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Hurdle Rates for Screening Capital Expenditure Proposals

Author(s): Eugene F. BrighamSource: Financial Management, Vol. 4, No. 3 (Autumn, 1975), pp. 17-26Published by: Blackwell Publishing on behalf of the Financial Management Association InternationalStable URL: http://www.jstor.org/stable/3665186 .

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HURDLE R A T E S F O R SCREENINGCAPITAL EXPENDITUREROPOSALS

EUGENEF. BRIGHAM

Dr. Brigham, Professor of Finance and Director of the Public UtilityResearch Center, University of Florida, is author and coauthor of anumber of books and many articles in finance.

Several of my colleagues and I are in the process ofwriting a series of financialmanagementcases to illus-trate what might be called "standard textbook pro-cedures."While finding firms to illustratemost aspectsof finance was not difficult, we were initiallyunable tofind even one firm that used different hurdle ratesfordifferent projects or adjustedthem as often as we ex-pected. This raisedsome ratherfundamentalquestions:Are theredifficultieswith the hurdleratesrecommendedin the academic iterature that render hemimpractical?Are businessmen missing an opportunity to improvetheir operations?Or, had we simply examined an un-representative et of firms?Thispaperreportsthe resultsof an investigationof these questions.

Capital Budgetingin AcademeAlthough many basic issues in the theories of capitalbudgetingand cost of capitalare still unresolved,mostacademicianswould accept the following statements:(1) In general,discounted cash flow (DCF) techniquesshouldbe used to evaluatecapitalexpenditureproposals.

Further,the net presentvalue(NPV)method is the bestof the DCF criteria. 2) The discount rate usedto calcu-late a project's NPV should reflect the project's risk(however measured). A large, multi-divisional,multi-product firm will undertakeprojects with differingde-grees of risk. Thus, diversifiedfirms should ordinarilyuse a number of different hurdle rates in their capitalbudgetingprocess.(3) A firm'scapital budgetinghurdlerates should be based on its averagecost of capital,which depends on (a) capital market conditions (re-flected in part by the level of interestrates)and(b) theamount of capital the firm plans to raise during thebudget period. Since capital market conditions arevolatile, and since firms'capitalrequirementsdo changefrom time to time, firms would be expected to makerelatively requenthurdleraterevisions.Obtainingthe Data

As in earlierresearch 1, 3,4, 8, 9, 11, 12, 13, 14] oncapital budgetingdecisions,a questionnairewas used inthepresentstudy.Uniquely,however,we simultaneouslyconstructedboth a questionnaireand in 45 pagesa pairAutumn 1975 17

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of hypotheticalcases that detailedhow a firmmightap-ply textbook principles(e.g., the capital asset pricingmodel) to the problemof settinghurdlerates. The caseexplained how we thought hurdle rates should be set,while the questionnaireaskedhow it wasactuallydone.Next, we discussed the case with the financialstaffsof severalcorporationsandusedit in MBAclasses n fivedifferent universities.By special arrangement, inancialofficers of such firmsas Armco Steel and 3Mexaminedthe case, participatedin the MBA classes, and helpedclarify points and make the case more realistic. Also,after each class the corporatepeoplewereaskedto com-plete the questionnaire.We next used the case at DukeUniversity n a 3-weekexecutive programdevoted to capital budgeting.All theparticipantshad a responsibilityfor capital budgeting,and at the conclusion of the course completed thequestionnaires and discussed them with the author.Participantswere from both industrialcompanies(14persons), on which this study concentrates,and utilitycompanies,which will be examinedseparately n a laterreport.To further broaden our coverage,the case and thequestionnairewere sent to a group of executives whohad recently completeda Universityof Illinois programand who were(1) knownto be interested n the problemaddressed n the case and (2) probably willing to takethe time to providethoughtfulanswers o the question-naire. Of 20 companies polled, 14 completed and re-turnedthe questionnaires.In total, data were obtainedon the 33 firms listedinAppendixA. This is certainlynot a randomsample-thecompaniesare all quite large,andthe fact that they par-ticipated in universityprogramscould mean that theyare more in sympathywith "academic echniques" hanthe averagefirm in their industryand size group.How-ever, even if the samplefirms are not representative findustry at present, the data may well indicatethe fu-ture directionof capital budgeting.

