The Capital Budgeting Decisions of

Small Businesses
Morris G. Danielson and Jonathan A. Scott

This paper uses survey data compiled by the National Federation of Independent Business to analyze the
capital budgeting practices ofsmallfirms. While largefirms tend to rely on the discounted cashflow analysis
favored by finance texts, many small firms evaluate projects using the payback period or the owner's gut
feel. The limited education background of some business owners and small staff sizes partly explain why
small firms use these relatively unsophisticated project evaluation tools. However, we also identify specific
business reasons—including liquidity concerns and cashflow estimation challenges—to explain why small
flrms do not exclusively use discounted cashflow analysis when evaluating projects. These results suggest
that optimal investment evaluation procedures for large and small flrms might differ. [G31 ]

•This paper analyzes the capital budgeting practices of
small firms. The US Small Business Administration esti-
mates that small businesses (which they define as firms
with fewer than 500 employees) produce 50% of private
GDP in the U.S., and employ 60% of the private sector
labor force. Many small businesses are service oriented;
but according to the 1997 Economic Census, over 50%
are in agriculture, manufacturing, construction, transpor-
tation, wholesale, and retail—all industries requiring
substantial capital investment. Thus, capital investments
in the small business sector are important to both the
individual firms and the overall economy.
Despite the importance of capital investment to small
firms, most capital budgeting surveys over the past 40
years have focused on the investment decisions of large
firms (examples include Moore and Reichardt (1983),
Scott and Petty (1984), and Bierman, (1993)). An ex-
ception is Graham and Harvey (2001), who compare
the capital budgeting practices of small and large firms.
Even their small firms are quite large, however, with
a revenue threshold of $1 billion used to separate firms
by size.
Indeed, less than 10% of their sample report revenues
below $25 million. Thus, Graham and Harvey's results
do not directly address the investment decisions of very
small firms.'
There are several reasons small and large firms might
use different criteria to evaluate projects. First, small
business owners may balance wealth maximization (the
goal of a firm in capital budgeting theory) against other
objectives—such as maintaining the independence of the
business (Ang (1991) and Keasey and Watson (1993))—
when making investment decisions. Second, small firms
lack the personnel resources of larger firms and, there-
fore, may not have the time or the expertise to analyze
projects in the same depth as larger firms (Ang, 1991).
Finally, some small firms face capital constraints, mak-
ing project liquidity a prime concern (Petersen and Rajan
(1994) and Danielson and Scott (2004)). Because of
these small firm characteristics, survey results on the
capital budgeting decisions of large firms are not likely
to describe the procedures used by small firms.
To document the capital budgeting practices of small
businesses, defined here as firms with fewer than 250
employees, we use survey data collected for the National
Federation of Independent Business (NFIB) Research
Foundation by the Gallup Organization. The results
include information about the types of investments the firm
makes (e.g., replacement versus expansion), the primary

Morris G. Danielson is an Assistant Professor of Finance at St. Joseph's

'The Federal Reserve Board of Governor's Survey of Small Business
University in Philadelphia, PA 19131 and Jonathan A. Scott is an Finance serves as the data source in many studies of small business
Associate Professor of Finance at Temple University in Philadelphia, finance. The firms in the Board of Governor's Survey tend to be much
PA 19122. smaller than the firms in the Graham and Harvey (2001) sample; in the
1993 Board of Governor's survey, 83% of the firms report revenues
We acknowledge the helpful comments of Jacqueline Garner, William under $1 million. The firms in the Graham and Harvey sample, there-
Petty, and participants at the 2005 Financial Management Association fore, are much larger than firms typically included in studies of small
and Eastern Finance Association Conferences. business finance.

