Capital Budgeting Theory and Practice: A Review and Future Research

This report provides a comprehensive review of capital budgeting theory and practice, drawing on research published over the last two decades. It examines the evolution of capital budgeting methods, the influence of globalization and technological advancements, and the challenges posed by uncertainty and risk. The study highlights the disparities between theoretical models and practical applications, particularly in the context of developing countries. It identifies factors affecting the choice of capital budgeting techniques and emphasizes the importance of incorporating risk management tools. The report underscores gaps in the existing literature, particularly concerning behavioral finance and event study methodologies, and suggests directions for future research to build a more robust understanding of capital budgeting in dynamic environments. The research aims to provide valuable insights for academics, practitioners, policymakers, and stakeholders involved in capital investment decisions.

Applied Economics and Finance
Vol. 3, No. 2; May 2016
ISSN 2332-7294 E-ISSN 2332-7308
Published by Redfame Publishing
URL: http://aef.redfame.com
15
Capital Budgeting Theory and Practice:
A Review and Agenda for Future Research
Lingesiya Kengatharan1
1Department of Financial Management, University of Jaffna, Sri Lanka.
Correspondence: Lingesiya Kengatharan, Department of Financial Management, University of Jaffna, Sri Lanka.
Received: December 21, 2015 Accepted: January 14, 2016 Available online: February 4, 2016
doi:10.11114/aef.v3i2.1261 URL: http://dx.doi.org/10.11114/aef.v3i2.1261
Abstract
The main purpose of this research was to delineate unearth lacunae in the extant capital budgeting theory and practice
during the last two decades and ipso facto become springboard for future scholarships. Web of science search and iCat
search were used to locate research papers published during the last twenty years. Four criteria have been applied in
selection of research papers: be an empirical study, published in English language, appeared in peer reviewed journal
and full text research papers. These papers were collected from multiple databases including OneFile (GALE), SciVerse
ScienceDirect (Elsevier), Informa - Taylor & Francis (CrossRef), Wiley (CrossRef), Business (JSTOR), Arts & Sciences
(JSTOR), Proquest ,MEDLINE (NLM), and Wiley Online Library. Search parameters covered capital budgeting,
capital budgeting decision, capital budgeting theory, capital budgeting practices, capital budgeting methods, capital
budgeting models, capital budgeting tools, capital budgeting techniques, capital budgeting process and investment
decision. Thematic text analyses have been explored to analyses them. Recent studies lent credence on the use of more
sophisticated capital budgeting techniques along with many capital budgeting tools for incorporating risk.
Notwithstanding, it drew a distinction between developed and developing countries. Moreover, factors impinging on
choice of capital budgeting practice were identified, and bereft of behavioral finance and event study methodological
approach were highlighted. More extensive studies are imperative to build robust knowledge of capital budgeting theory
and practice in the chaotic environment. This research was well thought out in its design and contributed by stating the
known and unknown arena of capital budgeting during the last two decades. This scholarship facilitates to academics,
practitioners, policy makers, and stakeholders of the company.
Keywords: Capital budgeting theory and practices, capital budgeting tools for incorporating risk, discount rate
1. Introduction
Predominantly, area of capital and capital budgeting of financial management have been attracted many researchers
during the last five decades and the seminal studies culminated with presenting many theories (e.g., Markowitz,1952;
Modigliani & Miller,1958; Markowitz,1959; Miller & Modigliani,1961; Fama,1970; Black & Scholes,1973; Ross, 1976;
Roll,1977; Myers,1977; Myers,1984; Jensen,1986; Ritter,1991;Graham & Harvey, 2001; Myers,2003; Halov &
Heider,2004; Atkeson & Cole,2005;) and models (e.g.,Markowitz,1952; Sharpe,1963; Sharpe,1964; Linter,1965;
Roll,1977) time to time. Notwithstanding, due to the globalization, environmental changes and cutting edge advanced
technological developments, theories and models developed in the past do not applicable today and many of them are
criticized and their applicability in practice is intriguing (e.g., Malkiel, 2003; Bornholt, 2013). A curious instance
illustrated by Brounen, de Jong and Koedijk (2004) is that ‗Nobel Prize winning concepts like the capital asset pricing
model and capital structure theorems have been praised and taught in class rooms, but to what the extent to these
celebrated notions have also found their way into corporate board rooms remains somewhat opaque‘ (p.72). ‗Traditional
capital budgeting methods have been heavily criticized of discouraging the adoption of advanced manufacturing
technology and thus undermining the competitiveness of Western firms‘ (Slagmulder, Bruggeman & Wassenhove, 1995,
p.121). In a similar vein, many research scholars on their seminal scholarships argued that there are gaps in theory of
capital budgeting and its applicability (e.g., Mukheijee & Henderson, 1987; Arnold & Hatzopoulos, 2000; Graham &
Harvey, 2001; Cooper, Morgan, Redman & Smith, 2002; Brounen et al., 2004; Kersyte, 2011).
