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The use of capital budgeting techniques: An outlook from Italy
Article in International Journal of Management Practice · January 2015
DOI: 10.1504/IJMP.2015.068302
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Int. J. Management Practice, Vol. 8, No. 1, 2015 43
Copyright © 2015 Inderscience Enterprises Ltd.
The use of capital budgeting techniques: an outlook
from Italy
Matteo Rossi
DEMM Department,
University of Sannio,
Via delle Puglie, 82, 82100 Benevento, Italy
Email: [e-mail]
Abstract: Capital budgeting is one of the most important areas of financial
management. Different techniques are used to evaluate capital budgeting
projects: the Payback Period (PP), the Net Present Value (NPV) and the
Internal Rate of Return (IRR). Graham and Harvey (2002) highlight that
financial managers favour methods such as the IRR or non-discounted Payback
Period (PP). The results of this research revealed that PP, followed by NPV, is
the most used method. The more complex methods are most favoured by the
large enterprises. The principal weakness of the evaluation process is the
definition of cost of capital: approximately 70% of the enterprises considered
use non-quantitative techniques to consider risk. This study provides those
evaluating investment projects or conceiving capital budgeting manuals or
policies with knowledge about common pitfalls that, if acted upon, could
improve decision making. This study is exploratory research and the results
represent a basis for further research.
Keywords: capital budgeting; NPV; net present value; IRR; internal rate of
return; payback period; WACC.
Reference to this paper should be made as follows: Rossi, M. (2015) ‘The use
of capital budgeting techniques: an outlook from Italy’, Int. J. Management
Practice, Vol. 8, No. 1, pp.43–56.
Biographical notes: Matteo Rossi is an Assistant Professor of Corporate
Finance at the University of Sannio, Italy. He holds a PhD in Corporate
Governance, and his prime research interests are corporate finance, financing
innovation and finance for SMEs. He is Vice President of the EuroMed
Research Business Institute. He is an Associate Editor of Global Business and
Economics, International Journal of Bond and Derivatives and International
Journal of Managerial and Financial Accounting. In 2014, he won the highly
commended paper award of the International Journal of Organizational
Analysis (Emerald) for the paper ‘Mergers and acquisitions in the high-tech
industry: a literature review’.
1 Introduction
Capital budgeting plays a fundamental role in any firm’s financial management strategy.
Capital budgeting is the “process of evaluating and selecting long term investments that
are consistent with the business’s goal of maximising owner wealth” (Gitman, 2007,
p.380).

44 M. Rossi
These decisions require that a firm define all of the necessary steps to ensure that its
decision-making criteria support the business’s strategy: “the realisation that a business
leverages its competitive advantage on its resources and on how it undertakes decisions
relating to the use of its resources, such as financial resources call for managers to make
informed decisions” (Brijlal and Llorente Quesada, 2008). Today, it is necessary – in a
highly competitive environment – to make each decision after acquiring information.
This paper is based on a survey of managers of firms in Southern Italy on how they
undertook capital budgeting practices. The research follows similar surveys conducted
around the globe (such as Kester et al., 1999; Kester and Chong, 2001; Sandahl and
Sjogren, 2002; Brijlal and Llorente Quesada, 2008; Bennouna et al., 2010; Hartwig,
2012).
The paper is organised as follows. Section 2 presents a literature review on capital
budgeting techniques. Section 3 presents the research methodology and objectives and
Section 4 presents the main results of our research. Section 5 presents some managerial
implications, and the final Section 6 draws conclusions from the research findings and
investigates future directions.
2 Literature review
Many scholars (Arya et al., 1998; Swain and Haka, 2000; Brijlal and Llorente Quesada,
2008) maintain that capital budgeting decisions are crucial to a business’s performance.
In fact, capital budgeting plays a vital role in a business’s competitive model. Kwak et al.
(1996) thus states that capital budgeting is not a banal decision. A business, whose ability
to effectively develop a possible mechanism for capital budgeting, may realise a better
competitive advantage over its rivals in an environment that is characterised by change
and volatility (Lazaridis, 2004).