45
46
tools used to evaluate projects (e.g., discounted cash
flow analysis, payback period), the firm's use of other
planning tools (e.g., cash flow projections, capital budgets,
and tax planning activities), and the owner's willingness
to finance projects with debt. The survey also includes
demographic variables that allow us to examine the
relations between capital budgeting practice and firm
characteristics such as size, sales growth, industry, owner
age, owner education level, and business age.
Not surprisingly, we find small and large firms evalu-
ate projects differently. While large firms tend to rely on
the discounted cash fiow calculations favored by capital
budgeting theory (Graham and Harvey, 2001), small
firms most often cite "gut feel" and the payback period
as their primary project evaluation tool. Less than 15%
of the firms claim discounted cash fiow analysis as their
primary criterion, and over 30% of the firms do not esti-
mate cash fiows at all when they make investment deci-
sions. The very smallest of the surveyed firms (firms
with three employees or fewer) are significantly less
likely to make cash fiow projections, perhaps because of
time constraints.
Certainly a lack of sophistication contributes to these
results, as over 50% of the small-business owners sur-
veyed do not have a college degree. Yet, there are also
specific business reasons why discounted cash fiow anal-
ysis may not be the best project evaluation tool for every
small firm. For example, 45% of the sample would delay
a promising investment until it could be financed with
internally generated funds, suggesting the firms face real
(or self-imposed) capital constraints.^
We also find that the most important class of invest-
ments is "replacement" for almost 50% of the firms.
Discounted cash fiow calculations may not be required
to justify replacement investments if the owner is com-
mitted to maintaining the firm as a going concern and if
the firm has limited options about how and when to
replace equipment.
Finally, investments in new product lines are the most
important class of investments for almost one quarter of
the sample firms. Because the ultimate success of this
type of investment is often uncertain, it can be difficult to
obtain reliable future cash fiow estimates, reducing the
value of discounted cash fiow analysis. Thus, our results
suggest that optimal methods of capital budgeting analy-
sis can differ between large and small firms.
^Survey participants were asked: "Suppose you had the opportunity
to make an investment in your business that would allow eamings to
rise 25% within the next two years. The project had minimal risk, but
you did NOT have the cash right then to make the investment. Would
you most likely . . . ?" The choices included waif until you accumulate
enough cash, borrow the money and make the investment, seek an out-
side investor, and other Wait until you accumulate enough cash was
selected by 45% of the respondents.
JOURNAL OF APPLIED FINANCE — FALL/WINTER 2006
I. Capital Budgeting Theory and
Smail Firms
Brealey and Myers (2003) present a simple rule man-
agers can use to make capital budgeting decisions: Invest
in all positive net present value projects and reject those
with a negative net present value. By following this rule,
capital budgeting theory says firms will make the set of
investment decisions that will maximize shareholder
wealth. And, because net present value is a complete
measure of a project's contribution to shareholder wealth,
there is no need for the firm to consider altemative capi-
tal budgeting tools, such as payback period or account-
ing rate of return.
Yet, small firms often operate in environments that do
not satisfy the assumptions underlying the basic capital
budgeting model. And, small firms may not be able to
make reliable estimates of future cash fiows, as required
in discounted cash fiow analysis. We discuss these poten-
tial problems in detail, and explain why discounted cash
fiow analysis is not necessarily the one best capital budg-
eting decision tool for every small firm.
A. Capital Budgeting Assumptions and
the Small Firm
Capital budgeting theory typically assumes that the
primary goal of a firm's shareholders is to maximize firm
value. In addition, the firm is assumed to have access to
perfect financial markets, allowing it to finance all value-
enhancing projects. When these assumptions are met,
firms can separate investment and financing decisions
and should invest in all positive net present value projects
(Brealey and Myers, 2003).
There are at least three reasons to question the appli-
cability of this theory to small firms. First, shareholder
wealth maximization may not be the objective of every
small firm. As Keasey and Watson (1993) point out, an
entrepreneur may establish a firm as an altemative to
unemployment as a way to avoid employment boredom
(i.e., as a life-style choice) or as a vehicle to develop,
manufacture, and market inventions. In each case, the
primary goal of the entrepreneur may be to maintain the
viability of the firm, rather than to maximize its value.'
Second, many small firms have limited management
resources, and lack expertise in finance and accounting
(Ang, 1991). Because of these deficiencies, they may not
evaluate projects using discounted cash fiows. Providing
Mn a survey of Swiss firms, Jorg, Loderer, and Roth (2004) find that
maintaining the independence of the firm was cited more frequently
than shareholder value maximization as a goal of managers. They also
find that firms pursuing goals other than shareholder value maximi-
zation were less likely to rely on discounted cash flow analysis for
investment decisions.
 DANIELSON & SCOTT —THE CAPITAL BUDGETING DECISIONS OF SMALL BUSINESSES 47

some support for this conjecture, Graham and Harvey
(2001) find that small-firm managers are more likely to
use less sophisticated methods of analysis, such as the
payback period."
The final impediment is capital market imperfections,
which constrain the financing options for small firms.
Some cannot obtain bank loans because of their informa-
tion-opaqueness and lack of strong banking relationships
(e.g., Petersen and Rajan (1994) (1995) and Cole (1998)).
Ang (1991) notes that access to public capital markets
can be expensive for certain small firms and impossible
for others. These capital constraints can make it essential
for small firms to maintain sufficient cash balances
in order to respond to potentially profitable investments
as they become available (Almeida, Campello, and
Weisbach, 2004). Thus, capital constraints provide small
privately held firms with a legitimate economic reason to
be concerned about how quickly a project will generate
cash flows (i.e., the payback period).
decisions. In many cases, replacing equipment is not
a discretionary investment for a small firm; the firm
must replace the equipment to stay in business. In
some replacement decisions, a small firm may have
limited replacement options and differences in the future
maintenance costs of the various options can be difficult
to forecast.'
Because small firms do not satisfy the assumptions
underlying capital budgeting theory, and because of
these cash flow estimation challenges, it would be natu-
ral for small firms to evaluate projects using different
techniques than large firms. But, evidence about these
differences is largely anecdotal. We use survey data to
document the capital budgeting practices of small firms
and to provide evidence about whether small-firm project
evaluation methods are related to the type of investment
under consideration.
II. Description of Data