Firms operating in a dynamic environment must respond to changes to beat competitors and to sustain, survive and
grow in markets (Ghahremani, Aghaie & Abedzadeh, 2012). Most changes impinge on capital investment decisions,

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which can invariably involve large sums of money over the long period (e.g.,Peterson & Fabozzi, 2002, Cooper et al.,
2002; Dayananda, Irons, Harrison, Herbohn & Rowland, 2002) and these decisions are critical in managing strategic
change and sustaining long term corporate performance (Emmanuel, Harris & Komakech, 2010). Capital investment
decision can be acquisitions, investing new facilities, new product development, employing new technology and
adoption of new business processes or some combination of these (Emmanuel et al., 2010). Capital budgeting
investment decisions are critical to survival and long term success for firms due to many factors and those factors are
commonly named as uncertainty. The global financial crisis is epitomized this truth. One of the most intractable issues
confronted by researchers is how to identify, capture, and evaluate uncertainties associated with long term projects
(Haka, 2006). Sources of uncertainty range from the mundane (cash flow estimation, number and sources of estimation
error, etc.) to the more esoteric (complementarities among investments, options presented by investment opportunities,
opportunity cost of investments, etc.) (Haka, 2006). Since capital investment decision deals with large sum of fund,
scrupulous attention has been given in making decision. ‗Capital budgeting is as the procedures, routines, methods and
techniques used to identify investment opportunities, to develop initial ideas into specific investment proposals, to
evaluate and select a project and to control the investment project to assess forecast accuracy‘(Segelod,1997). Albeit
there are number of capital budgeting methods assist in making decision, number of other uncertainty factors have
deleterious penetration into making capital budgeting decision.
Nowadays, complex methods are used for making capital budgeting decision rather purely depends on theories of
capital budgeting because of uncertainty and other contingency factors (Singh, Jain &Yadav, 2012; Zhang, Huang
&Tang, 2011; Kersyte, 2011; Bock & Truck, 2011; Byrne & Davis, 2005;Cooper et al, 2002; Arnold & Hatzopoulos,
2000; Mao, 1970; and Dickerson, 1963). After the advent of full-fledged globalization and in the era of cutthroat
competition (Verma, Gupta & Batra, 2009), advanced developments in technologies, other macro environmental factors
and demographic factors are intruding into capital budgeting practices (Verbeeten, 2006). In a world of geo-political,
social as well as economic uncertainty, strategic financial management is of process of change, in turn requiring a re-
examination of the fundamental assumption (e.g, efficient market hypothesis, Fama,1970) that cut across traditional
boundaries of the financial management (Hill, 2008). With limited credit and other sources of financing in today‘s
uncertain and challenging economic environment, also required to be scrupulously evaluated the profitability and
successfulness of proposed capital investments and allocate limited capital is more vital than ever (Kester & Robbins,
2011).
Over the last 20 years, there have been many changes and challenges in making financial decision due to the global
financial crisis, fluctuations in value of money, advanced technology, interest rate, exchange rate and inflation rates‘
risks and dramatic changes in economic and business environment both in national as well as in global markets. Thus,
there is need to re- examine and re- study for re-building capital budgeting practices since it has considerable impact on
investment decision making. The investment decision making is not a simple or straightforward approach, the risk is an
important element in making investment decision. There are number of risk techniques employed by companies for
evaluating investment projects. However, there is problem in setting up theoretical model and applying that model into
practice (e.g: Arnold & Hatzopoulos, 2000; Digkerson, 1963). Thus, the theory is not purely able to apply at all times.
Sometimes theories developed in the past do not applicable today. There is no doubt, over the last two decades
corporate practices regarding capital budgeting practices have not been static, diverged from the theories.
This study presents systematic review on capital budgeting practices literature published in the last two decades. The
systematic review of literature is referred to as 'principally justified by the manner in which the reviewer proceeds, stage
by stage, with full transparency and explicitness about what is (and what is not) done, typically using a protocol to
guide the process' (Young, Ashby, Boaz & Grayson, 2002, p.220). Through this review, updating information about the
capital budgeting techniques which being used by firms and to compare the current usage of various techniques,
methods with those found in previous studies. This study is thus accumulatively builds a robust knowledge in the area
of capital budgeting practices and identifying unearth gaps will become springboard for future research. Therefore, this
research guides the researchers to reflect on and assess where they are in an area of capital budgeting practices and
guide future research directions.
1.1 Objective of the study
Examining empirical research on capital budgeting practices to date has been very useful in explaining importance of
capital budgeting practices for the long time success of the business organization. Nowadays, complex methods are used
for making capital budgeting decision rather purely depends on theories of capital budgeting. Advanced developments
in technologies, other macro environmental factors and demographic factors are intruding into capital budgeting
practices and thus some of the theories become out of use in well developed countries (e.g: payback period). Thus, the
main aim of this research is to demonstrate unearth gaps in the existing capital budgeting practices literature and to
suggest the directions for the future research .It will further attempt to

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- Explain the capital budgeting theories and practices in different countries and demonstrate the disparities
between theories and practices of capital budgeting
- Identify the factors that determine use of capital budgeting practices of a country or firm
1.2 Problem Statement
During the past twenty years (1993-2013), the theory of capital budgeting has been characterized by the many increased
applications on the basis of risk and uncertainty resulting from global economic, technological and advanced educational
changes e.g: inflation risk, interest rate and exchange rate risk. Capital budgeting is the backbone of the financial
management. Modern financial management theory generally assumes that the primary objective of a firm is to
maximize the wealth of its owners (Atrill, 2009). Uncertainty and risk are the major influence in making investment
decision and thus Mao (1970) says ‗a central aspect of any theory of capital budgeting is the concept of risk‘ (p.352). In
order to implement the objective of modern financial management theory, ‗financial executives need criteria for
choosing between alternative time patterns of project evaluations within his planning horizon' (Mao, 1970). There are
complexities in making investment decision and the theory could not always applicable in all situations. Problem
statement of this study is how far capital budgeting theory differentiates with practice and to demonstrate the nature
of the gaps in existing capital budgeting literature.
1.3 Research Questions
On the basis of background of research, the following research questions have been developed as the way to attain
research objectives.
 What are the capital budgeting theories and practices used by firms? Are there any disparities between
the capital budgeting theories and practices? If so how?
 What are the factors determines the use of capital budgeting practices? Are there different across
countries? If so how?
 What are the gaps in the existing capital budgeting literature?
