bills, wages and salaries,
accounts payable, trade advances) from current assets (cash, inventories,
accounts receivable). Working capital indicates the firm’s ability to meet its
short-term liabilities as they fall due. A firm without enough liquid assets to pay
off its current liabilities is compelled to borrow on short notice to meet its shortterm liabilities. Usually, short-notice borrowings carry high interest rates, which
increase the cost expense and in turn increase financial risk to the firm.
• Dividend decisions: In theory, dividends to the shareholders should be paid only
when available investments with positive NPV are fully financed, because the
internal source of capital is the cheapest, followed by debt and then equity last
(following the pecking order theory). However, in practice, decisions to pay
dividends follow the firm’s established dividend policy to keep its existing
shareholders and attract more potential shareholders.
Corporate financial management also includes the following:
• Reviewing and refining financial budgeting, revenue and cost forecasting;
• Seeking funding options for business expansion – both short and long-term
financing;
• Analysing the financial position of the business using various methods including
ratios;
• Understanding the various techniques used in project appraisal and asset valuation;
• Applying sound investment appraisal techniques; and
• Understanding valuation techniques for businesses, portfolios and intangible
assets.
Figure 2.2 shows that investment appraisal (in bold) is one of the two decisions
which has a direct link to all other business activities and objectives via strategic
planning. The second decision is financing. Capital budgeting is one of the integral

2.2 Capital Budgeting

19

Shareholders

Management

Finance from
shareholders

Finance
from
lenders

Business
objectives
Dividends
Investment
appraisal

Strategic
planning

Financing
decisions
Retained
profits

Fixed and
working capital
control

Operational
planning and
control

Profit
control

Fig. 2.2 Link between investment, financing/dividend decisions and corporate strategic planning
(Source: Knott 2004)

parts of corporate financial management, because without investing in long-term
projects, organisations do not grow. Capital budgeting has a direct impact on operational planning and control of a firm. Operational planning and control, in turn,
directly impact on the fixed and working capital requirements of a firm and its
profitability. Profits can then be either distributed to shareholders in the form of
dividends or retained and channelled for financing decisions. Therefore, it can be
said that all corporate financial planning activities are interrelated or have to be carried
out simultaneously to achieve the goals of the organisation. The different components
of corporate financial management have either a direct or an indirect impact on each
other.
Firms need money for day-to-day operations and for strategic objectives.
Organisations achieve their long-term objectives through allocating capital
resources to long-term assets, such as buildings, plant and machinery. Investment
projects are evaluated to identify those that maximise the value of the firm by the
use of NPV. The two main decisions financial managers make are investment
decisions (capital budgeting or investment appraisal) and financing decisions.
Financing decisions explain how the chosen capital projects should be funded by
equity or debt or a mix of both. If the organisation decides to fund the chosen
investments using both equity and debt, the next question is: what should be the
proportion? That is, how much should be raised through equity and how much

20

2 Literature Review

through debt. The answer to this question is not easy because it depends on various
factors, including the level of risk the capital market assigns to the company, the
type of industry the company operates in, the written policies and guidelines the
company has in place, etc. The investment and financing decisions have a relationship which is complementary, though they are independent of one another; but both
aim at maximising the value of the firm.
The most popular traditional investment appraisal method uses net present value
(NPV) to measure the performance of capital projects (Seitz and Ellison 1999). The
NPV is calculated by discounting future net cash flows using a risk-adjusted discount
rate to find the present value (PV) and then subtracting the initial investment from the
sum of the present values. The use of NPV alone as the only measure of performance
does not serve the interests of all stakeholders, because not all stakeholders are
interested in NPV, but in other units of measure such as minimising agency costs,
etc. The case study on World Airways modifies the maximisation of the NPV
objective by adding mitigation of agency costs. This study uses debt equity ratio as
a proxy for reducing agency costs (Cui and Mak 2002; Florackis 2008; Jensen 1986).
The DCF approach was not used when Lau (from a consulting firm) evaluated Tom.
com, citing the unique characteristics of companies in the e-commerce sector. Lau
used a multiple approach using accounting ratios of Amazon.com in the US to
evaluate Tom.com located in Hong Kong. However, our study on Tom.com develops
a DCF approach for evaluating capital investments in the e-commerce sector in
general, and Tom.com in particular. Lau failed to recognise that Tom.com was
different from the average e-commerce sector companies. The detailed features of
Tom.com are explained in Chap. 4.

2.3

Capital Budgeting Methods and Models

In practice, there are a number of capital budgeting techniques which can be used
by financial managers for investment appraisal (Ross et al. 2011). The capital
budgeting methods and models are broadly grouped in two categories: the
discounted cash flow (DCF) and the non-discounted cash flow (NDCF) methods.
The DCF methods (sometimes referred to as sophisticated methods) discount
expected net future cash flows using a risk-adjusted discount rate to find the
present value, and they consider the time value of money. These include net
present value (NPV), the internal rate of return (IRR) and the profitability index
(PI). The NDCF methods (sometimes referred to as naive methods) do not
discount the net future cash flow, and therefore do not consider the time value
of money and ignore project, financial and business risks. These include the
payback period (PBP) and the accounting rate of return (ARR). The ARR does
not use cash flow, but instead it uses average profit and average investment. The
PBP uses cash flow, but it does not discount it. However, the PBP can be modified
to use discounted cash flow. The various NDCF and DCF techniques are discussed
in detail below.

2.3 Capital Budgeting Methods and Models

2.3.1

21

Accounting Rate of Return

The accounting rate of return (ARR) represents the proportion of the average annual
net profits to either the original net investment or the average investment in the
project. The formula for ARR is written as follows:
ARR ¼

Average annual net profit
Initial investment=Average investment

Very often ARR is calculated using the original net investment rather than the
average investment. Once the ARR has been determined, the next step is to
compare it to a desired rate of return. The decision rule is that if the ARR calculated
above is equal to or greater than the desired rate of return (subjectively chosen), the
project is accepted. When management decides to use ARR for investment
appraisal, they have to make a number of assumptions based on the message they
want to send to the users of financial statements. The operating corporation tax rate
and the depreciation rate for the life of the project have to be assumed.
The disadvantages of ARR include not using the cash flow ignoring the popular
metric for measuring wealth and ignoring the time value of money – an important
concept in finance. The size of investments in terms of investment outlay is not
considered in the ARR calculation. The ARR does not conform to the principles of
shareholder wealth maximisation, because wealth is not measured in terms of ARR
but in terms of cash flow. The advantage of ARR is that it is simple to understand
and easy to calculate, and many financial managers are familiar with it.