B. Cash Flow Estimation Issues The use of survey data to document capital budgeting
practices has a long history in the finance literature.' Yet,
In his critique of capital budgeting theory. Booth survey results should be interpreted with caution because
(1996) describes estimation issues managers must confi-ont surveys measure manager beliefs, not necessarily their
when implementing discounted cash flow analysis. He actions; survey participants may not be representative of
concludes that discounted cash flow analysis is less the defined population of firms; and survey questions
valuable when the level of future cash flows is more may be misunderstood by some participants (Graham
uncertain. According to this view, discounted cash flow and Harvey, 2001, p. 189). Nonetheless, surveys provide
analysis can be applied most directly to projects with cash information that cannot be readily gleaned from finan-
flow profiles similar to the firm's current operations (such cial statements. In particular, surveys can shed light on
as projects extending those operations). Discounted cash how firms make investment and financing decisions and
fiow analysis will be less valuable to evaluate ventures why they use these approaches.
that are not directly related to current activities. The data for this study were collected for the NFIB
Although Booth developed these ideas for large mul- Research Foundation by the Gallup Organization. The
tinational corporations, they can also be applied to small interviews for the survey were conducted in April and
firms. If a small firm is considering investment in a new May 2003 from a sample of small firms, defined as a
product line, future cash flows cannot be estimated business employing at least one individual in addition to
directly from the past performance of the firm's current the owner, but no more than 249. The sampling frame for
operations. In addition, because of the firm's scale, mar- the survey was drawn at the NFIB's direction from the
ket research studies to quantify fiiture product demand files of the Dun & Bradstreet Corporation. Because the
(and cash flows) might not be cost effective. For these
reasons, small firms may not rely exclusively on dis-
'Booth (1996) also concludes that discounted cash flow analysis might
counted cash flow analysis when evaluating investments not be used for replacement decisions, but for a different reason. He
in new product lines. argues that the payback period combined with judgment can often lead
There are also reasons why a small firm may not use a firm to the correct decision for replacement projects, making dis-
discounted cash flow analysis to evaluate replacement counted cash flow analysis unnecessary.
'Scott and Petty (1984) summarize the results of 21 early studies of
"The small firms in Graham and Harvey (2001) have up to $1 billion large firm capital budgeting practices. The selection criteria in these
in annual revenues. Thus, it is likely that many of these firms have studies include membership in the Fortune 500/1000, a minimum level
more complete management teams than the small firms envisioned by of capital expenditures, size, or stock appreciation in excess of certain
Ang (1991). In contrast, we evaluate the capital budgeting policies of benchmarks. In more recent studies, Moore and Reichardt (1983) sur-
very small firms—our sample includes only firms with less than 250 veyed 298 Fortune 500 firms, Bierman (1993) looked at 74 Fortune
employees, and over 80% of the firms have less than 10 employees— 100 firms, and Graham and Harvey (2001) investigated the behavior
where the problem of incomplete management teams is likely to be of 392 firms chosen from the membership of the Financial Executives
most severe. Institute and the Fortune 500.
48
distribution of small businesses is highly skewed when
ranked by number of employees, interview quotas were
used to add more larger firms to the sample. Once the
data were compiled, the responses were weighted to
reflect population proportions based on US Census data,
yielding a sample of 792 observations.
Exhibit 1 summarizes the demographic characteris-
tics of the sample—industry, sales growth, business age,
employment, owner education, and owner age. For each
attribute, we group responses into three to five categories.
Exhibit 1 shows 72% of the sample firms are in con-
struction, manufacturing, retail, or wholesale, all indus-
tries requiring substantial capital investments. Service
industries, where capital expenditures may have less
importance, account for 20% ofthe sample.
The sample is distributed evenly across four real sales
growth categories. The high-growth category is defined
as a cumulative (not annualized) increase of 20% or
more over the past two years, and includes 24% of the
sample firms. At the other extreme, 24% of the firms
report two-year sales declines of 10% or more. This dis-
tribution implies that approximately 75% ofthe sample
firms have experienced an average annualized growth
rate of 10% or less over the last two years. Thus, many of
the capital budgeting decisions of small firms may be
focused more on maintaining current levels of service
and quality, rather than on expansion.
Similarly, the sample is distributed fairly evenly across
four business-age categories, ranging from six years in
business or less (23% ofthe sample), to 21 years in busi-
ness or more (27% ofthe sample). The number of years
in business could infiuence both the type of investments
a firm will make and the firm's planning process. For
example, firms in business longer may have more equip-
ment in need of replacement. A business with a limited
operating history may not be able to obtain a bank loan
unless it can demonstrate that it has appropriate planning
processes in place.
The median (mean) number of total employees is 4
(9). 16% of the firms have only one employee, and only
18% have 10 or more. Thus, it is likely that many sample
firms do not have complete management teams, and may
not have adequate staff to fully analyze capital budgeting
alternatives.
The data in Exhibit 1 also suggest that the educational
background of owners could influence how the firm
makes capital budgeting decisions. Over 50% of the
business owners do not have a four-year college degree,
and only 13% have an advanced or professional degree.
Therefore, many ofthe small-business owners may have
an incomplete (or incorrect) understanding of how capi-
tal budgeting alternatives should be evaluated.
Finally, 63% of the business owners are at least 45
years old, and 32% are 55 or older. There is some evi-
dence that older managers evaluate capital investments
JOURNAL OF APPLIED FINANCE — FALL/WINTER 2006
using less sophisticated methods (see Graham and
Harvey, 2001).
III. Survey Results
We use the NFIB survey to address three questions
concerning the capital budgeting activities of small firms.
We first consider whether the investment and financing
activities of small firms conform to the assumptions
underlying capital budgeting theory. Then, we look at
the overall planning activities of small firms (e.g., use of
business plans, consideration of tax implications) and
identify firm characteristics that tend to be present when
more sophisticated practices are in place. Finally, we
provide evidence about the specific project evaluation
techniques small firms use (e.g., payback period, dis-
counted cash flow methods). We identify significant dif-
ferences between the average responses in various
subsets of firms and the overall sample averages using a
binomial Z-score. We use multinomial logit to evaluate
how the choice of investment evaluation tools is related
to a set of firm characteristics.
A. Investment Activity
Exhibit 2 describes the investment activities of sample
firms. It identifies the firms' most important type of
investment over the previous 12 months, and reports the
percentage of firms that will delay a potentially profita-
ble investment until the firm has enough internally gen-
erated cash tofiandthe project.
The most important type of investment is replacement
for 46% ofthe sample firms. Firms in service industries
were more likely than the average sample firm to select
this response, and those in construction and manufactur-
ing were less likely. Firms with the highest growth rates
and those in business less than six years were less likely
than the average sample firm to report replacement activ-
ity as the primary investment type. Finally, the impor-
tance of replacement activity increases with the age
of the business owner; it is significantly less than the
overall sample mean when the business owner is younger
than 44.'
'The significance of the subsample entries depends on the difference
between the subsample mean and the overall sample mean in a given
column, and on the number of observations in the subsample (most of
these numbers appear in Exhibit 1). Thus, it is possible for two sub-
samples to have similar response percentages, one significant and the
other not. For example, 54% ofthe service firms identify replacement
as the primary investment type, while 55% ofthe firms in the "other"
industry category select this investment type. This response percentage
is significantly different from the overall sample average for service
firms, but not for the "other" firms. As shown in Exhibit 1, there are
twice as many service industry firms.
DANIELSON & SCOTT —THE CAPITAL BUDGETING DECISIONS OF SMALL BUSINESSES 49
Exhibit 1. Sample Description