2. Methodology
The main objective of this study is to find out gaps in extant capital budgeting literature during the past 20 years of
study. The methodology covers research philosophy, research approach, research strategy, methods of data collection
and data analysis. These entire methodological spheres used throughout the research have been below discussed in
details.
2.1 Research Philosophy
One of the dominant philosophical concepts is the ‗ontological assumption‘ that enquires about nature of reality, and
any study absence of this assumption would be treated as 'blinded' (Easterby-Smith, Thorpe & Lowe, 2002, p. 27). This
research assumes that capital budgeting practices are different across firms/ nations and the ways of looking at capital
budgeting practices are not same at all the time. It can be further articulated that even when there are number of capital
budgeting theories, we cannot expect similar application at all situations and thus it is subject to changes. Thus, the
ontological assumption is of constructionism. Constructionist ontology‘s view that world is being internally constructed
and both individually and collectively generate meaning where we are not sure about what is real! Consequently, people
guess reality of the world with the experience of external indicators.
Another important philosophical assumption is the epistemological assumption. It enquires about what should be taken
as acceptable knowledge in a particular field (Easterby-Smith et al., 2002). The traditional practices do not applicable in
the contemporary borderless global businesses and thus try to understand the factors determine the use of capital
budgeting practices. It guides how can we understand and determine capital budgeting practices in different context and
in different geographical location. The knowledge can be attainable by text analysis with subject methods. Thus, it
offers what is already known about capital budgeting practices and captures the gaps in extant literature by
systematically reviewing literature.
This research takes interpretive approach on epistemology for answering research questions. The reality is not
independent of individual thought and thus all the research findings are not similar with one another (Blaikie, 2007).
Thus, this multiple reality is called ‗subjectivism‘. Findings could vary in different context such as nature of
measurement tools, geographical location, company‘s size, organizational practices, types of sectors and form of
methodology used. Thus, this research is organized by collecting relevant literature review and interpreting concepts of
relationship between researchers and research. Inductive approach is thus suited by exploring thematic text analysis.
2.2 Research approach
The research strategy leads to design qualitative research approach. This research covered sufficient researches carried

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out during the past two decades in the area of capital budgeting. This research analyzed past literature by identifying
relevant themes and then thematic text analysis was employed. Thus, this research is ‗subjective‘ and adopts inductive
approach in order to answering research questions.
2.3 Research strategy
Research strategy tells about how research should be designed for answering a set of developed research questions and
consequently research aims are attained. As this research covers last twenty years of research papers carried out in the
area of capital budgeting from 1993 to 2013, this study adapts research strategy of longitudinal research design.
However, the collection of literature covers broad areas including different sectors, different locations/countries and
different size of firms. Thus, the systematic literature review sometimes takes comparative research design as well.
2.4 Data collection methods
Web of science search and iCat search were used to locate research papers published during the last twenty years. Web
of science is a mass search engine linking with mass database covering more than 10000 journals and 110 000
conference proceedings. However, all most all the databases (online the full text of electronic resources) have been
covered by iCat search which is subscribed and launched by Kingston University, London. Kingston University
library‘s access service was exploited for collecting all the research papers. Search parameters includes capital
budgeting, capital budgeting decision, capital budgeting theory, capital budgeting practices, capital budgeting methods,
capital budgeting models, capital budgeting tools, capital budgeting techniques, capital budgeting process and
investment decision.
Initially, there are 363 research papers identified during the last 20 years. Of them, 201 research papers were screened
and considered for this research to be reviewed based on the following criteria.
- An empirical study (i.e., sampling process, measurement , analysis): 363 papers were identified
- Published in English language: Of 363, 264 were published in English.
- Should be published in peer reviewed journal : Of 264, 239 were published in a peer reviewed journals
- Full text research papers: Of 239, 201 papers were full text journal
These papers were collected from following databases: OneFile (GALE), SciVerse ScienceDirect (Elsevier), Informa -
Taylor & Francis (CrossRef), Wiley (CrossRef), Business (JSTOR), Arts & Sciences (JSTOR), MEDLINE (NLM),
SpringerLink, Wiley Online Library , Inderscience Journals , ERIC (U.S. Dept. of Education), Sage Publications
(CrossRef), INFORMS Journals, Health Reference Center Academic (Gale), University of Chicago Press Journals,
Emerald Management eJournals, Directory of Open Access Journals (DOAJ),IngentaConnect, IEEE (CrossRef). All
these papers were spread over across many journals including Journal of Banking and Finance, The Journal of Finance,
Journal of Accounting and Economics, Management Decision, Journal of Cleaner Production, Journal of Financial
Economics, Management Science, European Journal of Operational Research, Accounting Review, Journal of
Economic Behavior and Organization, Long Range Planning, Energy Policy, Accounting, Organizations and Society,
Computers and Mathematics with Applications.
2.5 Data analysis
As discussed, at the outset, Miles and Huberman‘s (1984) proposed strategy was carried out that involves collection,
reduction, displays and conclusions. Based on the set criteria, 363 research papers were reduced to 201 and they
analyzed using a coding procedure. Initially, collected research papers were grouped into themes or topics. Theme
represents the focused area of research and it is selective coding on grounded theory (Corbin & Strauss, 1990). Themes
were in terms of current theory and practices of capital budgeting, factors influencing on capital budgeting practices/
determinants of capital budgeting practices, capital budgeting methods/ models, supplementary tools for the capital
budgeting methods, influences of capital budgeting practices on investment decisions, component of capital budgeting
process, capital budgeting stages, and global capital budgeting practices.
A thematic analysis was employed to capture key themes and concepts in chosen research papers. In doing so, open
coding, as suggested by Strauss and Corbin (1998), was adopted. The analysis was focused on the concepts related to
capital budgeting practices and theories, research design, research sampling techniques, research approach, year of
publication, nature of industry and so on. The results of this analysis were presented below.
