Capital Budgeting Practices of Small Businesses: Evidence from Rural America

By Prather, Larry J.; Topuz, John C. et al. | Journal of Business and Entrepreneurship, March 2009 | Go to article overview

Capital Budgeting Practices of Small Businesses: Evidence from Rural America


Prather, Larry J., Topuz, John C., Benco, Daniel C., Romer, David A., Journal of Business and Entrepreneurship


ABSTRACT

We surveyed members of the Durant, Oklahoma Chamber of Commerce to ascertain the level of sophistication that small rural businesses exhibit in capital expenditure decision making. Our survey covered a variety of discounted cashflow (DCF) and other traditional techniques and also examined the incidence and treatment of capital rationing. Finally, we examined the methods used to determine the required return and the use of sensitivity analysis, scenario analysis, and simulation. Results reveal that 71% of the sample firms do not have a written business plan and 66% use managerial judgment in project selection.

INTRODUCTION

Capital budgeting decisions, also known as capital investment or capital expenditure decisions, remain critical to the success of any firm. Brigham and Ehrhardt (2007) argue that sound capital budgeting decisions are vital to a firm's financial well-being and are among the most important decisions that owners or managers of firms must make. Their rationale for that belief is that capital budgeting decisions often involve a significant capital outlay to acquire land, buildings, or equipment. Additionally, the acquisition of these assets often comes with longlasting and recurring financial obligations. Thus, financial constraints such as loan payments, lease payments, or interest payments can create a financial hardship for firms that undertake a project whose expected stream of future cash flows does not materialize or is insufficient to provide the required return on investment. Moreover, capital budgeting may also define or constrain future strategic decisions because these decisions often require the acquisition of costly assets that have long economic lives and limited marketability or liquidity. Thus, firms often make long-term commitments that are not quickly or easily reversible. The long-lived and often illiquid assets, large capital requirements, and the constraints on future operating and strategic decisions combine to make sound capital budgeting decisions vital to the financial health of a firm.

Given the importance of capital budgeting decisions, it is crucial that decision-makers understand how to evaluate projects correctly so that they can make informed decisions concerning which projects to accept and which projects to reject. It is common in business schools to require all business students to take at least one finance course that covers the essential elements of capital budgeting. Moreover, finance majors are routinely required to take a specialized course in capital budgeting that extends the breadth and depth of coverage and includes many nuances that the student may encounter in practice. Despite the coverage by business schools, a plethora of past surveys of large firms suggests that decision-makers often use less formal procedures than those recommended by business schools. For example, Pattillo (1981) reports that 75% of his sample does not use discounted cash flow techniques (DCF). Despite the early evidence of the low usage of sophisticated capital budgeting practices of large U.S. firms, later studies report an increased usage of sophisticated capital budgeting and risk adjustment techniques (e.g., Klammer & Walker, 1987).

Evidence on the capital budgeting practices of firms other than large U.S. firms is not as theoretically satisfying. Lazaridis (2004) concluded that there is a need to educate and train managers of Cypriot firms in the capital budgeting area, suggesting that at least some countries are not using the most sophisticated techniques available.

While there is an abundance of studies targeting large and international firms, few studies examine small firms. However, Runyan (1983) reported that few small firms use sophisticated capital budgeting or risk adjustment techniques. More recently, Graham and Harvey (2001) surveyed 392 CFOs and found that small firms are much more likely to use the unsophisticated and severely flawed payback method than to use more robust discounted cash flow methods. …

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