The weighted distributions of the responses to the National Federation of Independent Business' Reinvesting in the Business
Survey conducted by the Gallup Organization.

No. of Obs % of Total

Industry
Service 155 20
Construction/manufacturing 194 24
Retail/wholesale 378 48
Other 65
Real 2-year sales growth
20 percent or higher 194 24
10-19 percent 179 23
+/- 10 percent 200 25
-10 percent or lower 187 24
No answer 32 4
Business age
< 6 years 183 23
6-10 years 173 22
11-20 years 213 27
21 + years 216 27
No answer 7 1
Employment
1 127 16
2-3 233 29
4-10 287 36
10+ 145 18
Owner education level
Less than college degree 415 52
College degree 260 33
Advanced/prof, degree 105 13
No answer 12 2
Owner age
<35 years 81 10
35-44 years 194 24
45-54 years 244 31
55+ years 255 32
No answer 18 2
Total 792 100

Projects to extend existing product lines are shown as
the primary investment activity for 21% ofthe sample
firms. Construction and manufacturing firms select this
response at a higher rate than the overall sample average.
The remaining subsample averages are not significantly
different from the overall sample averages (at the 5%
significance level).
Investments in new product lines are reported as the
most frequent investment for 23% of the sample firms.
Firms in the service industry were less likely than the
average sample firm to select this response. Firms with
the highest growth rates were more likely (than the over-
all sample average) to be expanding into new product
lines, while those with the lowest growth rate were less
likely. The oldest firms were also less likely than the
average firm to be considering expansion into new prod-
uct lines.
Exhibit 2 also suggests that many small firms face
real (or self-imposed) capital constraints. Approximately
45% of the sample firms report they would delay a
promising investment until it could be financed with
internally generated funds (wait for cash). Firms most
likely to wait for cash include the youngest firms,
the smallest firms, and those whose owner does not
have a college degree. As these firms are likely to face
capital market constraints, this result supports the pre-
diction in Almeida, Campello, and Weisbach (2004)
that capital constraints will make a firm more likely to
save cash. Firms with older owners are also slightly
more likely to wait for cash than firms with younger
owners.
These results suggest three reasons small firms
might not follow the prescriptions of capital budgeting
theory when evaluating projects. First, it is noteworthy
50 JOURNAL OF APPLIED FINANCE — FALUWINTER 2006

Exhibit 2. Investment Activity

Percentage distributions are presented for the question, "Measured in dollars, what was the purpose of the largest share of the
investments made in your business in the last 12 months?" The last column presents the percentage of all firms that would delay
investments until they could befinancedinternally with cash. ++ (- -) indicates that the cell percentage is significantly greater
than (less than) the column total, at a 5% significance level, and + (-) indicates that the cell percentage is significantly greater than
(less than) the column total, at a 10% significance level, using a binomial Z-score.

Type of Investment Recently Made

Expand Existing New Product Wait for
Replace Product Line Other Cash
Industry
Service 54** 21 16- 3 42
Construction/manufacturing 30" 31** 28* 1- 42
Retail/wholesale 49 18 24 5 45
Other 55 12- 22 9** 56
Real 2-year sales growth
20 percent or higher 37" 24 31** 5 45
10-19 percent 52 21 21 3 50
+/- 10 percent 50 22 23 3 35
-10 percent or lower 47 20 16- 5 47
Business age
<6 years 38" 23 26 4 52
6-10 years 40 27* 27 2 44
11-20 years 51 16- 24 3 38
21 + years 51 20 17" 6 45
Employment
1 47 20 20 5 58
2-3 47 20 21 4 43
4-10 42 25* 26 2- 43
10+ 48 19 23 5 37
Owner education level
Less than college degree 44 21 23 4 49
College degree 45 20 23 4 38
Advanced/prof, degree 53 22 23 1 44
Owner age
<35 years 33" 23 29 9** 42
35-44 years 38" 23 28 4 38
45-54 years 49 21 23 1" 49
55+ years 51 20 19 4 47
Total 46 21 23 4 45