3. Results
3.1 Multi-disciplinary concepts of capital budgeting
During the past twenty years, a total of 202 research papers appeared in peer reviewed indexed journals were identified
across many academic journals. Majority of the papers appeared in Engineering Economist (N= 32) yielding 15.92%
followed by Managerial Finance (27), Public Budgeting & Finance (16), Financial Management(9), Journal of Banking
and Finance (8), Journal of Business Finance & Accounting (6), Accounting Education(5), Management Accounting

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Research(5), The Journal of Finance(5), Journal of Corporate Accounting & Finance (4), Management Decision (4) and
The Review of Financial Studies. All of these journals represented 62.20 % of research papers in capital budgeting in
the last two decades. The reminder of the research papers appeared in many journals. Capital budgeting is thus
multi-disciplinary aspects and applied across many discipline. The table 1 below summarizes entire list of journals
contained capital budgeting research papers.
Table 1. Name of the journals: Capital budgeting research papers appeared during the past twenty years
Name of the Journal Number of
paper
published
Percentage
Engineering Economist 32 15.92%
Managerial Finance 27 13.43%
Public Budgeting & Finance 16 7.96%
Financial Management 9 4.48%
Journal of Banking and Finance 8 3.98%
Journal of Business Finance & Accounting 6 2.99%
Accounting Education 5 2.49%
Management Accounting Research 5 2.49%
The Journal of Finance 5 2.49%
Journal of Corporate Accounting & Finance 4 1.99%
Management Decision 4 1.99%
The Review of Financial Studies 4 1.99%
Three papers in each journal: Healthcare Financial
Management, Information Sciences, International Journal of
Energy Research, International Journal of Production Economics,
Journal of Financial Economics, Management Science,
Operations Research, The Journal of Business, Theoretical and
Applied Economics.
3 1.49%
Two papers in each journal: Accounting & Finance, Accounting
and Business Research, Accounting, Organizations and Society,
Computers & Industrial Engineering, Computers and
Mathematics with Applications, Contemporary Accounting
Research, European Financial Management, European Journal of
Operational Research, Health care strategic management,
Industrial Management & Data Systems, International Journal of
Business and Management, Journal of Accounting and
Economics, Journal of Computational and Applied Mathematics,
Journal of Information Technology, Journal of Marketing
Management, Journal of Small Business Management, Journal of
the International Academy for Case Studies, Journal of the
Operational Research Society, Long Range Planning, Managerial
and Decision Economics, The Bond Buyer, The Financial
Review.
2 1.00%
One paper in each journal: Academy of Marketing Studies
Journal, Accounting Review, Agricultural Finance Review.
1 0.50%

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Applied Financial Economics, Australasian Radiology, Australian
Journal of Management, BuR : Business Research, Business
Forum, Wntr-Spring, Business Process Management Journal,
Canadian Journal of Anesthesia/Journal canadien d'anesthésie,
Computational Management Science, Computers and Chemical
Engineering, Cornell Hotel and Restaurant Administration
Quarterly, Energy Policy, European Management Journal, Expert
Systems With Applications, Forest Products Journal, Fuzzy Sets
and Systems, Healthcare financial management. IEEE
Transactions on Engineering Management, Industrial
Management, International Journal of Commerce and
Management, International Journal of Information Technology &
Decision Making, International Journal of Project Management,
International Journal of Quality & Reliability Management,
International Transactions in Operational Research, Journal of
Accounting Research , Journal of Cleaner Production, Journal of
Economic Behavior and Organization, Journal of Empirical
Finance, Journal of Hospitality & Tourism Research, Journal of
International Financial Management & Accounting, Journal of
International Money and Finance, Journal of Management
Accounting Research, Journal of Managerial Issues, Journal of
Property Investment & Finance, Journal of Public Health
Dentistry, Journal of Retail Banking, Journal of Risk and
Insurance, Journal of Teaching in International Business, journal
of the Healthcare Financial Management, Knowledge-Based
Systems, Management Accounting Quarterly, Mid-Atlantic
Journal of Business, Naval Research Logistics (NRL), New
Directions for Higher Education, Operations-Research-Spektrum,
Quarterly Review of Economics and Finance, Real Estate
Economics, Review of Agricultural Economics, Review of
Business, Review of Finance and Banking, Review of
Quantitative Finance and Accounting, Scandinavian Journal of
Management, South East European Journal of Economics and
Business, Strategic Finance, The Accounting Review, The
European Journal of Finance, The Financier, Spring-Winter, The
McKinsey Quarterly, Tsinghua Science & Technology, UTMS
Journal of Economics, Vision: The Journal of Business
Perspective, Journal of advances in management research.
Percentages calculated in terms of number of papers appeared in each journal (N = 202).
3.2 Major themes identified in Capital budgeting research
A total of 201 research papers in capital budgeting have been meticulously reviewed and consequently following major
themes have been identified: capital budgeting theory and practices, capital budgeting theory and practices in developed
countries, capital budgeting theory and practices in developing countries and factor affecting capital budgeting decision.
Findings discusses under identified themes.
3.3 Capital budgeting theory and practices
Capital budgeting decisions are crucial and complex and have attracted many research scholars in this field. According
to Dayananda et al. (2002), capital budgeting is the process of deciding investment projects which create in
maximization of shareholder value. Capital budgeting is mostly dealt with sizable investments in long term assets.
Assets can be either tangible such as building, plant, or equipment or intangible assets such as patents, new technology
or trade mark (Brealey & Myers, 2003). Capital budgeting is not a short term aspects, generally prepared a year in
advance and extendable to five, ten or even fifteen years in future (Brickley, 2006). And thus, Peterson and Fabozzi
(2002) define capital budgeting is the process of analyzing and selecting investment opportunities in long term assets
where its benefits last for more than one year.
