CHAPTER-2

REVIEW OF LITERATURE
Van Horne (1971) showed that to be consistent, inflation in forecasting cash flows must also be
reflected in a discount rate containing inflation; that is, a bias was introduced if nominal cash
flows were discounted at the real and not nominal cost of capital.

Rappaport and Taggart (1982) examined various methods for incorporating the effect of
inflation into capital budgeting. They provided an analysis which showed the differential impact
of using a gross profit per unit approach, a nominal cash flow approach (where individual
forecasts are incorporated into each component of cash flow) and a real cash flow approach in
which a general price deflator is used to deflate nominal cash flows. They attempt to combine
the simplicity of a gross profit per unit methodology of adjusting for inflation with the more
realistic nominal case flow and real cash flow approaches.

Moore and Reichert (1983) determined that the economic conditions have placed increased
importance upon rigorous financial analysis. In order to determine which analytical techniques
are currently employed by management, a questionnaire was sent to each firm on the May
1980, FORTUNE 500 list. The research sought to establish a profile of the respondents'
organizational structure and to identify the primary procedures used in risk assessment,
working capital management, capital budgeting, and operations research modeling. The results
do suggest a basic profile of the more active employers of analytical techniques. Relatively
sophisticated capital budgeting procedures appear to be accepted across most industries, and
many firms support their decision making with a “package” of formal tools.

Andrews and Butler (1986). They received 132 responses out of 500 companies and they found
that larger firms tended to employ more sophisticated capital budgeting techniques. The uses
of capital budgeting techniques in South Africa were also investigated by . In his studies,
useable responses from 65 respondents out of a total population of 300 provided similar results
to those of previous South African studies.

Chadwell-Hatfield et al(1993) looked into the financial criteria used to evaluate projects, capital
budgeting and risk analysis techniques employed by medium and small US manufacturing firm.
In their survey, it was found that a large number of firms did not formally analyze all proposals.
The results also showed that multiple evaluation techniques were preferred in the analysis of
proposals. Techniques that were problematic in theory appealed to managers in practice. They
concluded that their results of the capital budgeting survey were inconsistent with previous
studies and they felt that it was due to the sample they chose.
Jog and Srivastava (1995) conducted a survey of capital budgeting practices in Corporate
Canada and the results showed that the most preferred method was the Payback period
method. Further results indicated that decreased use of ARR in Canada and the United
Kingdom, respectively. It was identified that Canadian firms seem to be increasingly using
sophisticated methods when dealing with risk .

Babu and Sharma (1996) studied Indian industries‘ capital budgeting practices and the findings
showed that 90% of the companies were using capital budgeting methods. Of them 75% of
companies reported that they were adopting DCF methods in evaluating capital budgeting,
among them IRR was most popular. Sensitivity analysis was found to be popular in assessing
risk.

Mills (1996) has explored the question of the impact of inflation on the capital budgeting
process. It had shown that it was reasonable to expect that the cost of capital will increase at
the same rate as the rate of inflation on an ex ante basis, and that this increase will be a
multiplicative relationship. The IRR method gives the rate of return result. This is especially
important in our current economic climate, where businesses were trying to cut costs and only
invest in those projects which will yield a higher rate of return.

Cherukuri (1996) surveyed about capital budgeting practices: a comparative study of India and
select South East Asian countries,‖ with those of Hong Kong, Malaysia and Singapore and a
sample consisted of top 300 non-government companies. This study found that of DCF
methods, 51% of companies used IRR, followed by NPV (30%). Of non DCF methods,PB (38%) is
the dominant method and the next widely used method was ARR (19%). The non DCF methods
were used as supplement to DCF methods. WACC is the widely used discount rate and
Sensitivity analysis was mainly used for risk assessment. A recent survey of capital budgeting
Practices in corporate India. The results confirmed findings of Cherukuri (1996).This study
showed that most preferred method is IRR (56.7%), followed by NPV (50%) and PB
(36.7%).WACC (43.3%) is the widely used discount rate and Sensitivity analysis (36.7%) was
mainly used for risk assessment.

Alhamoud and Ibrahim (1997) surveyed all the 29 publicly owned Qatari companies. The study
found that the payback method was the most widely used method (64.2% of the 24
respondents) followed by IRR (58%), profitability index (37.5%), NPV (20.8%), and ARR (8.3%).
However, no significant differences were found among industries regarding the use of one
technique over another, although discounted cash flows are mainly used by the manufacturing
sector. Some of the researches on the use of capital budgeting in the developed economies
reflect a move towards introducing practical aspects that are intended to refine the existing
capital budgeting methods.
Block (1997) noted that a number of patterns pertaining to capital budgeting were exhibited by
small firms. Payback continued to be the dominant technique employed not due to lack of
sophistication but rather the financial pressures placed on them by financial institutions. In
spite of this, small business has become more sophisticated as over 27% used DCF as the
primary method of analysis as compared to earlier studies. However, this conclusion may be
somewhat misleading as the discount rate was not scientifically calculated.