that replacement activity is the most important type
of investment for almost half of the sample firms. If
replacing old equipment is necessary for the firm to
remain in business, the owner's capital budgeting
decision is essentially a choice between replacing
the machine and staying in business, or closing the busi-
ness and finding employment elsewhere. In this case,
maintaining the viability ofthe firm as a going concem,
rather than maximizing its value, might be the owner's
primary objective.
Second, the results suggest that many small firms
place internal limits on the amount they will borrow.
Thus, many small firms cannot (or choose not to) separate
investment and financing decisions, contrary to capital
budgeting theory.
Finally, the results suggest that the personal financial
planning considerations of business owners may affect
the investment and financing decisions of small firms. In
particular, older owners are more conservative in their
strategies than younger owners (older owners focus more
on replacement activity and are more likely to report that
they will wait for cash). These results conflict with an
assumption of capital budgeting theory: that the transfer-
ability of ownership interests (at low cost) allows man-
agers to separate the planning horizon of a business irom
the planning horizon of its owners.
DANIELSON & SCOTT —THE CAPITAL BUDGETING DECISIONS OF SMALL BUSINESSES
B. Planning Activity
Exhibit 3 analyzes three dimensions of each firm's
planning environment: how frequently firms estimate
cash fiows in making capital budgeting decisions;
whether they have written business plans; and whether
they consider tax implications in making capital budget-
ing decisions.
Exhibit 3 reports that only 31% of the sample
firms have a written business plan. Over 30% of the
sample firms do not estimate future cash fiows when
making investment decisions, and 26% of the firms
do not consider the tax implications of investment
decisions. Thus, many small firms do not have a
formal planning system that guides capital budgeting
decisions.
Firms with the highest growth rates (over 20% growth)
are more likely to use each of these planning tools, par-
ticularly written business plans and consideration of tax
effects. Similarly, firms that extend existing product lines
or invest in new lines of business engage in more plan-
ning activities than the average sample firm. As firms
expand, they use up more of their borrowing capacity,
reducing their future financial fiexibility (assuming that
they face capital constraints). For these firms, it may be
essential to plan ahead, so the firm is not forced to pass
up promising opportunities in the future.
Newer firms (less than six years old) and younger
owners (less than 45 years old) are more likely than other
firms to use written business plans. This is an expected
result, given that banks require evidence of planning
before extension of credit to firms with short operating
histories.
The smallest firms (three or fewer employees) are
less likely to make cash fiow projections, while firms
with ten or more employees are more likely to make
these estimates. This finding supports conjectures
made by Ang (1991) and Keasey and Watson (1993) that
personnel constraints (incomplete management teams)
may hamper small firms in planning.
The planning activities of small firms are also strongly
related to the educational background of the business
owner. If the business owner does not have a college
degree, the firm is less likely than the averagefirmto make
cash fiow projections or to use written business plans. If
the business owner has an advanced/professional degree,
the firm is more likely to engage in such activities.
C. Project Evaluation iVIethods
Exhibit 4 summarizes responses about the primary
tool firms use to assess a project's financial viability:
payback period, accounting rate of return, discounted
51
cash fiow analysis, "gut feel," or combination. The most
common response is the least sophisticated, gut feel—
selected by 26% ofthe sample firms.^
The use of gut feel is strongly related to the business
owner's educational background. Owners without a col-
lege degree resort to it most frequently, and owners with
advanced degrees least. The use of gut feel is also
inversely related to a firm's use of planning tools. Firms
with written business plans and firms that make cash
fiow projections are significantly less likely to rely on
gut feel.
While the use of gut feel is concentrated in the least
sophisticated of small firms, it is also widely used by
firms that make primarily replacement investments. A
firm may have limited options when it replaces equip-
ment, and estimating future cash fiows (i.e., incremen-
tal maintenance costs or efficiency gains) for each
option might be difficult. For example, if a firm must
replace a delivery truck, it may be difficult for the firm
to estimate differences in the future annual operating
costs of two replacement vehicles under consideration.
Moreover, if an investment is necessary for the firm's
survival (and the owner is committed to maintaining
the business as a going concem), the maximization of
firm value may not be the business owner's primary
objective. Instead, the owner may simply look for the
altemative promising the required level of performance
at the most reasonable cost. Thus, it is not surprising to
find that small business owners use relatively unsophis-
ticated methods of analysis to evaluate replacement
options.
Gut feel is also used extensively by firms in the ser-
vice industry. Although some service firms make sub-
stantial capital expenditures, the investments of many
service firms might be limited to business vehicles or
office equipment. Because a firm's primary considera-
tions when evaluating this type of purchase decision may
be cost, reliability, and product features, stmcturing a
discounted cash fiow analysis of these investments can
be difficult.
Payback period is the second most common response,
selected by 19% of the sample. The payback period
is used slightly more often by firms that will wait for
cash, as expected. Firms using the payback period are
significantly more likely than other firms to estimate
future cash fiows (because cash fiow estimates are
required for this calculation). Finally, use ofthe payback
period appears to increase with the formal education of
the business owner.
These results suggest that the payback period con-
veys important economic information in at least some
'Vos and Vos (2000) report "intuition" as the most frequently used
project evaluation technique in a survey of 238 small New Zealand
businesses.
52 JOURNAL OF APPLIED FINANCE — FALL/WINTER 2006

Exhibit 3. Investment Planning Tools

Responses are presented to three questions about planning tools used in the evaluation of capital investments. "Make CF
Projections" presents the percentage of respondents who said they typically make cash flow projections prior to making a major
investment in their business. "Written Business Plan" presents the percentage of respondents who said they had a written business
plan projecting the major investments planned over the next few years. "Taxes Calculated/Considered" presents the percentage
of respondents who reported they typically calculated or considered the tax implications of a major investment in their business.
++ (—) indicates that the cell percentage is significantly greater than (less than) the column total, at a 5% significance level, and
+ (-) indicates that the cell percentage is significantly greater than (less than) the column total, at a 10% significance level, using
a binomial Z-score.