Capital budgeting is a fundamental and used everywhere as a tool for planning, control, and allocation of scare
resources among competing demands. Capital budgeting is a vital part in financial planning and decision making since

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capital budgeting tools leads better decision making and be able to justify selection of specific capital investments
among competing alternatives (Sekwat,1999).Decision to choose the best investment project among competing projects
is of critical and being taken by top management (Bowman & Hurry, 1993; McGrath, Ferrier & Mendelow, 2004) and
considerable attention is thus to be given to investigating the methods used in evaluating and selecting investment
projects (Sangster, 1993; Segelod, 1998).
The most prevalent capital budgeting techniques in the public finance literature include payback period (PB),
accounting rate of return (ARR), net present value (NPV), internal rate of return (IRR), benefit-cost ratio (BCR), and
profitability index (PI) (e.g., Sekwat,1999;Cooper et al.,2002). Among these methods, four methods .viz., NPV, IRR,
PB and ARR, have been identified as a predominant method and used in many studies (e.g., Pike,1996; Kester, Chang,
Echanis, Haikal, Isa, Skully,Tsui & Wang, 1999; Hermes, Smid, & Yao , 2007).
The PB model determines the length of time required to recover exactly the invested cash outlay. On the other hand, the
ARR is calculated as the ratio of the investment‘s average after tax income to its average book value (Cooper et al.,
2002). The PB period has been criticized for failing to make accurate assessments of project value as it does not
consider use of cash flows, time value of money, risk in a systematic manner and further it does not identify investment
projects that will maximize profits, therefore PB does not have theoretical justification (Pike, 1988; Lefley,1996).
Research scholars and practitioners criticized the ARR due to the ignorance of the time value of money (e.g., Cooper et
al., 2002; Ross, Waterfield, Jordan & Roberts, 2005). And PB methods failed to consider return from the capital
investment after the initial outlay recovered, yet it is also oft- used methods (e.g., Graham & Harvey, 2001; Brounen et
al., 2004; Bennouna, Meredith and Marchant, 2010). Researchers argued that the reasons behind widespread use of PB
method are of its easiness and of providing information about recovery of initial investment.
Thus, in the next generation, the NPV model came into practice where it measures the difference between present value
of the money in and present value of the money out (Cooper et al., 2002). If the NPV is positive, the capital investment
is accepted and vice versa. Alternatively, the IRR determines the rate at which capital investment can be acceptable and
thus equates the cost of the capital investment to the present value of that project (Cooper et al., 2002). In finance, the
methods of assessing capital budgeting using the concepts of the time value of money is called discounted cash
flow (DCF) analysis. The NPV and IRR methods are called discounted cash flow (DCF) methods. The PB and ARR
methods are considered to be non-DCF methods. ‗Capital budgeting theory assumes that projects are evaluated based on
economic merit. Building upon certain economic assumptions, including the time value of money, risk aversion, and an
assumed goal of value maximization, sophisticated investment appraisal techniques such as NPV and IRR, have been
advocated in the literature‘ (Slagmulder et al., 1995,p.123).Notwithstanding, several researchers criticized that requisite
necessary information for NPV and IRR is commonly not known with certainty owing to longer periods, uncertainty
in future, higher degree of risk, ignore the size of the investment and absence of logical comparison on time value of
money (e.g., Sekwat,1999;Cooper et al.,2002; Hermes et al., 2007).Thus, in order to overcome both the time value of
money and the size of the investment, the PI model has been emerged. It is the ratio of the capital investment to its
outlay and the decision being made in terms of the highest PI (Cooper et al., 2002). If this method used carelessly with
constrained investment resources, it generates bad results (Brealey & Myers, 2003).
However, Graham and Harvey (2001) reported that twelve capital budgeting methods were in practice: NPV, IRR,
Annuity, Earning multiple (P/E), Adjusted present value (APV), PB, Discounted Payback, PI, ARR, Sensitivity analysis,
Value at risk and real options. However, all of them are not in usable at all situations in capital budgeting practices. For
example, IRR should not be the best method if investments are mutually exclusive or have multiple rates of return,
however, IRR is oft-exploited methods in practice (Graham & Harvey, 2001; Brounen et al., 2004; Bennouna et al.,
2010).
Of these methods, discounted payback considers time value of money but it still ignores cash flows after initial outlay
recovered. Value-at-risk (VAR) is to measure 'the worst expected loss over a given horizon under normal market
conditions at a given confidence level' (Jorion, 2006; p.12), is a relatively new method. The APV additionally covers the
value of financial side-effects of an investment to NPV, and treated as having no drawbacks principally (Ross et al.,
2005).
The greatest problems of the traditional present value models are that its complete reliance on quantifiable cash flows.
However, in a contemporary high tech world, many new projects entail complete redesign of the manufacturing
environment and computerized design is of paramount important to be innovative, higher qualities and speedier
response (Cooper et al., 2002). And thus, the theory of capital budgeting is diverged from its practices.