Use of DCF TechniquesAs noted above, academiciansexpect firms to useDCF selection criteria,especiallythe NPV method, andExhibit 1 indicates that the samplefirmsoverwhelming-ly meet this expectation. Actually, the sample com-panies tend to use a number of different screeningcriteria.In many cases, cash flow data are punchedoncards, fed into a computer,and severalcriteria are gen-erated as output.Several nterestingpoints can be madeon the basisofthe interviews, he questionnairedata,andmarginal om-ments on the questionnaires.First, one firm uses onlythe payback; another firm uses only the payback and

Exhibit 1. ScreeningTechniquesUsed in CapitalBudgetingQuestion: Does your company use a discounted cash flow(DCF) analysisfor at least some prospectivecapitalexpenditures?Pleasecheck the method or methodsthat areused.

PaybackAccountingrate of return(ARR)Internalrate of return(IRR)Net presentvalue (NPV)Benefit/costratio, or profitabilityindex(PI)EitherIRR, NPV,or PITotal companies

Number Percent24 74%16 4826 7823 7063133

1894

the ARR; and the other 31 companiesall use one ormore of the DCF criteria.These 31 firms, if they alsocalculatethe payback,use it (1) as a riskindexfor largeprojectsor (2) to screenrelativelysmallreplacementn-vestments.On this point, one company ndicatedthat itsprocedures manual makes the following statement:"DCF calculationsare not requiredto justify replace-ment investments with a cost of less than $1,000 pro-vided (1) the payback is 3 years or less and (2) theeconomic life of the projectis 6 years or longer." Thiscompany's capital budgeting system is not computer-ized.)Second, six firms calculated an IRR but not aNPV; 4 firms calculated a NPV but no IRR; and 18firms calculated both. The questionnairedid not askfor this information,but severalrespondentsdid com-ment that greater weight is givento NPV than to IRR;none of the 18 companies indicated that the reversewas true.

Finally, six firms calculate the benefit/cost ratio orprofitability index (PI). Four of the six also calculateboth NPVandIRR;a fifth calculatesNPV;andthe sixthuses only PI for project screening.Three of the com-panies that use PI with another DCF criterion were in-terviewed;these executives suggestedthat little weightwouldbe givento PI should it conflict with NPV.On balance,our samplecompaniesareusingDCF toa somewhatgreaterextent than earlierstudies would in-dicate, and they give greaterweight to NPV as opposedto IRR. This could be becausethe samplesaredifferent,or it could simply reflect the fact that our data arenewer, and firmsare moving toward DCF in generalandNPV in particular.

Use of MultipleHurdleRatesAcademicliteraturesuggeststhat risk-adjustedurdleratesshouldbe used to screenprojects,so, except in the

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unlikely event that all projects are equallyrisky, firmsshould use more than one hurdle rate.To test for use ofmultiplerates,we asked the questiongivenin Exhibit 2.Of the 31 firms that use DCF and therefore requirehurdle rates, almost half use one rate to evaluate allprojects throughout the corporation. The remaindercategorize projects in some manner and use differenthurdlerates for different investmentcategories.Exhibit 2. Use of Multiple Hurdle Rates in CapitalBudgetingQuestion: Some companiesestablishone hurdlerateand use itthroughout the corporation. Others estimate dif-ferent rates for different units (e.g., subsidiaries,divisions,or productlines), or use different rates fordifferent types of projects (e.g., replacement,ex-pansion of old product lines, expansion into newproducts, overseas vs. domestic). Still other com-panies use different costs of capital for differentindividualprojects dependingon projects'riskinessor other characteristics.Whichstatement or state-ments areapplicable o your company?