2.3.2

Payback Period

The payback period (PBP) represents the number of years required to recover the
initial outlay using net cash flows after tax. Once the PBP has been calculated, it is
then compared with the minimum acceptable payback period which is chosen
arbitrarily (Brealey et al. 2007; Keown et al. 2011). The decision rule is that if
the calculated PBP is equal to or less than the desired period, the project is accepted,
because, the shorter the time taken to recover the initial investment the better. The
disadvantages of PBP include: giving equal weight to all cash flows before the
initial investment recovery date; not considering the cash flows beyond the payback
period; not using time value of money; not taking into account of project risk; and
not distinguishing between projects of different sizes in terms of investment outlay
(Campsey and Brigham 1991, p. 499). This can be partly overcome by using the
discounted cash flow to calculate payback period. The PBP may be useful as a
liquidity measure of the projects, but is not a profitability measure. Moreover, there

22

2 Literature Review

are other better methods available for considering risk, time value of money, etc.,
including the net present value and internal rate of return. The advantages of PBP
include being simple to calculate, if and when the initial investment is recovered it
can be re-invested to earn more return, and its concept is easy to understand by most
investors including non-financial managers. In practice, it is very popular in Japan
but not in the West.

2.3.3

Internal Rate of Return

The internal rate of return (IRR) is described as the discount rate that equates the
present value of the expected future net cash inflows with its initial outlay or which
projects have a NPV equal to zero. Another way of describing IRR is the rate of
growth a project is expected to generate. In general, the higher the IRR the capital
project has the more profitable the project is. The advantages of the IRR include:
considering the project risk; considering time value of money; and using cash flows.
The disadvantages of the IRR include: assuming that net cash flows may be
“re-invested” at a rate of return equal to the IRR; and giving more than one IRR
when the cash flows are not conventional. This produces conflicting results including non-separation between mutually exclusive projects of different sizes, and it
also assumes that different cash flows have the same opportunity cost (Brealey et al.
2007; Keown et al. 2011). The decision rule is that when the IRR is equal to or
greater than the cost of capital after tax, the project is accepted. In case of mutually
exclusive projects, the project with the higher IRR is accepted. Despite the number
of disadvantages in theory associated with IRR, Hendricks (1980); Anderson
(1982) and Mukherjee (1988) found that in practice IRR was the most popular
method used in capital decision making in Australia, followed by NPV. However
the use of IRR is decreasing and the use of NPV is increasing. The preference for
IRR over NPV is based on the convenience and ease of understanding (Mukherjee
1988).

2.3.4

Profitability Index or Benefit-Cost Ratio

The profitability index (PI) includes the discounting of future net cash flows, and
then the present values are added up. The sum of all the present values is divided by
the initial investment. The decision rule is to accept all capital projects with the PI
of one or greater than one. When the PI is greater than one, the present value of
future cash flows is greater than the initial outlay. Therefore, the capital project has
a positive net present value, so it adds value to the firm and should be accepted. The
IRR is similar to NPV but is expressed in different metrics. The IRR uses an index
and NPV uses cash flows. The disadvantages of the PI include the possibility of
misleading when dealing with two projects which are mutually exclusive. Project
one may have a higher positive net present value and project two may have a higher

2.4 Corporate Governance

23

profitability index, but because they are mutually exclusive, the firm is supposed to
choose between the two projects. In such a case Brealey et al. (2007) and Keown
et al. (2011) recommend the use of the NPV that adds up, rather than with a PI
which does not add up.

2.3.5

Net Present Value

In theory, the net present value (NPV) is the preferred method, and therefore, it is
the most popular capital budgeting method with academics. The NPV involves
management estimating future relevant revenue and expenses to find expected
future net cash flows from the capital project. It is also assumed that the cash
flows occur at the end of each period being considered and occur evenly throughout
the period – mostly the year. The scrap value of the project is also assumed, but in
most cases it is assumed to be negligible or zero.
NPV is calculated by discounting the future net cash flows after tax using the
firm’s risk-adjusted cost of capital. Then all the present values of the future cash
flows are added up. Then the initial outlay is subtracted from the sum of the present
values. The decision rule is to accept all projects if the NPV is equal to zero or
greater than zero, provided there is no capital rationing. When there is not enough
money to cover all projects with a positive NPV, then rationing of the funds is
necessary. Then the decision rule is to first accept the capital project with the
highest NPV, then the next capital project with the second highest NPV and so on
until the available funds are exhausted. A positive NPV means that the capital
project adds value to the company and a negative NPV diminishes the value of the
company. The advantages of the NPV include considering time value of money,
using all cash flows, considering project risk, and its use maximising the value of
the company. The disadvantages of NPV include not considering the financing
costs in the form of interest and dividends in the calculation of the cash flows, and
difficulties in calculation.

2.4

Corporate Governance

Banks (2004, p. 3) defines corporate governance as ‘the structure and function of a
corporation in relation to its stakeholders generally, and its shareholders specifically . . .’.
In Australia, the ASX (2007) defines corporate governance as the system used by
management to direct and manage companies to maximise the firm’s value. The
Economist Intelligence Unit (2002, p. 5) defines it as:
Corporate governance is the system by which business corporations are directed and
controlled. The corporate governance structure specifies the distribution of rights and
responsibilities among different participants in the corporation, such as the board,

24

2 Literature Review
managers, shareholders and other stakeholders, and spells out the rules and procedures for
making decisions on corporate affairs. By so doing, it also provides the structure through
which the company objectives are set, and the means of attaining those objectives and
monitoring performance.

The three definitions are similar in the way that all aim at achieving
stakeholders interests. Two of the three definitions above acknowledge that the
interests of non-financial stakeholders are as important as the interests of financial
shareholders. However, the emphasis is on financial shareholders’ interests. In
April 2006, the UN launched the Principles for Responsible Investment (PRI) at
the New York Stock Exchange. They were launched and endorsed by the UN
Secretary-General, Ban Ki-moon. These Principles have helped guide financial
managers make strategic investment decisions that try to maximise multiple
objectives. The Principles have become a benchmark for responsible investing.
A large number of international institutional investors have become members by
signing the Principles. The market value of the economy controlled by the
signatories of these Principles in the first year of their establishment was said to
have been greater than US$8 trillion. The signing of the Principles by high profile
international organisations demonstrates support from the top-level decision
makers for sustainable investment. The application of the Principles leads to better
long-term financial returns and a closer relationship between investors, the company and the community. These Principles also have the potential of minimising
agency costs. The UN Secretary-General when launching the Principles said
among other things:
By incorporating environmental, social and governance criteria into their investment
decision-making and ownership practices, the signatories to the Principles are directly
influencing companies to improve performance in these areas (see, PRI, 2006, p. 1). This,
in turn, is contributing to our efforts to promote good corporate citizenship and to build a
more stable, sustainable and inclusive global economy.1

Eight hundred and seventy nine signatories from the world have already signed
the Principles (see, PRI, 2006). They include 223 asset owners, 490 investment
managers and 166 professional service partners.2 The signatories committed to
adopt and implement the six Principles contained in the UN document. Broadly, the
members commit to:
1. Incorporate environmental, social and corporate governance (ESG) issues into
analysis and decision-making processes;
2. Be active owners and incorporate ESG issues into their ownership policies and
practices;
3. Seek appropriate disclosure on ESG issues by the entities in which they invest;
4. Promote acceptance and implementation of the Principles within the investment
industry;

1
2

See http://www.unpri.org/secretary-general-statement/index.php, accessed 19/02/2011.
See http://www.unpri.org/signatories/, accessed 19/02/2011.