Planning Tools

Make CF Projections Written Business Plan Taxes Calculated/Considered

Industry
Service 71 34 72
Construetion/manufacturing 68 32 71
Retail/wholesale 70 30 75
Other 67 27 83*
Real 2-year sales growth
20 percent or higher 74 38** 79*
10-19 percent 66 29 75
+ / - 1 0 percent 68 28 74
—10 percent or lower 70 29 68
Business age
<6 years 80** 46** 79*
6-10 years 71 28 72
11-20 years 71 28 72
21+years 58"- 23"- 74
Employment
1 61" 35 75
2-3 64- 24-- 77
4-10 72 33 72
10+ 81** 36 74
Owner education level
Less than college degree 65- 27- 73
College degree 73 35 75
Advaneed/prof. degree 81** 38 83**
Owner age
<35 years 80 40* 73
35-44 years 73 37* 78
45-54 years 69 34 73
55+years 66 21- 74
Wait for cash 69 32 77
Investment type
Replacement 67 23- 72
Expand existing product 71 37* 76
New product line 74 42** 80*
Other 81 49* 83
Total 69 31 74

circumstances. For example, the payback period can be
a rational project evaluation tool for small firms facing
capital constraints (i.e., firms that do not operate in
the perfect financial markets envisioned by capital budg-
eting theory). In this case, projects that return cash
quickly could benefit a firm by easing future cash flow
constraints.
The accounting rate of return is the next most frequent
choice, identified by 14% ofthe firms as their primary
evaluation method. The use of accounting rate of return
increases with firms' growth rates; it is significantly
higher than the sample mean for firms entering new lines
of business. Each of these characteristics can indicate
high borrowing needs. The accounting rate of return is
OANIELSON & SCOTT—THE CAPITAL BUDGETING DECISIONS OF SMALL BUSINESSES 53

Exhibit 4. Investment Decision Tools

Responses are presented to the question about the investment tools used to assess the financial viability of a major investment
in the business. ++ (—) indicates that the cell percentage is significantly greater than (less than) the column total, at a 5%
significance level, and + (-) indicates that the cell percentage is significantly greater than (less than) the column total, at a 10%
significance level, using a binomial Z-score.

Investment Tools
Payback ARR DCF Gut Feel Combination
Industry
Service 18 II 13 33** II
Construction/manufacturing 19 14 11 22 15*
Retail/wholesale 19 16 13 25 8-
Other 23 6- 9 29 14
Real 2-year sales growth
20 percent or higher 15 17 14 26 9
10-19 percent 26** 14 11 27 9
+/- 10 percent 21 12 11 24 12
-10 percent or lower 18 11 14 31 9
Business age
<6 years 21 14 18** 24 8
6-10 years 19 10 12 29 9
11-20 years 17 19** 13 23 11
21 + years 20 11 7-- 28 14
Employment
1 22 14 13 25 11
2-3 20 15 11 25 12
4-10 16 12 13 28 10
10+ 21 16 12 25 9
Owner education level
Less than college degree 18 12 12 29 10
College degree 20 18* 10 23 12
Advanced/prof, degree 24 11 17** 17- 13
Owner age
<35 years 26 10 14 19 14
35-44 years 14-- 19** 18** 21 11
45-54 years 24** 15 7" 31* 10
55+ years 16 11 13 27 11
Wait for cash 21 12 15 24 8
Investment type
Replacement 20 11 12 31** 13
Expand existing product 20 14 17* 20- 8
New product line 19 20** 9 23 13
Other 21 17 14 14 3
Planning tools
Cash flow projection made 23** 15 14 22- 13
Written business plan 19 18* 16* 20- 13
Taxes calculated/considered 20 16 14* 24 12
Total 19 14 12 26 11

thus especially important if a firm must provide banks
with periodic financial statements or is required to comply
with loan covenants based on financial statement ratios.
The most theoretically correct method—discounted
cash flow analysis—is the primary investment evalua-
tion method of only 12% of the firms. Not surprisingly,
owners with advanced/professional degrees are most
likely to use this method; 17% of these firms identify it
as their primary evaluation tool. Firms with written
business plans and those that consider the tax implica-
tions of investments are also significantly more likely
to use discounted cash flow techniques. Thus, firms using
this project evaluation method are among the most so-
phisticated of the small firms.
Firms extending existing product lines are also signifi-
cantly more likely to use discounted cash flow analysis.
54 JOURNAL OF APPLIED FINANCE — FALL/WINTER 2006