Number Percent*We calculateonly one hurdle rate and useit to screen all projectsthroughout hecorporation.We calculatedifferent hurdle rates fordifferentorganizational nits of thecompany:1. Subsidiaries2. Divisions3. Product ines4. Domesticvs. overseas

15 48%

533514**

the cash flow projectionsareregarded s being relativelyrisky. Thus, implicitly, but in an unspecified manner,differentialhurdle ratesarebeing applied.Second, inter-views established the fact that financialpeople engagedin project evaluation want very much to increase theweight given to quantitativerisk analysis-they want tomeasurerisk in some manner and to incorporate t ex-plicitlyinto the decisionprocess.

How Are Hurdle Rates Calculated?Academiciansgenerally agree that a firm's hurdlerates should be based on its cost of capital. There iscontroversyover the measurementof the cost of capital,but there is agreement that a risk-adjustedweightedaverage ost of capitalshould be used to screenproposedinvestments.As Exhibit 3 shows, 10%of the 31 firmsthat use a DCF capital budgetingcriterionand thus re-quire a hurdle or discount rate use their historical rate

of returnon investment;61%use a hurdlerate based onthe weighted averagecost of capital;and 29%checkedthe "other" category and provideda separateexplana-tion of theirprocedures.Exhibit 3. Basisfor EstablishingHurdleRatesQuestion: How do you establish your basic hurdle rate orrates?

16%10 Ourhurdleratesarebasedon historic10 ratesof returnon investment,e.g.,16 operating arnings/operatingssets.45%**Pleaseexplain.

Number Percent

3 10%We use different hurdle ratesfor differenttypes of investments e.g., replacement;expansion;old productlines;expansion:new products).Weattemptto evaluate he riskinessofindividualprojects(as opposedto unitsof companyor types of investmentsasdescribedabove) and varyhurdleratesdependingupon projectrisk.

Ourhurdleratesarebasedon our costof capital,e.g., weightedaverageofour cost of debt and equity. Please11 35% explain.Other(please specify):

731*These percentagesrelate to the 31 firms that use DCF andthereforerequirehurdlerates.**The numbersand percentagesdo not add up because somefirms use different hurdleratesfor severalorganizational nits.

Severalcomments areappropriate.First,althoughthesample firms are not using multiple hurdle rates as ex-tensively as theory suggests, every firm interviewednoted that judgment plays an importantrole in capitalbudgeting. If managementis confident of a project'sprojected cash flows, the projectmay be acceptedeventhough it fails to meet the DCF criterion;conversely,aproject that does meet the criterionmay be rejectedif

19 619 29

31 100%Academiciansregard he use of historicalratesof re-turn to screenprojectsas beingmost inappropriateandnot in the interest of maximizingequity value. Com-ments on several of the questionnairesprovideclues asto why historical returns are calculated and why theymight be usedas screeningrates.First,rates of returnoninvestment are widely used to evaluate divisionalman-agers-firms recognize that, other things held constant,a high rate of returnon investment s desirable.Further,if a successful firm earns,say, 15%aftertaxes on assets,and if it acceptsno projectwith an expected returnofless than 15%,then it will maintainor improveits his-torical return. However, the firm is clearly not maxi-mizing stockholder wealth if the historicalrate of returnhappensto be different fromthe currentcost of capital.

