Capital Budgeting Practices of the Fortune 1000: How Have Things Changed?

Article excerpt

Capital budgeting is one of the most important decisions that face the financial manager Prior studies spanning the past four decades show financial managers prefer methods such as internal rate of return or non-discounted payback models over net present value, the model academics consider superior. This interesting anomaly has long been a puzzle to the academic community. A recent survey of the Fortune 1000 Chief Financial Officers finds net present value to be the most preferred tool over internal rate of return and all other capital budgeting tools. While most financial managers utilize multiple tools in the capital budgeting process, these results better reflect the alignment of the academic and business view.

Corporate capital budgeting and cost of capital estimation are among the most important decisions made by the financial manager. In this process, it is crucial that management use accurate methods that will result in the maximization of shareholder wealth. Over time, managers have used various commonly taught capital budgeting models and cost of capital estimations procedures; however, the use of models has not always aligned with what is taught in collegiate finance. This study re-examines the capital budgeting decision methods used by the Fortune 1000 companies. We show management views net present value (NPV) as the most preferred capital budgeting tool. Both NPV and internal rate of return (IRR) are superior to other capital budgeting tools, a result that represents alignment between corporate America and academia.

The paper proceeds as follows. The first part of the study provides a review of prior capital budgeting studies. The next section discusses the sample selection and survey methodology. We then present the results, followed by a concluding section.


Over the past four decades, financial research has recorded how businesses use capital management methods and how large corporations determine the cost of capital used in capital budgeting decisions. Financial managers and academics have not been in full agreement as to the choice of the best capital budgeting method. In Table 1, Miller (1960), Schall, Sundam, and Geijsbeek (1978), and Pike (1996) report payback technique as the most preferred method, while Istvan (1961 ) reports a preference for accounting rate of return. Early studies generally report discounted cash flow models to be the least popular capital budgeting methods. This might be attributed to the lack of financial sophistication and limited use of computer technology in that era. Mao ( 1970) and Schall et al. (1978) specifically point to NPV as the least popular capital budgeting tool, a result in contrast to modem financial theory. Klammer (1972) reports a preference for general discounted cash flow models, and subsequently, the overwhelming majority of published research indicates that management prefers the use of internal rate of return (IRR) over all other capital budgeting methods.1 Eight studies dating from 1970 to 1983 show profitability index, a ratio of present value and initial cost, to be the least most popular capital budgeting tool. Recently, Jog and Srivastava (1995) and Pike (1996) indicate a decreased acceptance of accounting rate of return in Canada and the United Kingdom, respectively.2 Interestingly, throughout the literature, NPV has always trailed IRR in management preference. Managers have argued the perception of a percentage return is more easily understood and comparable than an absolute dollar value increase in shareholder wealth. Therefore, in the past, managers have chosen IRR over NPV. Evans and Forbes (1993) argue management views IRR as a more cognitively efficient measure of comparison. In a comparison of past studies, it is seen that managers are moving toward NPV as a method of choice, but never to the level of IRR.

Academics have long argued for the superiority of NPV over IRR for several reasons. …