2.4 Corporate Governance

25

5. Work together to enhance their effectiveness in implementing the Principles;
and
6. Each report on their activities and progress towards implementing the Principles.
A decade before the UN Principles were launched in 1996, the Australian Stock
Exchange (ASX) introduced a requirement that all listed companies should include
a statement of corporate governance in their annual reports under the Listing Rule
4.10.3. The ASX Corporate Governance Council lists ten essential corporate
governance principles, which include among others that the board should add
value, recognise and manage risk and encourage enhanced performance (Shailer
2004). These principles are broad allowing firms to pick and choose sections of the
Listing Rule that send positive messages or good news to the stakeholders or reflect
the company in a good light.
In the UK, investment management best practices are contained in the Hermes
Principles Statement (Watson and Pitt-Waton 2002, pp. 6–11). The statement
contains ten principles. Principles 2 and 3 are directly related to this study.
• Principle 2 states that ‘Companies should have appropriate measures and
systems in place to ensure that they know which activities and competencies
contribute most to maximising shareholder value’.
• Principle 3 states that ‘Companies should ensure all investment plans have been
honestly and critically tested in terms of their ability to deliver long-term
shareholder value’.3
The two principles above summarise the main goal of most capital investments,
be it private or public investments.
Corporate governance became a hot topic of discussion in the economic world
after the high profile company failures in the 1990s, including Arthur Andersen,
Global Crossing, Enron, WorldCom in the US, and HIH in Australia, etc. In the same
year, WorldCom defaulted on US$23 billion of debt – the largest default in history
(Banks 2004, p. 8). In 2002, 234 companies with US$178 billion in assets filed for
bankruptcy (Banks 2004, p. 390). In 2001, 257 public companies with US$258 billion
in assets filed for bankruptcy in the US. After the kind of losses and bankruptcies that
were experienced in the late 1990s and early 2000s, stakeholders including
shareholders lost confidence and trust in financial reports, directors’ statements and
external auditors’ reports (Keasey et al. 1997). A loss of trust in the companies’
official documents impacts negatively on the financial accounting numbers used as
inputs in the investment appraisal decision making. The loss of trust and confidence
in the company’s ability to invest investors’ money efficiently, prevents new
investors from buying shares in the company, existing shareholders may divest,
new debts will be charged higher interest rates because of the higher risk expected,
etc. All these will increase the total cost of running the company including the cost of
capital, thus reducing the net operating income and the net cash flow. Such a financial

3

See http://www.ecgi.org/codes/documents/hermes_principles.pdf, accessed 19/02/2011.

26

2 Literature Review

situation does not maximise shareholder wealth which is the main goal of the
companies in the first place. Surprisingly, from the reviewed literature in capital
budgeting (Dean 1951; Weingartner 1967; Seitz and Ellison 1999; Bierman and
Smidt 2007), there is evidence that the boards of directors do not significantly pay
attention to long-term investments. Therefore, there is a need for a study such as this
one to bring the capital budgeting issues that have been neglected in the board rooms,
to the fore. Banks (2004) listed and discussed a sample of 339 significant companies
that had governance problems ranging from improperly recognising advertising
revenues in 2002 of US$190 million. All these 339 companies in the US were forced
to restate their revenues and earnings in 2002. This confirms that corporate governance has a direct link to the figures reflected in the financial statements.

2.5

Relationship Between Capital Budgeting and Corporate
Governance

The firm adopts good corporate governance for the benefit of different stakeholders
such as, investors, creditors, directors, managers, employees and various industry
groups (Banks 2004). Capital budgeting decisions are made to maximise the net
present value of the organisation, which in turn benefits all stakeholders, so they
have similar goals. According to Banks (2004) good corporate governance
conforms to, among others, the structure and function of a corporation in relation
to its stakeholders generally, and its shareholders specifically by aligning
conflicting interests such as those which may arise during investing decisions,
financing decisions, financial reporting, directors’ compensation, directors’ selection instilling monitoring and bonding measures, a sense of ethics, and encouraging
transparency. The benefits of good governance may include among others,
accessing better flow of funds, improved access to lower interest rate sources of
funds, better credit ratings, better reputation and more business opportunities,
which lead to lower debt funding costs and/or higher share price and lower agency
costs. The lower debt funding costs impact on the NPV because the future cash
flows are discounted at a lower discount rate. Good corporate governance can
reduce inter and intra-firm agency problems (Shleifer and Vishny 1997) and is
also associated with higher firm value (Gompers et al. 2003). Figure 2.3 shows the
relationship between capital budgeting and corporate governance.
As mentioned before, since the collapse of high profile companies in the US such
as Enron, WorldCom, etc., management decisions, both operational and strategic,
have come under scrutiny. The common factor in these companies is the astronomical
executive remuneration and compensations – agency costs. The executives, whose
compensations are based on the annual performance (profits), will want to maximise
annual profits in the short term, so that they can receive large amounts of money
quickly before their contracts expire. Such executives will be reluctant to make
investment appraisal decisions which will bring in profits after their contract period.
The minimisation of the short-term executive compensation (agency costs) and

2.6 Different Theories to Conceptualise and Incorporate Capital Budgeting and. . .

Capital Budgeting

Corporate Governance

27

Maximise: NPV

Minimise: Agency Costs
Maximise: Debt equity ratio
Capital markets

Maximisation
of the firm’s
value

Fig. 2.3 Relationship between capital budgeting and corporate governance

introducing long-term executive compensation, including share options, may
persuade executives to invest in long-term capital projects. Therefore, there is a
need to integrate corporate governance principles, including minimisation of agency
costs, to improve investment appraisal decisions.

2.6

2.6.1

Different Theories to Conceptualise and Incorporate
Capital Budgeting and Corporate Governance in Strategic
Management Framework
Stakeholder Theory

Freeman and Reed (1983, p. 91) define stakeholders as: ‘any identifiable group or
individual who can affect the achievement of an organisation’s objectives, or is
affected by the achievement of an organisation’s objectives’. The theory is also
defined as “the degree to which managers give priority to competing stakeholder
claims”.
This definition does not mention shareholders; they define stakeholders which
includes shareholders. The definition implies that it is not the shareholders alone
who are affected by the achievement of the organisation’s objective, but also the
other stakeholders. Using Figs. 2.4 and 2.5 Donaldson and Preston (1995) show and
discuss what managers in the past believed to be the organisations’ main objective
(the input–output model) and what the managers of a modern economy believe to be
the main objective of the firm (the stakeholder model). The Donaldson and Preston’s
stakeholder model is similar to Freeman and Reed’s definition (1983).
Figure 2.4 shows the relationship between the firm and its stakeholders. The
number of stakeholders has increased since corporate governance became prominent after the collapse of high profile companies, and the acknowledgement that
corporations with good corporate governance perform better than corporations with
poor corporate governance. The success of organisations depends on more than just
stakeholders with explicit contracts and financial interests such as investors,
shareholders, suppliers, employees, customers as in Fig. 2.4; it now depends on
all stakeholders with explicit and implicit contracts such as government

