Capital budgeting in Europe: confronting theory with practice

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Capital budgeting in Europe: Confronting theory with practice
Article in International Journal of Managerial and Financial Accounting · January 2014
DOI: 10.1504/IJMFA.2014.066403
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Matteo Rossi
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Int. J. Managerial and Financial Accounting, Vol. 6, No. 4, 2014 341
Copyright © 2014 Inderscience Enterprises Ltd.
Capital budgeting in Europe: confronting theory
with practice
Matteo Rossi
DEMM Department,
University of Sannio,
Via delle Puglie, 82, 82100 Benevento, Italy
Email: [e-mail]
Abstract: Capital budgeting is an important area of financial management. It is
a process used to determine whether firm’s long-term investments are worth
the funding of cash through the firm’s capitalisation structure. Different
techniques are used: the payback period, the accounting rate of return, the
present value and the internal rate of return and the profitability index. This
research presents an analysis of capital budgeting in three different countries:
Italy, France and Spain. The results revealed that PP, followed by net present
value, is the most used method, but there is a difference between large and
small firms. This research has demonstrated that capital budgeting decision-
making is a complex process and that it is undervalued by SMEs. The
limitations of the paper are the result of its very nature: it is a largely
conceptual paper.
Keywords: capital budgeting; NPV; net present value; IRR; internal rate of
return; payback period; WAAC.
Reference to this paper should be made as follows: Rossi, M. (2014) ‘Capital
budgeting in Europe: confronting theory with practice’, Int. J. Managerial and
Financial Accounting, Vol. 6, No. 4, pp.341–356.
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 has 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, 2008,
p.380).

342 M. Rossi
These decisions require that a firm defines 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 three different countries of EU
on how they undertook capital budgeting practices. The research follows similar surveys
conducted around the globe such as those by Kester et al. (1999), Kester and Chong
(2001), Sandahl and Sjogren (2003), Brijlal and Llorente Quesada (2008), Bennouna
et al. (2010) and Hartwig (2012).
The paper is organised as follows: Section 2 presents a literature review on capital
budgeting techniques. Subsequently, Section 3 presents the research methodology and
objectives. Section 4 presents the main results of our research. Section 5 presents some
managerial implications, and finally, 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 state 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,
2003; 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 few research has
considered small and medium enterprises (Rossi, 2014). Managers use different
techniques to facilitate capital budgeting procedures. In practice, capital budgeting differs
from industry to industry and from country to country. The first important conclusion is
that in managerial decision-making, 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 (2003), Lazaridis (2004),
Hermes et al. (2007) and Rossi (2014). These studies focus on different countries such as
Italy, Cyprus, the Netherlands, China, Singapore, other Asiatic countries, Sweden,
Canada, the USA, and the UK. These surveys have shown that the sophistication of the
analytical techniques used by executives has increased over time. But, literature on
capital budgeting techniques presents a high fragmentation. 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

Capital budgeting in Europe 343
investment. Rossi (2014) shows that PP, followed by NPV, is the most used method, but
there is a difference between large and small firms. In fact, the more complex methods
are most favoured by the larger enterprises.
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) stressed that enterprises
that analysed each project had a higher share price on an average compared to those that
did not. A second result of their study was that the NPV technique did not maximise the
value of the business. Their results suggest that firms should not only use one capital
budgeting technique but also apply at least two or three methods when evaluating a
project.
Block (1997) focuses on the capital budgeting techniques used by small firms. He
examines a sample of 232 small businesses. Research reveals 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) 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) conducted 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 “while
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 of capital budgeting and
cost of capital estimation methods in Swedish-listed companies to study the relationship
between characteristics of the company 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 to US and continental European companies, Swedish-listed
companies employed capital budgeting methods less frequently.