The complex nature of the capital investment in today‘s world incubates many new models into practices including
multi-attribute decision model, and analytical hierarchy process that are more subjective (Cooper et al., 2002). Modern
theoretical developments in finance views that DCF methods are not the best methods to select capital investment
projects: they have severe drawbacks in the analysis of investment projects if the information about future investment

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decision is not available (Brennan & Schwartz, 1992; Trigeorgis, 1993; Dixit & Pindyck, 1994). In such a situation,
Real Options Reasoning (ROR) and Game Theory (GT) serves as better analytical tools to evaluate such investment
projects (Smit & Ankum, 1993). GT stresses that firm is having an incentive to invest early in the case of fear of
pre-emption (Smit, 2003)
Real option theory: Real option is closely related to corporate capital investment decision-making and has been
introduced as an alternative approach for investment appraisal under uncertainty. The starting point for real options
research was the criticism of traditional strategic investment decision-making and capital budgeting methods. In general,
a real option represents or reflects the option or options that a company has when it comes to deciding whether to invest
in a project, delay, put it on hold, expand or reduce an investment, or any other flexibility that it may have (Rigopoulos,
2014). ROT involves the use of investment evaluation tools and processes that properly account for both uncertainty and
the company‘s ability to react to new information (Verbeeten, 2006). ROT has operating flexibility (which enables the
management to make or revise decisions at a future time, such as expansion or abandonment of the project) and the
strategic option value (resulting from interdependence with future and follow-up investments, such as implementation in
phases and the postponement of investments) (Verbeeten, 2006). Many researchers have argued that the use of real
options analysis has an advantage over NPV, since NPV is not able to capture the value of managerial flexibility (e.g.,
Ingersoll & Ross, 1992; Trigeorgis, 1993; Dixit & Pindyck, 1994). For example, the management could delay, expand,
abandon, temporarily close or alter the operation during the project‘ life. Ross et al. (2005) argued that most capital
investment projects have options (i.e., the option to expand, the option to modify, the option to abandon), which have
value per se. Although this method has not been applied on a large scale in practice (Hermes et al., 2007), it is mostly
applicable in specific industries or situations. DCF techniques are used concurrently with real options in order to
determine the true NPV (Amram & Howe, 2002). Many research scholars have found that only a few firms have
employed real options (Graham & Harvey, 2001; Ryan & Ryan, 2002; Brounen et al., 2004; Block, 2007; Truong,
Partington & Peat,2008; Verma et al., 2009; Bennouna et al., 2010; Shinoda,2010, Singh et al.,2012; Andres, Fuente &
Martin,2015).
It is obvious that widespread use of sophisticated capital budgeting during the last two decades. Many earliest studies
investigated about capital budgeting decision rule, in contrast, recent researches attempted to focus on the use of
sophisticated capital budgeting practices (e.g., Miller & Waller, 2003). Application of sophisticated capital budgeting is
more complex, and required the firms to be able to expend cost, time and effort (Busby & Pitts, 1997; Miller & Waller,
2003). Thus, it is important to think about the appropriate level use of sophisticated capital budgeting practices to the net
benefits against costs. Anyhow, theory, in contrast, suggests that if uncertainty exists, use of sophisticated capital
budgeting practices is valuable and the costs would be offset by the gains from successful investments (Verbeeten, 2006).
If uncertainty exists, additional information needed to solve the problem of investment dilemma (Miller & Waller, 2003).
It was identified that Canadian firms seem to be increasingly using sophisticated methods when dealing with risk (for
example, sensitivity analysis, decision-tree analysis, Monte Carlo simulation, ROR, GT) (Bennouna et al., 2010).
Nowadays, there are number of other methods including the project-dependent (risk-adjusted) cost of capital (PDCC), the
weighted average cost of capital (WACC), the cost of debt (CD) used in capital budgeting practices. Among them PDCC
and WACC are said to be sophisticated method and CD is the least sophisticated method (Hermes et al., 2007).
3.4 Capital budgeting tools for incorporating risk
Overall, uncertainty affects future cash flows and causes estimation difficulties. Therefore, various risk analysis and
management science techniques have been developed to supplement the traditional present value based decision models.
Scholarship on the practice of capital budgeting in many countries has found that firms are increasingly employing
more sophisticated capital budgeting techniques in order to make investment decisions over several years (Klammer,
1973; Klammer & Walker,1984; Pike,1988; Jog & Srivastava,1995; Gilbert & Reichart,1995; Farragher, Kleiman &
Sahu,1999; Arnold & Hatzopoulos, 2000; Brounen et al.,2004; Truong et al., 2008; Baker, Dutta & Saadi,2011). In the
contemporary world, there are a number of sophisticated capital budgeting methods including the oft-cited: Monte
Carlo Simulations, Game theory decision rules , Real option pricing, Using certainty equivalents, Decision trees, CAPM
analysis / ß analysis, Adjusting expected values, Sensitivity analysis/break-even analysis, Scenario analysis, Adaptation
of required return/discount rate, IRR, NPV, uncertainty absorption in cash flows, and PB (e.g., Arnold & Hatzopoulos,
2000; Hall, 2000; Graham & Harvey, 2001; Ryan & Ryan, 2002; Murto & Keppo, 2002; Cooper et al., 2002; Smit, 2003;
Sandahl & Sjogren, 2003; Brounen et al., 2004; Lazaridis, 2004; Lord, Shanahan & Bogd, 2004; du Toit & Pienaar,
2005;Verbeeten, 2006; Elumilade, Asaolu & Ologunde, 2006; Hermes et al., 2007; Leon et al., 2008; Correia &
Cramer, 2008; Verma et al., 2009; Bennouna et al., 2010; Shinoda, 2010; Hall & Millard, 2010; Dragota et al, 2010;
Poudel et al., 2009; Kester & Robbins, 2011; Maroyi & Poll, 2012; Singh et al., 2012; Andres et al., 2015). Thus, the
complex models of capital budgeting practices are dependent on not only the use of DCF techniques, but also proper
cash flows, discount rates and the risk analysis (Brigham & Ehrhardt, 2002).