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2 Literature Review

Investors

Suppliers

FIRM

Customers

Employees

Fig. 2.4 Contrasting models of the corporation: the input–output model (Source: Donaldson and
Preston 1995)

Governments

Suppliers

Trade
associations

Investors

FIRM

Employees

Political
groups

Customers

Communities

Fig. 2.5 Contrasting model of the corporation: the stakeholder model (Source: Donaldson and
Preston 1995)

departments, local communities, trade unions, political groups, etc., as shown in
Fig. 2.5 below.
Many researchers (Freeman and Evan 1990; Freeman and Reed 1983; Jensen
2002) concur that all stakeholders are important for the success of organisations.
Deegan (2009) further clarified the stakeholder theory by adding that the stakeholder theory protects the stakeholder interests in two ways. The first one is the
ethical (moral) or normative one and the second is the positive (managerial) one.
The normative one asserts that stakeholder management should lead to improved
and efficient financial management, and that, managers should make decisions
which benefit all stakeholders and treat stakeholders equally. This view is explained
further by Hasnas (1998, p. 32) cited in Deegan (2003, p. 268):
When viewed as a normative (ethical) theory, the stakeholder theory asserts that, regardless
of whether stakeholder management leads to improved financial performance, managers
should manage the business for the benefit of all stakeholders. It views the firm not as a
mechanism for increasing the stockholders’ financial returns, but as a vehicle for
coordinating stakeholder interests, and sees management as having a fiduciary relationship
not only to the stockholders, but to all stakeholders. According to the normative stakeholder
theory, management must give equal consideration to the interests of all stakeholders and,
when these interests conflict, manage the business so as to attain the optimal balance among
them. This of course implies that there will be times when management is obliged to at least
partially sacrifice the interests of the stockholders for those of the other stakeholders.

2.6 Different Theories to Conceptualise and Incorporate Capital Budgeting and. . .

29

Hence, in its normative form, the stakeholder theory does imply that businesses have true
social responsibilities.

Jensen (2001, p. 16) concurs with the view above and takes it further in support
of what he called ‘enlightened value maximization’, that ‘we cannot maximize the
long-term market value of an organization if we ignore or mistreat any important
constituency’.
Regarding the positive theory (managerial), managers use financial information
to manipulate the stakeholders to gain their support (Gray et al. 1996, p. 46).
Stakeholder theory is an extension of agency theory assertions (Shankman 1999)
because agency theory only considers the relationship between the principal
(shareholders) and the agent (management) (Psaros 2009). Stakeholder theory
extends agency theory to include other parties who can affect the achievement of
the firm’s goals, or who are affected by the achievement of the firm’s goals even
though their interests are measured in different units. This extension is very timely
and appropriate in the current economic environment because of the impact groups
in society, such as environmentalists, animal lovers, the greens, etc., have on the
firm’s reputation, performance and success.
In a broad sense, stakeholder theory is similar to the OECD’s definition of
corporate governance which encompasses all stakeholders – internal and external
(Neville et al. 2011). It is apparent that there are indisputable implicit contracts
between society and organisations. Society allows organisations to exploit its
natural resources and therefore, organisations are required to compensate society
with a form of payment in return for exploiting the natural resources. The payments
can be in different forms of return and metrics. There are also explicit contracts
between internal stakeholders, such as employees and shareholders, and the
organisation. The forms of return for explicit contracts are written in the contracts
of employment, articles of association, etc. The academics refer to the implicit and
explicit relationship between the organisation and its stakeholders as stakeholder
theory (Psaros 2009). The argument is that organisations expand, grow and prosper
only when the interests of all stakeholders are maximised or served well to their
satisfaction. External stakeholders are vital parts of the various stakeholders. Often,
the interests of the different stakeholders conflict with each other. In such a
situation, the organisation has to find a balance between the various interests.
There is an apparent conflict between stakeholder theory and agency theory
which asserts that the only important relationship the organisation has to cherish
and protect is that between the shareholders and the managers (Psaros 2009).
Stakeholder theory looks at an organisation from a broad perspective rather than
a narrow focus, because there are many other factors that make an organisation a
successful entity. For example, unhappy employees, suppliers, customers, government departments, local community, etc., can cause a company to fail in its
endeavours, which could lead to the collapse of the organisation. These various
stakeholders have an impact on the organisation and the organisation too has an
impact on them. It is a symbiotic relationship. The organisation benefits from
stakeholders and the stakeholders benefit from the organisations. In conclusion, a

30

2 Literature Review

convincing statement regarding the shareholder theory is that it is about achieving
the satisfaction of all parties interested in the success of the company comes from
Shankman (1999, p. 332) who states that:
The agency theory: (1) must include a recognition of stakeholders; (2) requires a moral
minimum to be upheld, which places four moral principles above the interests of any
stakeholders, including shareholders; and (3) consists of contradictory assumptions about
human nature and which give rise to the equally valid assumptions of trust, honesty and
loyalty to be infused in the agency relationship. In this way, stakeholder theory is argued to
be the logical conclusion of agency theory.

2.6.2

Stewardship Theory

Psaros (2009) states that similar to stakeholder theory, the views of stewardship
theory differ from agency theory. For example, stewardship theory does not support
the view that individuals are utility maximisers and also does not support the
assertion that all business decisions are based on economic considerations only. It
asserts that some business decisions are based on non-economic returns such as
those related to social status in the community. Donaldson and Davis (1991) add
that some individuals are motivated in their decisions by an intrinsic satisfaction in
undertaking a task that challenges them or/and achieving trust from peers and
supervisors. The core of stewardship theory is about how individuals rank their
social needs in a community, such as being accepted and valued by their peers and
supervisors. Similar to executive remuneration or compensation, ‘these needs help
align the individual’s interests with their organisation’s goals’. If the organisation
maintains a good relationship with the stakeholders, including the local community,
individuals would want to make decisions that identify them with the organisation
because that would help promote their social status in the community. If the
individuals rank social status high on their list of needs, then it would help them
perform harder to achieve the organisation’s goal. Psaros (2009) asserts that
stewardship theory states that managers do not start out with the intention of
maximising their own utility at the expense of the interests of other stakeholders.
In support of stewardship theory, Kiel and Nicholson (2003, p. 190) state that
‘underlying this rationale is the assertion that since managers are naturally trustworthy there will be no major agency costs’.
The acceptance of stewardship theory has adverse implications on one theory
that has become widely accepted, that having the chair of the board independent of
the CEO gives the organisation legitimacy for claiming to have an efficient or sound
financial management in place and hence improving the return on equity (ROE) to
the shareholders. However, Kiel and Nicholson (2003) state that their findings
support Boyd’s (1995) conclusion that the issue of CEO duality is explained better
if the size and complexity of the organisations are considered. In highly entrepreneurial firms, for example in the humble beginnings of Microsoft and internet
companies the chairman-CEO duality may send a positive message to the market

2.6 Different Theories to Conceptualise and Incorporate Capital Budgeting and. . .

31

because it supports stewardship theory and enhances social status by minimizing
the agency cost. It can also lead to the organisation being seen as having a clear
leadership which may lead to better corporate performance.