Many studies have been conducted worldwide that provide interesting results on
capital budgeting practices (Jog and Srivastava, 1995; Pike, 1996; Drury and Tayles,
1996; Block, 1997; Kester et al., 1999; Graham and Harvey, 2001; Sandahl and Sjogren,
2002; Brounen et al., 2004; Lazaridis, 2004; Hermes et al., 2007; Truong et al., 2008;
Bennouna et al., 2010; Andor et al., 2012). The major international research is
concentrated on capital budgeting practices in large firms. Only some research has
considered small and medium enterprises. Managers use different techniques to facilitate
capital budgeting procedures. In practice, capital budgeting differs from industry-to-
industry and firm-to-firm, but in managerial decision making, that theory seems to be
ignored in practice.
Important studies on capital budgeting were conducted by Drury and Tayles (1996),
Maccarrone (1996), Kester et al. (1999), Sandahl and Sjogren (2002), Lazaridis (2004),
Hermes et al. (2007) and Danielson and Scott (2006). These studies focus on different
countries such as Italy, Cyprus, the Netherlands, China, Singapore and other Asiatic
countries, Sweden, Canada, the USA, and UK. These surveys have shown that the
sophistication of the analytical techniques used by executives has increased over time.
Particularly, Kester et al. (1999) affirm that Discounted Cash Flow (DCF) techniques –
such as Net Present Value (NPV) and Internal Rate of Return (IRR) – have become the
dominant methods of evaluating capital investment.

The use of capital budgeting techniques 45
Concerning the result of capital budgeting decisions on a firm’s performance, an
important contribution comes from the study of Hatfield et al. (1998). They investigate
the importance of PP, ARR, IRR, and NPV capital budgeting techniques on the
performance and value measures of firms. Hatfield et al. (1998) stress that enterprises
analysed each project had a higher share price on average compared with those that did
not. A second result of Hatfield et al.’s study is that the NPV technique did not maximise
the value of the business. This conclusion contrasts with the theory of finance. In
conclusion, their results suggest that firms should not use only one capital budgeting
technique but should apply at least two or three methods when evaluating a project.
In interesting research, Block (1997) focuses on the capital budgeting techniques
used by small companies. The results, based on a sample of 232 small businesses, reveal
that the payback method is still the preferred approach in 42.7% of the firms. Unlike
many larger firms, these firms’ time horizon is often the period over which a financial
institution will extend them funding.
Graham and Harvey (2001, 2002) survey 392 CFOs about the cost of capital, capital
budgeting and capital structure. The results disclose that “large firms rely heavily on
present value techniques and the capital asset pricing model, while small firms are
relatively likely to use the payback criterion” (Graham and Harvey, 2001, p.187). The
authors find that IRR and NPV were the most frequently used capital budgeting
techniques. Other techniques such as the payback period were less popular but were still
used by many companies.
Brounen et al. (2004) conduct a survey of 313 CFOs across four European countries
(the UK, the Netherlands, Germany and France) on capital budgeting, cost of capital,
capital structure and corporate governance. Their results indicate that “[w]hile large firms
frequently use present value techniques and the capital asset pricing model when
assessing the financial feasibility of an investment opportunity, CFOs of small firms still
rely on the payback criterion” (Brounen et al., 2004, p.71).
More recently, Truong et al. (2008) perform an important study on capital budgeting
in Australia. They use a sample survey to analyse the capital-budgeting practices of 356
Australian-listed companies and find that NPV, IRR and payback are the most popular
evaluation techniques.
Bennouna et al. (2010) focus on the capital budgeting decision making of Canadian
firms, including 88 large firms. The results show that the trends towards sophisticated
techniques have continued; however, even in large firms, 17% did not use DCF. Of those
that did use DCF, the majority favoured NPV and IRR.
Hartwig (2012) conducts a similar study, analysing the use f capital budgeting and
cost of capital estimation methods in Swedish-listed companies to study the relationship
between company characteristics and their choice of methods, making both within-
country longitudinal and cross-country comparisons. The results reveal that larger
companies seem to use capital budgeting methods more frequently than smaller
companies. Compared with the US and continental European companies, Swedish-listed
companies employed capital budgeting methods less frequently.
Andor et al. (2012) perform another important study on capital budgeting techniques
in European countries. They conduct a survey of 400 executives in ten countries of
Central and Eastern Europe (CEE) – Bulgaria, Croatia, Czech Republic, Hungary, Latvia,
Lithuania, Poland, Romania, Slovak Republic and Slovenia. They find that the capital