This result is evidence that discounted cash flow analysis capital constraints and the type of investment (e.g.,
is most useful when evaluating projects with cash flow replacement, expand product line, new product line) can
profiles similar to current operations (such as projects influence how firms evaluate projects.
extending existing product lines), because it is easier to The wait for cash coefficient is positive and signifi-
obtain reliable cash flow estimates in this case. cant for both payback period and discounted cash flow
Another noteworthy finding is that 18% of the firms analysis. These results suggest that firms committed to
in business less than six years use this method, the most funding projects internally are not necessarily irrational
of any age group. Although younger firms are less likely or unsophisticated. Instead, the decision to wait for cash
to have complete management teams in place, it is also might be an acknowledgment that the firm does not oper-
possible that banks may encourage newer firms to dem- ate in a perfect financial market, and faces capital con-
onstrate adequate planning (and project evaluation) straints. Because the firm knows it may not be able to
procedures before qualifying for credit. fund all valuable projects, it will evaluate projects using
Of the specific evaluation techniques firms could the payback period (to help it allocate investment funds
choose from, combination of methods was selected least over a multiyear horizon) or discounted cash fiow analy-
often, by 11% of firms. Use of this approach does not sis (to help it identify the best projects).
appear to be strongly related to any of the firm character- The accounting rate of return is fi-equently the choice
istics listed in Exhibit 4. of firms pursuing either growth strategy: expand product
line or new product line. The coefficients for both of these
The results in Exhibit 4 are very different fi^om results
in Graham and Harvey (2001). Approximately 75% of variables are positive and significant for accounting rate
of return. As a firm grows, it may need to raise new capi-
their firms evaluate projects using estimates of project net
present value or internal rate of return. The vast majoritytal, either by obtaining a bank loan or by attracting new
of their firms also appear to consider multiple measures ofequity investors. In either case, the firm's historical and
project value in making investment decisions. However, projected financial statements will be used to communi-
even the smaller firms in the Graham and Harvey study cate information about the firm to investors. The account-
are much larger than the firms in our sample and are thus ing rate of return can be valuable tofirmspursuing growth
more likely to have complete management teams. It is strategies because it provides information about how a
therefore not surprising that their firms use more sophis- project will affect a firm's financial statements (and its
ticated methods of project analysis. ability to meet accounting-based loan covenants).
The importance of discounted cash fiow analysis
D. Multivariate Analysis depends on the type of growth the firm is pursuing. The
coefficient for expanding an existing product line is posi-
To provide a multivariate perspective on how small tive and significant for discounted cash fiows, but the
firms make investment decisions, we use multinomial coefficient for new product line is not. Firms will use
logit to jointly identify factors influencing the choice of discounted cash fiows to evaluate projects that extend
a project evaluation tool. This technique is appropriate existing product lines because future cash fiow estimates
when an unordered response, such as a set of project can be based on past performance in this case. But, if it
evaluation tools, has more than two outcomes. is contemplating a new product line, where obtaining
Exhibit 5 reports the results of this exercise; gut feel future cash fiow estimates can be difficult, the firm is less
is the omitted category. Thus, the coefficients listed in likely to use a discounted cash fiow method of analysis.
Exhibit 5 should be interpreted as the increase (a positive
coefficient) or the reduction (a negative coefficient) in
the log odds between the evaluation tool specified and IV. Summary
gut feel.
The results show that firms using any of the formal Firms with fewer than 250 employees analyze poten-
investment evaluation tools are more likely to make cash tial investments using much less sophisticated methods
flow projections than firms using gut feel. Firms using than those recommended by capital budgeting theory. In
the accounting rate of return, discounted cash fiow, or a particular, survey results show these businesses use dis-
combination of methods are more likely to consider tax counted cash fiow analysis less frequently than gut feel,
implications when they evaluate projects. These results payback period, and accounting rate of return.
corroborate the results in Exhibit 4—-firms using gut feel Many small-business owners have limited formal edu-
to evaluate projects have much less structured planning cation, and their firms may have incomplete manage-
environments than other firms. ment teams. Therefore, a lack of financial sophistication
Exhibit 5 also identifies factors that differentiate is an important reason why the capital budgeting prac-
between firms attaching primary importance to the vari- tices of small firms differ so dramatically fi-om the rec-
ous investment evaluation tools. The results suggest that ommendations of theory. Small staff sizes also constrain
 DANIELSON & SCOTT—THE CAPITAL BUDGETING DECISIONS OF SMALL BUSINESSES 55

Exhibit 5. Multinomiai Logit Results

Mulitnomial logit estimates are presented of the factors that affect the decision tool most frequently used to assess the financial
viability ofa project. All of the dependent variables are 1/0 variables that take a value of 1 if the method of investment evaluation
in each column is reported for large investments. The omitted choice is Gut Feel; thus the significance of the coefficients should
be interpreted as the effect on the log odds of the evaluation tool choice relative to Gut Feel. In each case where there is a set
of 1/0 variables for the independent variable, the omitted variable is identified and significance should be interpreted relative
to this omitted variable. The observations included in these estimates are limited to those respondents reporting one of the five
investment analysis techniques, which limits the sample size to 583 observations.

Payback Rate of Return DCF Combination

Coeff Std Err Coeff Std Err Coeff Std Err Coeff Std Err
Industry
Manufacturing/construction 0.221 0.332 0.512 0.383 0.040 0.399 0.512 0.379
Retail/wholesale -0.063 0.287 0.621 0.333* 0.259 0.334 -0.505 0.362
Service/other (omitted)
Real 2-year sales growth
10 percent or higher (omitted)
No change (+/- 10 percent) 0.374 0.296 -0.142 0.336 0.347 0.360 0.250 0.356
-10 percent or lower -0.330 0.305 -0.420 0.338 0.226 0.342 -0.252 0.366
Business age
Under 6 years (omitted)
6-10 years 0.151 0.362 -0.216 0.411 -0.179 0.400 0.349 0.489
11-20 years 0.451 0.381 0.924 0.391** 0.314 0.403 1.404 0.485***
20+ years 0.604 0.384 0.442 0.422 -0.482 0.461 1.671 0.499***
Employment
Under 4 (omitted)
10-Apr -0.666 0.278** -0.570 0.310* -0.346 0.321 -0.838 0.336**
Over 10 -0.503 0.331 -0.336 0.358 -0.243 0.397 -1.067 0.418**
Owner education level
College (BA or AA) 0.251 0.268 0.299 0.287 -0.206 0.322 0.085 0.327
Graduate school 0.915 0.388** 0.059 0.461 0.683 0.439 1.104 0.472**
No college (omitted)
Owner age
Under 35 1.367 0.486*** 0.249 0.578 0.448 0.551 1.712 0.603***
35-44 0.448 0.371 0.881 0.374** 0.565 0.378 0.803 0.441*
45-54 0.432 0.296 0.164 0.336 -^.845 0.384** 0.089 0.370
55 up (omitted)
Wait for cash 0.426 0.241* -0.084 0.269 0.593 0.280** -0.452 0.305
Investment type
Replacement (omitted)
Expand product line 0.381 0.313 0.640 0.339* 0.880 0.343** -0.018 0.395
New product line 0.255 0.305 0.637 0.322** 0.031 0.377 0.334 0.361
Planning tools
Cash flow projection made 1.297 0.286*** 0.635 0.296** 0.731 0.323** 1.157 0.357***
Written business plan -0.041 0.275 0.363 0.297 0.422 0.308 0.397 0.322
Taxes calculated/considered -0.047 0.274 0.744 0.344** 1.020 0.394*** 0.762 0.388**
Constant -3.836 1.512** -1.849 1.646 -0.461 1.738 -3.402 1.898*