2.6.3

Resource Dependent Theory

In addition to the studies investigating the relationship between board composition
and firm performance, sociologists have focussed on the relationship between the
firm’s social network and the firm’s performance. These studies formed
the resource dependency theory. The resource dependency theory explains how
the firm’s success is linked to its ability to control its external resources (Psaros
2009). The board of a company plays several vital roles, such as providing advice to
management on operational and strategic issues and monitoring management.
Besides these, it is also an important link between the organisation and the external
resources which an organisation needs to maximise its performance (Hillman et al.
2000; Pfeffer and Salancik 2003). The more control an organisation has on external
resources, the lower the costs of resources and the higher the chances that the firm
will minimise agency costs. The firm may then maximise the use of resources to
maximise the value of the firm. It will also help in making strategic plans more
workable and mitigate agency costs. If the success of the organisation depends on
external resources, then having its members on the board of directors of the
resources company who can help to establish a relationship between the
organisation and the external resources improves the financial efficiency and
management of the organisation, reduces agency costs and hence maximises the
value of the firm. It also reduces uncertainty of accessing the resources, and external
dependencies (Psaros 2009). Kiel and Nicholson (2003) argue that agency theory,
stewardship theory and resource dependence theory all play a vital role in determining what should be appropriate corporate governance policies and structures.

2.6.4

Agency Theory and Agency Cost

Agency theory forms an important part of the positive accounting theory (PAT)
(Gaffikin 2008). PAT attempts to predict such actions as the choices of accounting
policies the firm managers will choose to maximise either their own interests or the
interests of the firm and how managers will respond to proposed new accounting
standards. It also explains what is observed in accounting and auditing practices
(Watts and Zimmerman 1990). Furthermore, it is based on the contracts between
the organisation and its managers, for example executive compensation and debt
contracts (Scott 2006). There are three hypotheses of PAT: the bonus plan
hypothesis (BPH), the debt covenant hypothesis (DCH) and the political cost
hypothesis (PCH). In both BPH and DCH, the reported earnings are shifted to the
current period to increase the bonus payable and reduce the possibility of failing to

32

2 Literature Review

pay the interest on debt as it falls due and the principal on retirement. In the case of
PCH, reported earnings may be shifted to a future period to defer political cost
(Scott 2006).
Agency theory discusses the separation of ownership from control (Kim et al.
2009). In practice, it is the norm that managers or executives make all operational
and most strategic decisions in an organisation. In most cases, if not all cases, the
managers who make decisions in the organisation do not own shares in the
company. By nature, human beings are self-interested and utility or wealth
maximisers. Although managers are employed to maximise shareholders’ or
owners’ wealth, it is reasonable to expect that they will not only make decisions
that maximise shareholders’ wealth all the time, but their own wealth too. They
often focus on their own interests first before the shareholders’ interests. This is the
background for the problems in the agency theory. Agency theory is brought about
by managers maximising their own wealth at the expense of shareholders’ wealth
through excessive self remuneration; making decisions that focus on short-term
performance rather than long-term growth (capital budgeting), which is the focus of
this study, and avoiding long-term risky projects (Psaros 2009), thus increasing
agency costs and impacting on investment appraisal decisions.
Corporate governance policies aim to minimise agency costs and maximise the
firm’s value. A firm uses bonding and monitoring measures to reduce agency
costs – the divergence from the main goal of maximising shareholders’ wealth.
These measures are sometimes referred to as ‘the carrot and the stick’, which means
to reward for good performance and to punish for poor performance. One of the
ways that will minimise the possibility of managers avoiding to invest in risky
projects thus increasing agency costs, is to develop a corporate policy that assigns
decision making to the managers and control to the shareholders, which helps
shareholders determine their own level of risk which they can control.
Psaros (2009) also states that managers sometimes may accept short-term riskier
investments provided the decision does not jeopardise their short-term interests.
The implications of agency theory in organisations can be extended and explained
through understanding corporate governance policy. One of the problems with
agency theory starts with allowing executives to have the authority to control the
firm and make decisions for the firm. The shareholders of the company have no
control over the operational decisions, these are entrusted to management. Also,
some strategic decisions are left to management depending on the size of the
company. The amount of money involved in investment appraisals is often huge,
which gives an incentive to managers to make decisions to maximise their own
wealth at the expense of the shareholders. The managers will not choose capital
investment projects which do not maximise their wealth in the short term. However,
this decision will not maximise the shareholders’ wealth in the long term. For this
reason, firms spend money to limit or minimise the agency costs or the divergence
from the goal of maximising shareholders’ wealth (Jensen and Meckling 1976).
Agency costs include offering various types of incentives to entice managers to act
appropriately in the interests of stakeholders. Also the firm develops various
policies to monitor management behaviour and specify the kind of penalties if

2.7 Capital Budgeting, Corporate Governance and Agency Cost

33

managers do not act appropriately. Jensen and Meckling (1976) define agency costs
as ‘the sum of the monitoring expenditures by shareholders, bonding expenditures
by managers and the residual loss.’
Many researchers from different disciplines have discussed corporate governance for decades, from economics (Tirole 2001; Jensen and Meckling 1976), from
law (Richards and Stearn 1999), from finance (Fama and Jensen 1983), from
sociology (Useem 1984), from strategic management (Boyd 1995) and
from organisation theory (Kiel and Nicholson 2003). Having different researchers
from different disciplines has resulted in the establishment of different corporate
theories. They include agency theory (economics and finance), stakeholder theory,
stewardship theory and resource dependency theory. Though academics have often
used agency theory to explain the current corporate governance practice, these
other theories also contribute to explaining the same.
However, there is no one theory that has a ‘complete explanation’ for the
relationship between corporate performance and corporate governance (Kiel and
Nicholson 2003). There is a relationship between agency theory and stewardship
theory, and stakeholder theory and resource dependency theory, because when
there is a conflict of interest (agency theory) in the organisation, then the objectives
of the other theories will not be achieved (Psaros 2009). However, the main
objective of all organisational theories is to maximise the value of the firm. One
of the ways of maximising the value of the firm is by minimising agency costs. This
is the focus of the study.