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The companies that use a cost of capital screeningrateprovidedsome interesting nsightsinto practicalat-tempts to measurethe cost of capital. First, 29 of 31companiesuse balance sheet figures(book weights) tocalculatethe weightedaverage ost of capital.It wasnotalways clear if the weights represented he actual bookvalue figures at the time the cost of capitalwas calcu-lated or a target capital structure.At least some firmsuse a target as opposed to the actual capitalstructure.Second, the companiesall use the after-taxcost of newdebt. Most concentrate on long-termdebt, but severaluse an averageof long and short-termcosts. Further,executives have as much troubleestimatingthe cost ofequity as academiciansdo, and many of the question-nairerespondentsand intervieweeswere quite candid nadmittingthat their estimatesrely heavilyon judgment.As to quantitative measures, most use the D/P + gformulation,with g beingestimatedon the basisof pastearningsgrowth. Two companiesspecifically indicatedtheir use of the capitalassetpricingmodel (CAPM)ap-proach, although both indicated that they also useD/P + g. Finally, a number of the companiescalculatean averagecost of capital, then increase t for use as ascreeningrate on profitableinvestments n orderto off-set zero (or negative) returns on environmentalandother non-earningnvestments.In otherwords,if a com-pany estimatesits averagecost of capitalto be 12%,butit must allocate20%of its capitalbudgetto non-revenueproducingprojects,then it mightuse 15%as its screen-ingrate(12%/.8= 15%).Although this procedure seems reasonableat firstglance, it could presentproblems.Whatis happening ssimilarto the sunkcost problem.Therearetwo types ofenvironmentalexpenditures: (1) those associatedwithnew plants, where the analysis presumablyalreadyin-cludes pollution control costs, and (2) those associatedwith bringingexisting plants up to standard.For thefirst type, a regularcost of capitalhurdlerateshouldbeused. For the second type, the correct analysis nvolvescomparingthe cost of the environmental nvestmenttothe entireprofit contributionof the plant. The existingplant cost is, for purposesof this analysis,a sunk cost.If a company can raise capital at a cost of 12%, itshouldtake all investmentsyielding anythingmorethan12%,even if it cannot earnsufficientlymore than 12%to cover zero or negative returnprojects.Of course, ifthe firm thinks that plants currentlybeingbuilt will re-quire subsequent pollution abatementexpenditures,itcan use an inflatedhurdlerate to screenprojects,but itwould be better to estimate pollution costs and buildtheminto the analysis.It is impossibleto generalizeabout the "other" cate-gory in Exhibit 3 except to state that these companies,while usinga DCFacceptancecriterion,arenot attempt-ing to screenon the basisof a cost of capital.Generally,

the companies made such statementsas: "Our hurdlerate is set duringour strategicplanningprocess.It variesamong operatingunits depending on economic condi-tions that affect specific product lines. Basically,we areconcernedwith what is possible and in getting rates ofreturnthat will meet our corporategrowthand profita-bility targets."We attempted without much success topin down such statements in the interviews.While theintervieweesgenerallystated that a good dealof thoughtgoes into the hurdle rate specification, those in the"other"category all agreedthat the final rate is some-what arbitrary, nd that it is not basedon the firms' costof capital.How OftenAre HurdleRates Changed?

Hurdlerates should reflect both capitalmarketcon-ditions and the firm's internalsituation, includingtheamountof capital t plansto raise.Giventhat conditionschange fairly often, responses to the question in Ex-hibit 4 shows that firms revisehurdlerates ess frequent-ly than one might expect. Based on the interviewees'comments and notes accompanyingthe questionnaires,most of the companiesthat revise ess than once a yeardo not have a system for reviewingtheir hurdle rates.The "depends on conditions" companies stated thatthey revise rates to reflect product and capitalmarketconditions, with revisionsgenerallyoccurring ess thanonce a year.Exhibit4. Frequencyof HurdleRate RevisionsQuestion: How often do you changeyourhurdlerate?

Number PercentAnnually 4 13%More han once a year (pleasespecify) 5 16Lessthan once a year (pleasespecify) 12 39Dependson conditions(pleasespecify) 10 32

31 100%

Do HurdleRates ReflectVolumeof Financing? the Firms'Because of transactionscosts, marketimperfections,taxes, and other factors, most academicians hink themarginalcost of capitalschedule(MCC) acing a firmisupward sloping, at least beyond some volume of fi-nancing.(See Exhibit 5.) In theory(andin at least somefirms), the budgeting process goes somethinglike this:(1) The treasurerestimates the MCCschedule.(2) The

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director of capital budgeting obtains from the oper-ating divisions the approximate dollar volume of ac-ceptable projects at differenthurdlerates(e.g., $5 mil-lion at a 20%screeningrate, $6 million at a 19%rate,etc.). (3) The projected, or ex ante, MCCand invest-ment opportunity schedules (IOS) are plotted on agraph such as that shown in Exhibit 5. (4) The per-centage interest rate (k) at which the two schedulesin-tersect is used as the hurdlerate; f the ex post MCCandIOS schedules are reasonably close to the ex anteschedules, the use of this hurdle rate will produce anoptimal capital budget. If the investment opportunityschedule is anywhereto the left of IOS2, then shifts inIOS, and consequently in the amount of funds raised(Q), have no effect on the MCC; hence, such shiftsshould not be reflected in the firm'shurdle rate. How-ever, if the IOS is to the rightof IOS2, then year-to-yearshifts will affect the MCCandshould be reflectedin thehurdlerate.Exhibit 5. RelationshipBetween HurdleRates, Invest-ment Opportunities,and the MarginalCost of CapitalScheduleInterest Rate(%)