***significantat theO.Ol level.

**significant at the 0.05 level.
•significant at the 0.10 level.

the atnount of capital budgeting analyses the fimis can
perform. Beyond this, there are also substantive reasons
a stnall firtn tnight choose to use methods other than dis-
counted cash flow analysis to evaluate projects.
The primary reason is that many small businesses do
not operate in the perfect capital markets that capital bud-
geting theory assumes. Most of the firms in our sample
are very small (with fewer than 10 employees); they have
short operating histories (almost half have been in busi-
ness under 10 years), and their owners are not college edu-
cated. These characteristics may limit their bank credit,
posing credit constraints. Ifso, these firms may be required
56
to finance some future investments using internally gener-
ated funds, and it would not be surprising for the owners
to consider measures of project liquidity (such as the pay-
back period) when making investment decisions.
Second, many of the investments that small firms
make cannot easily be evaluated using the discounted
cash flow techniques recommended by capital budgeting
theory. Many investments by small firms are not dis-
cretionary (a firm either makes a specific investment
or it goes out of business), and future cash flows can be
difficult to quantify. For example, if a firm is introducing
a new product line, estimates of future cash flows can be
imprecise (and market research studies required to obtain
better cash flow estimates may not be cost effective).
References
Almeida, H., M. Campello, and M. Weisbach, 2004, "The Cash
Flow Sensitivity of Cash," Journal of Finance 59 (No. 4, August),
1777-1804.
Ang, J., 1991, "Small Business Uniqueness and the Theory of Financial Keasey K. and R. Watson, 1993, Small Firm Management: Ownership,
Management," The Journal ofSmall Business Finance I (No. 1), 1-13.
Bierman, H., 1993, "Capital Budgeting in 1992: A Survey, " Financial
Management 22 (No. 3, Autumn), 24.
Booth, L., 1996, "Making Capital Budgeting Decisions in Multinational
Corporations," Managerial Finance 22 (No. I), 3—18.
Brealey R. and S. Myers, 2003, Principles of Corporate Finance, New
York, McGraw-Hill/lrwin.
Cole, R., 1998. "The Importance of Relationships to the Availability
of Credit," Journal of Banking and Finance 22 (Nos. 5-8, August),
959-977.
Danielson, M. and J. Scott, 2004. "Bank Loan Availability and Trade
Credit Demand," Financial Review 39 (No. 4, November), 579-600.
Graham J. and C. Harvey, 2001. "The Theory and Practice of Corporate
Finance: Evidence from the Field," Journal of Financial Economics
60 (Nos. 2-3, May), 187-243.
JOURNAL OF APPLIED FINANCE — FALL/WINTER 2006
When future cash fiows cannot be easily estimated, dis-
counted cash fiow analysis may not provide a reliable
estimate of a project's contribution to firm value, and it
is not surprising that a firm might resort to gut feel to
analyze the investment.
For these reasons, small firms face capital budgeting
challenges that differ from those faced by larger firms.
Thus, it is possible that optimal capital budgeting meth-
ods for large and small firms may differ. However, a fully
integrated capital budgeting theory—identifying the
conditions under which discounted cash flow analysis is
appropriate—has yet to be developed. The question of
how to better tailor the prescriptions of capital budgeting
theory for small firms remains unanswered. •
Jorg, P., Loderer, C, Roth, L., 2004, "Shareholder Value Maximization;
WhatManagers Say and What They Do," DB(f£>;eBerrietewi>tec/ifl//
64 (No. 3), 357-378.
Finance and Performance, Oxford, Blackweil.
Moore J. and A. Reichert, 1983. "An Analysis of the Financial
Management Techniques Currently Employed by Large US
Corporations," Journal of Business Finance and Accounting 10
(No. 4, Winter), 623-645.
Petersen, M. and R. Rajan, 1994. "The Benefits of Firm-Creditor
Relationships: Evidence from Small Business Data," Journal of
Finance 49 (No. 1, March), 3-37.
Petersen, M. and R. Rajan, 1995. "The Effect of Credit Market
Competition on Lending Relationships," Quarterly Journal of
Economics 60 (No. 2, May), 407-444.
Scott, D. Jr., and W. Petty II, 1984. "Capital Budgeting Practices in
Large American Firms: A Retrospective Analysis and Synthesis,"
Financial Review 19(No. 1, March), 111-123.
Vos, A. and E. Vos, 2000. "Investment Decision Criteria in Small New
Zealand Businesses," Small Enterprise Research 8 (No. 1), 44—55.