2.7

Capital Budgeting, Corporate Governance and Agency Cost

There is evidence that the gap between normative theory (what should be done) and
positive theory (what is done in practice) in capital budgeting has been reduced due
to the improved technical facilities available today (Scapens et al. 1984). These
technical facilities have helped decision makers develop multi-criteria models that
can handle multiple objectives and constraints using mathematical programming
software. Agency theory addresses the reduction of conflict of interest between the
principals (shareholders) and the agents (management). It has also helped to reduce
the gap between normative and positive theories. Positive accounting theory has
become more general to accommodate the normative accounting theory as a result
of agency theory (Lister et al. 2006). The integration of the agency theory, the
theory of property rights and the theory of finance has allowed the development of
the theory of ownership structure in the organisation (Jensen and Meckling 1976).
Agency theory in this case focuses on the property rights embedded in the contracts
between management and owners of the organisation.
The organisation before the law, is considered as having a set of explicit and
implicit contracts between itself and its stakeholders who include management,
employees, creditors, shareholders, local community, etc. All stakeholders are

34

2 Literature Review

wealth maximisers, a fact which causes a conflict of interest and agency costs. The
larger the portion of the ‘cake’ (profits) one group of stakeholders gets from the
profits available, the less of the ‘cake’ the other stakeholders share. The ‘cake’ is
only so big.
There are efforts aimed at reducing or eliminating the conflict of interests. These
efforts cost money. The costs are called agency costs. Agency costs are incurred to
enable all stakeholders to share the ‘cake’ (profits), equitably to their satisfaction.
These costs include monitoring costs, bonding costs and residual loss. Residual
losses are described as the ‘real inefficiencies caused by the capital market imperfection of agency costs’ (Scapens et al. 1984). Agency costs themselves, such as the
purchase of controlling interests by lenders (Fama and Jensen 1983), the purchase
of debt by owners, etc., also reduce the ‘size of the cake’ available for distribution.
For example, the purchase of controlling interests may make managers lose their
rights to control and make decisions which maximise their wealth, and as a result
they would demand compensation in the form of higher remuneration such as high
salaries or in kind. The minimisation of the agency costs increases the ‘cake’ left for
distribution.
The pursuit of positive net present values in investment appraisal decisions
originates from capital market imperfections and frictions including the treatment
of tax on interest on debt payable. In a nutshell, agency theory deals with capital
market imperfections that originate in capital control and ownership structure.
Lister et al. (2006) state that agency costs impact on project selection in two
ways: one, it may cause a conflict which entices shareholders to accept high risk
and sub-optimal projects which transfer wealth from bondholders to shareholders;
and two, there is motivation for stockholders to give up new profitable investments
when existing debt is supported by current assets and the choice to undertake the
investments.
Modern finance is founded on utility theory (Lister et al. 2006). There are other
theories that stem from utility theory such as marginal utility that impact on the
investment appraisal decisions. Marginal utility is defined as the additional benefit
(utility) that a consumer derives from consuming an additional unit of the product.
Utility theory is appropriately applied to capital budgeting decision making. Financial managers invest in capital projects provided that one additional dollar invested
(cash outflow) results in a net benefit (cash inflow). The net benefit keeps on
reducing with one extra dollar invested until a breakeven point is reached. Beyond
this point, the extra dollar invested results in a negative net cash inflow thus
reducing the value of the firm. Further, utility theory extends into modern
portfolio theory (MPT) and the utility of mean and variance theory. The main
goal of MPT is to invest in projects that give optimal benefits. The mean variance
optimization (MVO) is one of the quantitative tool which helps to make investment
decisions in MPT by considering the trade-off between risk and return. However, it
is important to note that MVO is applied to investment decisions that consider
multiple periods as a major input rather than multiple objectives which are the focus
of this study.

2.8 Capital Budgeting, Accounting Practices, Capital Markets and Regulations

2.8

2.8.1

35

Capital Budgeting, Accounting Practices, Capital Markets
and Regulations
Capital Budgeting and Accounting Practices

Research in financial accounting reporting has established that patterns of earning
management are part and parcel of communicating accounting information (Scott
2006). Earnings management is defined by (Scott 2006, p. 344) as ‘the choice by a
manager of accounting policies so as to achieve some specific objective’.
When preparing financial statements which include the performance, financial
position and cash flow statements, professional accounting bodies require an entity
to prepare them in accordance with the General Accepted Accounting Practices
(GAAP). The GAAP principles are broad and give a variety of options, so that
managers who prepare financial statements can pick and choose the accounting
policies that help achieve their specific objectives. Table 2.1 shows the impact
accounting choices have on cash flows.
Ultimately, whatever accounting figures are produced in the financial
statements, whether they are within GAAP or violate GAAP, they are all used by
investors and financial managers for investment appraisal decisions. However,
decisions based on accounting numbers whose financial statements violate GAAP
are not optimal as they do not maximise the value of the firm. Such decisions impact
on expected future cash flows, future taxable income, tax payable, etc. Therefore,
the accounting practice a company adopts impacts on accounting figures in the
financial statements and hence on investment appraisal decisions.
Managers, by virtue of their responsibilities, make operational and strategic
decisions for the organisation and they have privileged access to inside information
which investors can not access; a situation referred to as information asymmetry.
Since managers are rational decision makers who are wealth maximisers, they
choose accounting policies from accounting standards and use inside information
selectively to maximise their wealth, which weakens corporate governance and
increases agency costs. In these cases, figures in these financial statements are
irrelevant and unreliable to the financial statements users, including shareholders
and other stakeholders. Therefore, the projected cash flows and discount rate
estimated using such accounting numbers cannot be relied on for making optimal
investment appraisal decisions.
Table 2.1 shows some of the activities, when earnings management becomes
relevant, reliable, legal and acceptable, and when it becomes fraudulent. Figure 2.6
shows the impact various economic issues have on accounting practices and on
financial statements users. It shows the relationship between accounting theory and
the standard setting process and factors which impact on accounting practices. It
can be seen that economic conditions such as the inflation rate, unemployment rate,
foreign exchange rate, etc., impact on political factors and accounting theory, and
so directly impact on accounting practice. In turn, they affect the numbers in the

36

2 Literature Review

Table 2.1 Earnings management
“Real” cash flow
choices

Accounting choices
“Conservative”
accounting

“Neutral”
earnings
“Aggressive”
accounting

“Fraudulent”
accounting

Within GAAP
Overly aggressive recognition of provisions
or reserves
Overvaluation of acquired in-process R&D in
purchase acquisitions
Overstatement of restructuring charges and
asset write-offs
Earnings that result from a neutral operation
of the process
Understatement of the provision for bad debts

Drawing down provisions or reserves in an
overly aggressive manner
Violates GAAP
Recording sales before they are “realisable”
Recording fictitious sales
Backdating sales invoices
Overstating inventory by recording fictitious
inventory

Delaying sales
Accelerating R&D
or advertising
expenditure

Postponing R&D
or advertising
expenditures
Accelerating sales

Source: Dechow and Skinner 2000

Accounting
Theory

Political
Factors

Economic
Conditions

Accounting
Policy Making

Accounting
Practice

Audit Function:
Compliance of
practice with
accounting rules
(control function)

User
Main flow
Secondary flow

Fig. 2.6 The financial accounting environment (Source: Wolk et al. 2004)

2.9 Limitations of Existing Literature and Motivation for This Study

37

financial statements on which investments and economic decisions are based. The
political factors include rules or regulations which impact on decision making.
They also include auditors who represent accounting and financial professionals,
financial analysts who represent investors and government organisations such as the
Australian Securities and Investment Commission (ASIC) representing public
interest. Accounting theory is a well developed process explaining the role and
responsibility of an accountant as a result of accounting research. The users include
all stakeholders such as creditors, investors, suppliers, shareholders, debt holders
and the community (Wolk et al. 2004).