fossilplants,it will need only $1 billion. In analyzing healternatives,the company has been usingthe same dis-count rate. Nuclear appearsto have an advantage thepresent value of total capital and operating costs arelower for nuclear),but the treasurer s very concernedabout the effect raisingthis volume of capitalwill haveon his cost of capital.Discussionwith managementndi-cates that the treasurercan estimate a MCCcurve inwhich he is reasonablyconfident, and that the nuclear/fossil analysis will be rerunwith higher discount ratesappliedto the nuclearplant. (The companyis also con-sideringthe relativeriskiness of the nuclearand fossilplants, and may also use risk-adjustedrates in theanalysis,but at this point the risk differentialsare notclear. It is interesting, though, that the company isthinking seriouslyof shifting from a single to multiplehurdlerates.)Exhibit 6. Responsivenessof HurdleRates to Amountof CapitalRaisedQuestion: Does your hurdle rate reflect the amount of capitalyou plan to raise, e.g., if preliminaryorecasts ndi-cate a need to raise a relativelylarge amount ofcapitalvis-a-vispast years, would you tend to use ahigherrate to screenprojects?

Ourhurdleratedoes reflect theamount of capitalwe plan to raise(or that is available).Ourhurdleratedoes not reflectthe amountof capitalwe plan toraise(or that is available).

Number Percent

17 55%

1431

45100%

MCCIOS

Q3 Q2 Q1 $ Raised DuringBudget Period

= Marginal Cost of Capital= Investment Opportunity Schedule

Exhibit 6 shows that over half the firmsconsider fi-nancialneeds when setting hurdle rates. The 45%thatdo not could, of course, simplybe in the MCCrange othe left of IOS2, but it was evident from the interviewsthat some of the companieshave simply neverthoughtin a formalway of the relationshipbetweenfundsraisedand capitalbudgetinghurdlerates. Oneparticularlydra-matic exampleis a utility companywith assetsof about$1.5 billion (1975) considering he constructionof nucle-ar or fossil generatingplants. If it "goesnuclear," t willhave to spendanadditional$2 billionby 1985;if it builds

WeightsGiven to QuantitativeAnalysisbyProject TypeTwo importantpoints began to emergein our earlyinterviews.First, different types of projectshave syste-maticallydifferentriskcharacteristics, nd,second,thesedifferences affect the relative weight given to formalquantitative analysis versus "judgment." A project's

riskinesscan be separated nto two components-uncer-tainty about how much it will cost to buy or build aparticular acilityandmake it operative,anduncertaintyabout the cash flows the project will generateover itsexpected life. For many routine replacementsandsmallcost-reducing nvestments,both the initial cost and thecash flow streamcan be estimatedwith a relativelyhighdegree of accuracy.On the other hand, buildinga newplant that utilizes a new technology to producea newproductwill involve a greatdeal of uncertaintywith re-gard to both the initial outlay and the annual cashflows. Executives recognizethese differences,and theyAutumn 1975

k1

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account for them in two ways. First, projectsareclassi-fied by type (replacement,expansion,etc.), and differ-ent screening procedures are employed for differenttypes of projects.Second, where the cash flow data arerelativelyreliable,a greatdeal of weight is givento theDCF calculations,and where the cash flow data areun-certain, more weight is given to "judgment."In otherwords, if management is confident of the cash flowdata, a projectwith a positive NPV or with IRRgreaterthan MCCwill be acceptedwithout much ado, but if itdoes not have such confidence, projectswith positiveNPV's may be rejected and negativeones acceptedbe-cause of "corporate strategy" or other nonquantifiedreasons.To obtain information on the firms' use of invest-ment project classifications,and also on the extent towhich they rely on quantitative analysisas opposed tojudgment, we asked the question given in Exhibit 7.Twenty-one of the 33 executives were able to answer