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3.5Classification of Capital budgeting Practices
Capital budgeting practices help managers to select n out of N investment projects with the highest profits and an
acceptable ‗risk of ruin‘ (Verbeeten, 2006, p.108). By and large, all capital budgeting practices can be subsumed into the
categories of sophisticated, advanced and naive (e.g., Haka, 1987; Haka, Gordon & Pinches, 1985; Verbeeten, 2006;
Wolffsen, 2012). Naive practices includes PB, the adaptation of required payback and ARR, and the advanced /NPV
based, including Sensitivity analysis/break-even analysis, scenario analysis, the adaptation of required return/discount
rate, IRR, NPV, uncertainty absorption in cash flows, MIRR and PI. Farragher et al. (2001) suggested that a degree of
sophistication is represented by the use of DCF techniques and incorporating risk into the analysis. Sophisticated capital
budgeting methods generally include Monte Carlo simulations, GT, RO, using certainty equivalents, decision trees,
CAPM analysis / ß analysis, and adjusting expected values (Verbeeten, 2006; Wolffsen, 2012).
3.6 Capital budgeting theory and practices in developed countries
This section clearly discusses the capital budgeting theory and practices especially in developed countries. As
aforementioned, the capital budgeting practices are the investment decision taken for increasing shareholders value
(Dayananda et al., 2002).
Many studies have been conducted about capital budgeting practices in U.S. and Europe (e.g., Pike, 1996; Sangster,
1993; Block, 2007; Herme et al., 2007). Chadwell-Hatfield et al.(1997) conducted a survey among 118 manufacturing
firms in the U.S. Results showed that NPV (84%) and IRR (70%) were preferred primary methods. However, it was
clearly observed that two thirds of firms relied on shorter PB periods rather IRR or NPV. A seminal study carried out by
Graham and Harvey (2001) 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. Very similar results were reported in Ryan and Ryan‘s
(2002) study where sample consisted of Fortune 1000 companies. 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. Block (1997) studied about capital budgeting
techniques across small business firms operating in the United States. The most popular method was the PB (42.7%),
followed by ARR (22.4%). Notwithstanding, researchers connotes that small business owners seemed to be increasingly
using DCF as the primary method for evaluating.
Cooper et al. (2002) studied capital budgeting practices in fortune 500 companies in America. Sample consisted of 102
chief financial officers reported that commonly used primary capital budgeting model is the IRR and the second is the
payback. Ken and Cherukuri (1991) found that IRR was mostly preferred method in larger companies operating in the
U.S. NPV was the next preferred method. The widely used discount rate was the WACC (78%) and the risk was
commonly measured by sensitivity analysis (80%).Almost similar results were reported in the survey of Fortune 100
firms by Bierman in 1993.
Arnold and Hatzopoulos (2000) conducted a study on "The gap between theory and practice in Capital Budgeting:
Evidence from the UK for 300 UK companies (comprising 100 large, 100 medium and small 100). Results of study
indicate that UK companies have increasingly adopted the analysis of financial textbooks prescribed. Stage has been
reached in which only a small minority do not make use of discounted cash flows, formal risk analysis, adjustment
corresponding inflation and post-audit in their study. Study reported however, managers still using simple rules of
thumb techniques in UK
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 PB. Similar results were found in the UK in Pike‘s (1996) study. 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 (for example, sensitivity
analysis, decision-tree analysis, Monte Carlo simulation, ROR, GT) (Bennouna et al., 2010).
Drury, Braund and Tayles (1993) surveyed 300 manufacturing companies in the UK about their capital budgeting
practices. Results showed that PB (86%) and IRR (80%) were mostly preferred methods across the sample. The widely
used risk analysis was the sensitivity analysis. In a seminal study of 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

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limited number of studies are also available for the Netherlands (e.g., Herst, Poirters & Spekreijse, 1997; Brounen et al.,
2004).
Many researches recognized that DCF is the dominant in capital budgeting evaluation methods in the UK (e.g., Arnold
& Hatzopoulos, 2000), the USA (e.g., Ryan & Ryan, 2002) and in Canada (e.g., Payne et al., 1999). However, most of
the US firms use DCF techniques in comparison with firms in European countries (e.g., Brounen et al., 2004). There is
still some reluctance in this field due to the technical aspects of DCF (e.g., Cary, 2008; Magni, 2009). In 1993, Bierman
and Smidt opined that the DCF methods are the pre-eminent investment decision tool and thus, it is imperative to
manager to learn about its uses. Anyhow, NPV, IRR and PB are the most popular methods among North American and
Western European companies (Graham & Harvey, 2001; Brounen et al., 2004).
Sekwat (1999) studied capital budgeting practices among 321 Tennessee municipal governments. His results showed
that most of the municipal government‘s organizations are using benefit cost ratio (62.5 %) and payback methods
(61.5%), and financial officers were in reluctant using IRR, ARR and even NPV methods. 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, Truong et al., 2008 found that NPV, IRR and PB were the most popular capital
budgeting evaluation methods. Researchers were also identified the use of real option across the sample but not yet part
of the mainstream.
In 2009, Kester and Robbins 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 rate. On the other hand, Lazaridis (2004) studied
capital budgeting practices in Cyprus. The PB was found as the most preferred method and not NPV.
Shinoda (2010) carried out a survey of capital budgeting in Japan. Questionnaire has been administered to collect data
from a sample of 225 companies listed on Tokyo Stock Exchange. Results showed that firms were using combination of
PB and NPV for evaluating capital investment projects.
In summary, many studies have found that increasing use of sophisticated capital budgeting techniques among many
developed countries: US, UK, European and Australian companies (Freeman & Hobbes, 1991;Shao & Shao, 1996;
Pike, 1996; Herst, Poirters & Spekreijse, 1997; Brounen et al., 2004 ; Truong et al., 2008). However, US companies
seem to be using more DCF methods as compared to European countries.
3.7 Capital budgeting theory and practices in developing countries
There is dearth of studies carried out on capital budgeting practices in developing countries during the last two decades.
In comparison with developed countries, the results of the most studies show a different picture. In most of the
developing countries, PB method was the dominant methods in evaluating capital investment. Kester et al.(1999)
surveyed a total of 226 companies across six countries: Australia, Hong Kong, Indonesia, Malaysia, Philippines and
Singapore. Results showed that PB is still important method and the DCF methods have become increasingly important.