2.8.2

Capital Budgeting, and Capital Markets and Regulations

In Australia there are three corporate regulators: the Australian Competition and
Consumer Commission (ACCC), the Australian Securities and Investments Commission (ASIC) and the Australian Prudential Regulation Authority (APRA). The
ACCC has the responsibility of protecting consumers’ interests from unscrupulous
companies which try to reduce competition in the market. The ASIC protects
investors’ and consumers’ interests who deal with financial institutions, including
capital markets such as banks and the stock exchange. The APRA is responsible for
making sure that prudential institutions such as deposit takers, insurance companies
and superannuation funds maintain a minimum level of financial soundness.
Based on stakeholder theory, corporate regulators protect weak consumers,
investors and creditors by ensuring that companies and financial institutions comply
with company and competition laws. Corporate regulators are treated as stakeholders
because through fulfilling their responsibilities, companies operate diligently, which
minimises agency costs, lessens stakeholders’ losses and protects stakeholders’
interests. Table 2.2 is a summary of the literature review on capital budgeting.

2.9

Limitations of Existing Literature and Motivation
for This Study

As summarised in Table 2.2, in theory NPV is the most popular of the three DCF
methods, but IRR is preferred in practice. However, non-DCF techniques are still used
in some countries including Japan and New Zealand. Some of the advantages of NPV
include the use of cash flow (creates economic value); time value of money; using a
risk-adjusted discount rate; and being a measure of wealth. However, NPV as a
technique is not without limitations. The limitations include:
• Difficulty in accurately forecasting future cash flows;
• No universal or standard method for setting the discount rate;
• Assuming the estimated discount rate will be the same for the life of the project;

38

2 Literature Review

Table 2.2 Extract of literature review
1

Author(s)
Donaldson
1972

Year Country
1972 USA

2

Ang 1973

1973 USA

3

Reilly et al.
1974

1974 USA

4

Hastie 1974

1974 USA

5

Brigham 1975

1975 USA

6

McMahon
1981

1981 Australia

Findings
Traditional bottom-up concept of a capital budgeting
selection process, in which individual proposals
are screened against a cost-of-capital hurdle rate,
results in economically wrong issues being
raised at the wrong level of management.
Firms using marginal WACC are likely to accept
projects whose returns are above the weighted
cost but below the “true” cost, especially for
firms with high level of leverage, and expected
dividend growth rate, a likely combination for
“growth companies”. There is a need to review
most of existing theory in the area where WACC
has been assumed.
If both debt and equity were to change so as to
maintain proportionality, WACC would be equal
to “true” cost.
A properly constructed WACC does not generate
biased estimate of a firm’s cost of capital.
Even with constant debt/equity ratio assumption,
weighted cost of capital will not equal “true” cost
of capital, because keeping debt/equity constant
requires marginal refinancing in every period,
uneconomical and unobtainable because firm’s
cash flows are only approximated by the constant
growth for expediency.
To rely on DCF or other refined evaluation
techniques for “improvement in decision
making” is an error. “What are needed are
approximate answers to the precise problems
rather than a precise answer to the approximate
problems”. Hastie suggested improved use of
sensibility analysis and the communication of its
results to top management.
DCF is used by both academics and in practice and
sophisticated techniques for quantifying risk
analysis are increasing. <63 % of the 33 firms
surveyed used a hurdle rate based on the cost of
capital. <53 % used more than one hurdle rate.
<50 % changed their hurdle rates once a year.
Managers do not use DCF because: (1) some
techniques are new; (2) some of the operating
personnel are “checked out” on these new
techniques; and (3) measurement of average cost
of capital, project risk and discount rates is
difficult.
The gap between theory and practice in capital
budgeting reduced during the 1970s. Use of DCF
and WACC increased (i.e. the mechanics), but
there is too little understanding of ideas and
concepts on which DCF techniques are set.
(continued)

2.9 Limitations of Existing Literature and Motivation for This Study

39

Table 2.2 (continued)
Author(s)

Year Country

7

Hendricks 1980

1980 USA

8

Rege and Baxter 1982 Canada
1982
Anderson 1982 1982 Australia

9

10 Gitman and
Mercurio
1982

1982 USA

11 Pike 1982

1982 U.K.

12 Pike 1983

1983 U.K

13 Lilleyman 1984

1984 Australia

Findings
Determination and use of hurdle rates was at a
relatively unsophisticated level.
The limitations of WACC were not fully understood.
In practice IRR was more popular than NPV. But
found that NPV maximises the net present value
of expected cash flows in capital budgeting
decisions.
NPV techniques resulted in a better ranking than
IRR.
IRR could give an incorrect ranking of mutually
exclusive projects or multiple rates of return.
NPV provided unambiguous, optimal project
selection when capital rationing exists.
The paper suggested the use of WACC as a cut-off
rate for investment decisions.
IRR was the most popular method in making capital
budgeting decisions, followed by ARR. Nearly
two-thirds of respondents considered riskadjusted rate of return being the most popular
method used. Australian firms were using more
sophisticated methods of analysis in capital
budgeting process than indicated in previous
empirical studies.
The gap between financial theory and practice
remains.
The transfer of knowledge from academics to
managers has not been effective as most
academics might expect.
Pike found 69 % of the respondents use DCF in UK
which falls well below the level suggested by
surveys conducted in the 1970s by Carsberg and
Hope (1976) – 85 % and Westwick and Shohet
(1976) – 80 %. Pike found that size of annual
capital expenditure is highly associated with the
use of discounted methods – particularly the IRR
method.
DCF techniques and practices advocated in capital
budgeting literature are found in very large firms.
But in practice, sound decision models in theory
are not viewed as synonymous with optimal
choice. Subjectivity and gut feeling are often
relied on. The paper revealed a great progress in
areas of inflation, hurdle rates, post audit, DCF
methods and risk analysis.
A significant gap between financial theory and
practice still exists. A number of firms seemed to
be clinging to the established procedures rather
(continued)

40

2 Literature Review

Table 2.2 (continued)
Author(s)