Graham and Harvey (2001) studied about the theory and practice of corporate finance:
evidence from the field‘ and the sample consisted of 392 CFOs in the USA. In larger firms with
high debt ratio, CFOs with MBA were more likely to use DCF (75% NPV and IRR) than their
counterparts. Larger firms applied risk-adjusted discount rate whereas small firms opted for
Monte Carlo simulation for adjusting risk. In addition, their findings further argued that PB
method has not used as a primary tool, however, it kept as a vital secondary tool. Results were
found that NPV was most popular technique, followed by IRR. Most of the firms used sensitivity
analysis, scenario analysis, inflation adjusted cash flows, economic value added, and
incremental IRR along with NPV and IRR.

Edward et al (2001) found that the early 1950s, the academic community has tried to convince
corporate managers that there are sophisticated techniques that can improve the capital
budgeting decision-making process. Over the years, many studies have documented a trend
toward increasing business use of such sophisticated capital budgeting techniques.The simple
rate of return method is another capital budgeting technique that does not involve discounted
cash flows. The method is also known as the accounting rate of return, the unadjusted rate of
return, and the financial statement method.

Cooper et al. (2002) confirmed the shift towards discounted cash flow techniques over time. In
their analysis of various research projects, they found that as a primary capital budgeting
method the IRR had increased in popularity from 10 per cent in 1959 to 41 per cent by 1975
and to 57 per cent by 1990. However, the NPV did not enjoy either the same popularity or the
same spectacular increase in use over time.

Ryan and Ryan (2002) indicated that financial managers have never been in full agreement as to
the choice of the best capital budgeting method. According to Ryan and Ryan (2002), earlier
studies by Miller in 1960, by Schall, Sundam and Geijsbeek in 1978 and by Pike in 1996 reported
the payback technique to be the preferred method and discounted cash flow models to be the
least popular. This may be attributed to lack of financial sophistication (and even training or
education in corporate finance) and the limited use of computer technology in that era. Ryan
and Ryan (2002) reported more recently, that a decrease in the use of the accounting rate of
return was found by Jog and Srivastava in Canada in 1995 and by Pike in the United Kingdom in
1996.
Arnold and Hatzopoulous (2003) studied the results of a survey of capital budgeting techniques
used by United Kingdom firms. Where possible, the evidence is combined with data collected
over a 22 year period to provide a basis for the discussion of causes of trends. They also
observe that there has been a substantial narrowing of the theory‐practice gap in the use of
project appraisal methods. The gap has also narrowed in other areas: the analysis of risk,
inflation adjustment, capital budget preparation, WACC calculation and post‐auditing.
However, there are other elements of capital budgeting theory, e.g. probability and beta
analysis which have been adopted by very few practising managers. They also discuss non‐
economic projects, capital rationing and hurdle rates.

Sandahl and Sjorgen (2003) this study shows that the public sector companies are most
frequent users of discounted cash flow (DCF) methods. The payback method is the most used in
all industries. The use of the net present value method has increased over the years, although
the use of DCF methods is generally unchanged. Value-based management models have been
introduced in the listed companies. Another conclusion is that tradition is an important factor
explaining the choice of capital budgeting method. Large companies within the manufacturing
industry use DCF methods more often than other companies. In general, the companies seem
unconcerned with the tax consequences of capital budgeting decisions. It would appear as if
the public companies have not adopted capital budgeting practices supporting shareholder
value increases.

Brounen et al. (2004), four European countries viz., U.K., France, Germany and the Netherlands
consisting of 313 companies during 2002 and 2003 were examined. Their result showed that
47% and 67% of the UK companies were used NPV and PB respectively as a primary tool for
evaluating capital budgeting decision whereas companies in Netherlands were used 70% of NPV
and 65% of PB methods. However, companies in France and Germany reported lower usages of
both methods (42% for NPV, 50 % for PB and 44% for NPV, 51 % for PB respectively). Previous
studies have mainly conducted in the U.S. and the UK and limited number of studies are also
available for the Netherlands

Du Toit and Pienaar (2005) also found that companies that undertake relatively large capital
expenditures tend to prefer the IRR and the net present value (NPV) method. There are a
number of studies on risk incorporation in the capital budgeting decision by South African firms.