In five Asian countries, 95% of firms used PB method and 88% of them use NPV in evaluating projects. However, both
methods were treated as equally important. Kester et al. (1999) noted that sophistication of capital budgeting techniques
within the developing countries in Asia has been increased very rapidly during the last decade.
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. In 1998, Jain and Kumar studied about comparative capital budgeting practices: the Indian
context and sampled 96 nongovernment companies where listed in Bombay Stock Exchange and five companies of
South East Asia. They observed that most preferred capital budgeting techniques was the PB (80% companies),
followed by NPV and IRR. Sensitivity analysis was the preferred risk assessment method.
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, conducted by Verma et
al.(2009), took a sample of 30 manufacturing companies in 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.

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Researchers further observed that increasing adoption of DCF rather traditional use of non-discounted techniques. In
2012, Singh et al. studied on capital budgeting decision sampling from 31 listed companies in India. Albeit capital
budgeting decision continued in India, all sampled firms reported that they are using DCF techniques in combining with
non-DCF techniques. Of discounted cash flow techniques, more than three quarters of the sampled companies use IRR
which more preferred than NPV that used by half of the sampled companies. Further it has been reported that half of
the companies use real option techniques in selecting their capital investment projects. Long term capital is of financing
source to finance fixed assets (net) and working capital (net) in India. Most of the variables are country specific;
researchers call for further detailed research considering sectorial analysis of the constituent sectors of the sample
companies would be shed new light on this area.
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.
In 2008, Leon et al. conducted a survey of capital budgeting practices of listed companies in Indonesia. DCF was
mainly adopted methods in those companies as primary evaluation tool for capital investment projects. The most
prevalent risk assessment tools were scenario and sensitivity analysis. Results supported that CAPM was not so popular
Recently, a survey of capital budgeting practices have been conducted by Khamees, Al-Fayoumi, and Al-Thuneibat
(2010) in Jordan. Results reported that both DCF and non DCF method were still popular in evaluating capital
budgeting investment. Surprisingly, the most popular method was PI, followed by PB.
Most recently, Maroyi and Poll (2012) conducted a survey of capital budgeting practices in listed mining companies in
South Africa. Results showed that NPV, IRR and PB were the most prevalent methods in evaluating larger investment
projects. Results further indicated that PB was found to be continual use of method. Following table summarizes the
key findings on capital budgeting literature
Table 1. Key findings on capital budgeting studies during last two decades (from 1993 to 2013)
Author/s Population Most popular capital
budgeting method
Methods for evaluating
risk in Capital Budgeting
Drury, Braund & Tayles
(1993)
300 UK
Manufacturing
companies
PBP and IRR Sensitivity analysis.
Babu & Sharma (1995) 73 Indian
companies
DCF Methods Sensitivity analysis and
adjustment of discount
rate methods
Jog & Srivastava
(1995)
582 Canadian
companies
IRR and PBP Sensitivity analysis
Pike (1996) Large UK
companies
PBP
Kester & Chang (1996) 54 companies IRR and PBP Scenario and sensitivity
analysis
Farragher, Kleiman &
Sahu (1999)
379 US
companies in the
Standard & Poor‘s
industrial index
DCF Methods : NPV Capital Assets Pricing
Model
Sekwat (1999) 166 Finance
Officers of
Municipal
Governments
Cost-Benefit Ratio and
PBP

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26
(Tennessee)
Kester , Chang,
Echanis, Haikal, . Isa,
Skully, Tsui, & , Wang
(1999)
226 companies in
Australia, Hong
Kong, Indonesia,
Malaysia, The
Philippines and
Singapore in 1996-
1997
Equal importance to
discounted and
non-discounted cash flow
techniques in evaluating
projects
Scenario analysis and
sensitivity analysis
Arnold & Hatzopoulos
(2000)
300 UK Companies DCF is widely using by
the selected UK firms.
Hall (2000) 65 Respondents
(South Africa)
IRR
Graham & Harvey
(2001)
392 Chief
CFOs of
companies in the
U.S.
NPV and IRR Large firms- risk adjusted
discount rate Small firms-
Monte Carlo Simulation
Ryan & Ryan (2002) 205US Companies NPV and IRR Sensitivity analysis,
Scenario analysis,
inflation adjusted cash
flows, economic value
added, and incremental
IRR
Sandahl & Sjogren
(2003)
129 Swedish
Corporations
PBP Annuity
Lord, Shanahan & Boyd
(2004)
29 Local authorities
of New Zealand
Local Government
Cost Benefit Ratio
Brounen, deJong &
Koedijk (2004)
Four European
countries viz.,
U.K., France,
Germany and the
Netherlands
consisting of 313
companies during
2002 and 2003
Primary tools were in UK
– NPV and PBP, in
Netherland – NPV and
PBP , France and
Germany reported lower
usages of both methods
(42% for NPV, 50 % for
PB and 44% for NPV,
51 % for PB
respectively).
Lazaridis (2004) Small Medium
Sized Companies
(Cyprus)
PBP Statistical Risk Analysis,
Scenario Analysis
Elumilade, Asaolu &
Ologunde (2006)
94 firms from
Nigerian stock
exchange (Nigeria)
PBP, ARR , and NPV Linear programming
Lam, Wang & Lam
(2007)
157 Hong Kong
Building
Contractors
PBP and Average
Accounting Rate of
Return
Shortening Payback
Period, Raising Required
Rate of Return
Dedi & Orsag (2007) 200 firms
selected from 400
of the best Croatian
firms & 34 banks
IRR, PBP (cost of capital
is calculated by WACC)
Risk-adjusted discount
rate, Certainty equivalents
for cash flows