Year Country

14 Ross 1986

1986

15 Andrews and
Firer 1987

1987

16 Gordon et al.
1988

1988

17 Mukherjee 1988 1988

18 Pike 1988

1988

19 Patterson 1989

1989

20 Reimann 1990

1990

Findings
than drawing from the growing body of financial
literature. DCF methods of capital budgeting,
e.g. NPV, IRR or profitability index, were
commonly used by most major firms.
USA
The use of DCF is widespread especially IRR. Also
many firms continue to use simple payback
period. The study found that many firms use
either WACC or the cost of a specific source of
funds for the discount rate.
South Africa Single target hurdle rate for a firm with divisions
makes no allowance for different risks and
differing debt levels within the divisions.
USA
DCF methods of capital budgeting are commonly
used but the use of naı¨ve methods is still
widespread. One possible explanation for the
continued use of naı¨ve methods is the agency
theory.
USA
Projects are identified and usually developed at the
lower level of management and flows upwards.
Most firms use cash flows as cost/benefit data for
capital budgeting decision.
The use of DCF is almost universal IRR is the most
popular tool, followed by payback period.
The use of WACC increased.
Sensitivity analysis is a popular risk assessment
method, while risk-adjusted rate is the favoured
risk adjustment vehicle.
Most firms have some sort of post-audit system in
place.
U.K
There was a very significant increase in the use of
DCF capital budgeting techniques between 1975
and 1986. This was accompanied by higher
levels of capital investment effectiveness. The
firms’ performance was found to have improved
during this period.
New Zealand New Zealand firms rely on accounting-based rather
and
than market-based criteria in capital budgeting,
Canada
which is not the case in USA and Australia. ARR
and payback period are used at a greater extent
by firms in New Zealand than in USA and
Australia. The use of DCF and WACC in New
Zealand is comparably low, and the use of cost of
debt alone is high.
The most used hurdle rate was judgement-based
target return.
USA
Value-based planners will be better off if they do not
adjust divisional hurdle rates for differences in
risk. Instead, cash flows should be adjusted for
their relative uncertainty. It allows the managers
to focus on cash flows that create economic value.
(continued)

2.9 Limitations of Existing Literature and Motivation for This Study

41

Table 2.2 (continued)
Author(s)
21 Allen 1993

Year Country
1993 Australia

22 Cheng et al.
1994

1994 USA

23 Graham and
2002 USA
Harvey 2002

24 Ehrhardt and
Wachowicz
2006

2006 USA

25 Lobe et al. 2008 2008 Germany

26 Brijlal and
Quesada
2009

2009 South Africa

Findings
Firms preferred debt as an external funding source to
bridge investment projects. It would not be
regarded as being subjected to either external or
internal funding limits. All firms surveyed agreed
that funds would be found for unplanned projects
if they were of sufficient merit.
In theory, NPV is considered superior to IRR. NPV
is compatible with wealth maximisation and
makes realistic reinvestment rate assumptions.
Practitioners prefer IRR to NPV; however the
use of NPV is on the increase and the use of IRR
decreasing. The preference of IRR to NPV is
based on the “convenience” and
“understandability”.
The most popular capital budgeting technique is the
IRR followed closely by NPV. Profitability index
is rarely used. Most firms use NPV to evaluate
new projects. Surprisingly, simple payback
period is more popular than discounted payback
period.
According to the survey, most companies use DCF
methods to evaluate capital budgeting decisions.
DCF methods assume that initial cash outlay
(ICO) is known with certainty. However many
ICO are uncertain such as the construction of
new facility. This risk affects both ICO and
depreciation tax shields. This risk is not
considered by many companies. Sensitivity
analysis may address this risk.
All companies listed on Germany stock exchange –
CDAX – were surveyed to establish capital
budgeting methods used in Germany.
Findings: German managers do not follow the
shareholder value when applying capital
budgeting methods.
They do not use residual income valuation methods
measure ex-post performance of a company.
Surveyed about capital budgeting (CB) practices in
small, medium and large firms in the Western
Cape province of South Africa.
Findings: the most used CB technique is payback
period followed by NPV. Sixty-four percentage
of all firms surveyed use only one technique,
32 % use two to three techniques. Large firms
favour NPV and IRR. Project definition was the
most important stage of CB process and
implementation stage was the most difficult stage
for manufacturing companies. Most firms used
cost of bank loan as the discount rate.
(continued)

42

2 Literature Review

Table 2.2 (continued)
Author(s)
Year Country
27 Leon et al. 2008 2008 Indonesia

28 Bennouna et al.
2010

2010 Canada

Findings
Surveyed companies listed on Jakarta Stock
Exchange about their capital budgeting (CB)
practices.
Findings: The majority use DCF methods as their
primary measure for evaluating capital projects.
Scenario and sensitivity analysis are most used
risk assessment methods. Risk-adjusted discount
rate and CAPM are not widely used. The most
important goal of capital budgeting is growth in
cash flows and long-term earnings followed by
growth in share price.
Surveyed 88 large firms in Canada.
Findings: The use of DCF continued, however 17 %
did not use DCF. Of those firms which used DCF
the majority preferred NPV and IRR. Only 8 %
used real options.

• Ignoring the impact the different amounts invested have on the NPV – a capital
project that has a high NPV may not necessarily be the best if it requires
relatively more capital than other capital projects;
• Ignoring the impact of unequal lives of the capital projects on the NPV – a
capital project that has a longer life may not necessarily be the best if it requires
relatively more capital than other capital projects;
• Failure to factor in financial, technological and management flexibility and
changes that are common in a modern economy;
• It is a one-off time technique – economic conditions do not stay the same
throughout the life of the capital project;
• It cannot handle multiple objectives; and
• It cannot handle multi-criteria problems.
NPV analysis is just one of the many useful capital budgeting tools. Capital
budgeting techniques, whether naı¨ve or advanced, have the following common
limitations:
• They consider each project as an individual undertaking as opposed to considering the project as part of the overall organisation structure;
• They fail to consider the relationship between the investments and the
impact it may have on the goals of different investments and the firm as a
whole; and
• They assume that the investments need to achieve just one objective – to
maximise share prices, and they ignore the interests of other stakeholders.

2.10

2.10

Conclusion

43

Conclusion

The literature review above indicates that the gap between theory and practice still
exists. It also found that capital markets and accounting practices impact on
investment appraisal decisions significantly. Although the use of NPV has been
increasing, it is deficient in that it ignores the impact of the capital markets, agency
costs, accounting practices in the form of earnings management, etc., on investment
appraisal decisions. It must be noted that the studies reviewed in this chapter were
conducted in different timeframes, in different countries, using different samples,
different methods and different valuation techniques. However, it can be safely
concluded that all ‘sing one chorus’ – maximisation of NPV. It is the most popular
method in theory. However, it ignores the impact of other internal and external
economic factors, such as agency costs, multiple objectives, etc., in investment
appraisal decisions. This failure provides a justification for this study to develop a
new integrated approach in the form of MOLP model to investment appraisal to be
applied in the e-commerce sector and the airline industry that use IT as a major
source of information and have an inherent high risk. Significant amount of
research with multiple objectives in other sectors such as health, manufacturing,
hospitality, etc., and in capital markets, has been conducted but no study has
integrated them to find their impact on investment appraisal decisions.
The first section of the next Chap. 3 discusses the new directions in accounting
research, different types of research methodology, discounted cash flow analysis
and cash flow estimation in the context of project appraisal in the e-commerce
sector. The second section of Chap. 3 discusses solving an optimisation problem
which has multiple objectives and constraints, incorporating agency costs in the
investment appraisal decisions and identifying the suitable model for use in the
airline industry. This study attempts to bridge the gap in the existing literature and
practice by incorporating the principles of corporate governance, capital markets
and capital budgeting.

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