Gilbert (2005) established to determine the usage of capital budgeting methods and how they
are related to the performance of South African organizations in the manufacturing sector. The
study used of 318 manufacturing organizations as a sample. The study tested the usage of the
tools and their impact of accounting rate of return (ARR), payback method, net present value
(NPV) and the internal return rate (IRR). From this study it was established that 48 of the firms
employed the payback period technique, 25 organizations used purely discounting methods
while the rest of these 318 companies applied a combination of all methods. Even though the
management of these companies had recognized the advantages of using the discounted
methods like cost benefit. Their feedback indicated that they used mostly approximation and
shortcuts, but they have admitted that discounted cash flow methods are very significant and
needs to be considering when making investment decisions.

Holmen (2005) conducted a survey of capital budgeting techniques, used for FDI‘s by Swedish
firms and found that larger firms were preferred to use NPV and IRR methods. However, the
most preferred method was the PB (79%). In a survey of capital budgeting practices of
Australian listed companies.

Pandy (2005) states that the profitability index is the ratio of net present value of cash inflows
at required rate of return to the initial cash out flows of investment. The profitability index, or
PI, method compares the present value of future cash inflows with the initial investment on a
relative basis and payback period is defined as the number of the years required to recover the
original cash outlay invested in the project. He states that the number of period taken in
recovering the investment outlay on presented value basis is the discounted payback period.
Even though the payback method has some cons associated with it, the simplicity of the
method can allow it to be used as a filter for those projects which should go on to a more in-
depth method, if a project is not recommended based on the payback method, then chances
are pretty high the project should not even be considered for the other method .The real
options approach embraces the concept of uncertainty.

Danielson and scott(2006) studied While large firms tend to rely on the discounted cash flow
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
cash flow estimation challenges — to explain why small firms do not exclusively use discounted
cash flow analysis when evaluating projects. These results suggest that optimal investment
evaluation procedures for large and small firms might differ.

Yao et al. (2006) compared the use of capital budgeting techniques and their impact on
performance in Netherlands and China. They compared 250 Dutch and 300 Chinese firms. The
response rates were 87 firms responded in total. Out of these 42 and 45 were Dutch and
Chinese companies, respectively. Notably, these results suggested that 49% CFOs Chinese firms
use the NPV method against 9 % who use traditional investment decision methods. In Dutch,
89% of the firms use NPV investment decision method while traditional investment decision
methods took 11%.Their study used return on assets to measure performance which was used
in a regression model as a dependent variable and measured against the various investment
decision techniques. The results indicated that in both countries, sophisticated capital
budgeting techniques mostly NPV and IRR had a positive relationship with return on assets
(ROA) while the traditional methods showed an insignificant relationship

Chang(2006) shows that capital budgeting is regarded as efficiency improving tool in local
governments (municipalities). But in the many less developed countries (LDCs) private sector
companies are more likely to engage in small scale and short-term capital investments. Thus,
since the inputs to discounted cash flow techniques are not expected to change by much in the
short run, the UAE enterprises are more likely to adopt discounted cash flow methods.

Gerrans and Chandra (2007) found that the payback is the most widely used method by the
largest proportion of a sample of Australian companies and its use is persistent across
investment size, type, and the industry to which the company belongs. Further, when the
investment size is large, payback and NPV are the most widely used techniques. Some attempts
have been made to document the capital budgeting techniques in developing countries and
emerging markets. For example, as part of a study on the use of management accounting
techniques by Qatari companies.

Hermes et al. (2007) carried out a comparative study of the Dutch and Chinese firms about
capital budgeting practices. 66.7% of the Dutch CFOs stated that they used WACC and only 9.5
% of them used PDCC. Small firms use CD most often (22.7%) in comparison with larger firms
(5.0%). In the Dutch firms, 89% of CFOs reported that they used NPV methods however, 2% of
CFOs stated that they used the ARR which is the least popular method. In contrast, 53.3% of
Chinese firms indicated that they use WACC, and just 15.7% of CFOs of Chinese firms use PDCC.
However, 28.9% of CFOs reported that they use CD which is higher than that of the Dutch
counterparts. Chinese CFOs stated that they more likely to use NPV and PB methods (89% and
84% respectively) in evaluating capital budgeting projects. Thus, on average, Dutch CFOs use
more sophisticated capital budgeting techniques than Chinese CFOs do.

Ibrahim and Sayed (2008) examined capital budgeting process in 98 companies in UAE and the
results indicate that majority of the surveyed UAE companies adopted discounted cash flows
when making capital investment decisions and the company size is a determinant factor of
selecting a technique. Their study concentrated on differences in practices between large and
small companies.

Thomas Klammer (2008) sought to investigate the association of capital budgeting techniques
and performance in American firms. Attention was techniques and the relationship of
performance and capital budgeting procedures because the future of the firm is dependent
largely on the investment decisions made today. A total of 369 manufacturing firms were
sampled, of which 184 firms’s responded 48.9%. The study focused on the operating rate of
return as a measure of the firm’s performance. Capital budgeting techniques tested were
payback methods and the discounting techniques. For testing the association of firm
performance of capital budgeting techniques, the study adopted a hypothesis that, firms having
better performance will have adopted more sophisticated capital budgeting techniques. A
simple regression analysis was carried out to test the hypothesis. The results of the study
indicated that, despite a growing adoption of sophisticated capital budgeting methods, the
regression results did not show a consistent significant association between performance and
capital budgeting techniques.

Kester and Robbins(2009) surveyed about capital budgeting techniques used by Irish listed
companies. Results revealed that they use DCF methods and reported that most prevalent
method was NPV, followed by PB, and IRR. Scenario analysis and sensitivity analyses were
found to be most important tools for incorporating risk. WACC was the most important
widespread method employed for calculating discount rates. The PB was found as the most
preferred method and not NPV.

Prather et al(2009) determined how small rural firms apply capital budgeting techniques. They
surveyed 281 members of the Durant, Oklahoma Chamber of Commerce. Their goal was to
determine whether these small rural firms practice what academics teach. Their survey covered
a variety of discounted cash flow (DCF) and other traditional techniques and also examined the
incidence and treatment of capital rationing. The survey design permitted us to partition results
to examine differences due to firm size, industry, form of business organization, firm age, age
and education level of the primary decision-maker, and whether operations were international
or domestic.

Karim et al (2010) carried out a research on capital budgeting of large firms in Canada. many
large firms in Canada tend to use Discounted Cash Flow techniques (DCF) in evaluating their
investment opportunities. Thus Discounted Cash Flow Techniques are increasingly accepted by
the large firms in America specially NPV and IRR. But this study has not addressed the
alignment of financial objectives of the business strategy with the adoption of investment
appraisal techniques in evaluating the investment opportunities. Further they explained that
usage of non-discounted cash flow techniques has declined though the usage is still in the
system.

Mooi and Mustapha (2011) have investigated on degree of sophistication of capital budgeting
practice and firms’ performance. Using a sample of 42 firms, 19% used average capital
budgeting methods and 43% fairly superior methods. To test the level of association, they
performed a test. Their results showed that the degree of capital budgeting sophistication did
not significantly affect firm performance using ROA and EPS. Generally, the use of superior
capital budgeting process should increase the effectiveness of the firms’ investments decision
making. Thus their study failed to confirm with the theory.

Daunfeldt O. and F. Hartwig(2012) found out from the evidence from Swedish companies
studied indicates that larger companies tend to use capital budgeting methods more often
when deciding on investments. The choice of capital budgeting methods is also influenced by
financial leverage, growth opportunities, dividend pay-out policies, choice of target debt ratio,
degree of management ownership, foreign sales, and the education and other individual
characteristics of the CEOs.

Kadondi (2012) determined the capital budgeting techniques used by companies listed at NSE
and how the firms’ and CEO characteristics influence the use of a particular technique. With a
sample size of 43 companies, 65% responded to questionnaire. His results showed that 85%
carry out capital budgeting in stages though many of the respondents ignored the first stages of
capital budgeting. Of these, 31% used the payback method, 27% applied NPV while 23% were
using the IRR technique.

Olum (2012) studied capital budgeting from the viewpoint of shareholders’ wealth
maximization. He examined the extent to which capital budgeting techniques were applied by
Kenyan corporations. He noted that the current capital investment appraisal techniques were
not well applied. Only two fronts tend to utilize it namely private entrepreneur and the general
public.

Haka et al. (2014) determined the effects of a firm’s market performance by switching from
naïve to sophisticated capital budgeting selection procedures. They theoretically stated that, a
firm should perform better if it employs sophisticated techniques than if it uses naïve
techniques. Equally, a sample size of 50 firms was used. Only 60% of the firms responded. In
addition, they used personal interviews for two reasons; first to determine if the firm had
indeed adopted sophisticated capital budgeting techniques; secondly; it was important to
ascertain precisely when the adoption took place.

Batra and Verma(2017)observed that the volatility of the global economy, changing business
practices, and academic developments had created a need to re-examine Indian corporate
capital budgeting practices. Research was based on a sample of 77 Indian companies listed on
the Bombay Stock Exchange. Results reveal that corporate practitioners largely follow the
capital budgeting practices proposed by academic theory. Discounted cash flow techniques of
net present value and internal rate of return and risk adjusted sensitivity analysis were most
used. Weighted average cost of capital as cost of capital is most favored. Nevertheless, the
theory-practice gap remains in adoption of specialized techniques of real options modified
internal rate of return (MIRR), and simulation. Non-financial criteria are also given due
consideration in project selection.

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