this question; the other 12 either indicated that theysimply did not know how the final decisions werereached,or that their companiesdo not classifyprojectsin the manner ndicated n the question.The exhibitcanbest be understood f it is first considered n a somewhatartificialway. Supposea firm makes 100 investmentsofequal size(say $1,000) in eachof the 4 categories hownin columns1 to 4. Focusingon column 1, we see that onaverage27 of the 100 replacementand modernizationprojectsareaccepted primarilyon the basisof quantita-tive data,e.g., NPV > 0, IRR > cost of capital,or pay-back < minimumacceptable payback;36 projectsaredecided largelyon the basis of the quantitativedata;in33 cases most weightis givento "judgment"and the de-cision maker's "gut feel"; while 4 projectsare decidedalmost entirely on the basis of judgment and gut feel.Movingto column 2, expandedproduction of existingproduct lines, quantitative analysis plays an even moreimportantrole: 85%of the projectsin this categoryare

Exhibit7. WeightsGiven to QuantitativeAnalysisby ProjectTypeQuestion: Most companies consider qualitative and quantitative factors when makingaccept-rejectdecisions on capitalprojects.However, hese two types of factorsare given differentemphasis n differentcompanies,and a given companymayuse differentweights for different types of expenditures.For example,a highweight might be given to NPV, IRR, or payback for plant modernizationdecisions,but less weight for newproductdecisions. Recognizinghatjudgmentis involved in answering his question, please indicate the approximateweightyour company places on qualitativeversusquantitativeanalysis n each of thefollowingcategories.Approximateweightgivento formaleconomicanalysisin the accept-rejectdecision

Percentage f $ amountof capitalbudget n eachcategory

Replacement rmodernizationExpansion f Expansionexisting into newproducts products

(1)75-100% f weightplacedon formaleconomicanalysis50-75% f weightplacedon formaleconomicanalysis25-50%of weightplacedon formaleconomicanalysis0-25%of weightplacedon formaleconomicanalysis

TOTAL

27%

36

33

4100%

(2) (3)

35% 29%

50 47

14 22

1100%

2100%

*Includedhere mightbe pollution control expendituresand other non-incomeproducingprojects,R&Dexpenditures, ndthe like.

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Othercapitalexpenditures*Totalcapitalbudget

(4) (5)

28%

9 44

36 20

55100%

8100%

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decided primarily on the basis of formal economicanalysis.Somewhat less weight is given to quantitativefactors when new products arebeing considered,whilein the "other"categoryrelatively ittle weight is giventothe screeningcriteria-judgment s the dominantfactor.The total capital budget is a weighted averageof these 4categories,and column 5 indicates that, overall,about70%of the averagecompany's capital expendituresarebasedprimarilyon quantitativeanalysis.Thelogicbehind these findingsrelatesboth to qualityof data and to cost/benefit considerations.Replacementandmodernizationdecisions nvolverelativelygood data,makingquantitativeanalysis easible,but these decisionsare often repetitive, involve numerous small projects,and are frequently too obvious to warrant refinedanalysis.These two forces offset one another, and theresults are reflectedin column 1 of the exhibit. Thereissome indication that category 1, "replacementor mod-ernization," should have been divided into "replace-ment: cost reduction"and "replacement:maintenance."Had this separationbeen made,it is likely that relativelyheavy weight would be givento quantitativeanalysis orcost-reducinginvestments, but little weight to mainte-nance investments,which are often too obvious to war-rantdetailedanalysis.The data inputs aregenerallyof lowerqualityfor ex-pansioninvestments,but the projectsare larger,makingformalanalysismore worthwhile.So, on balance,formalanalysis is more important for expansion than for re-placement decisions. Investments in the "other" cate-gory (pollution, R&D,new home office building)gener-ally produce no direct revenuesupon which to base aNPV, IRR, or payback,or are so fraughtwith uncertain-ty as to make a DCFtype analysisunrealistic. f reliabledata are available, hese projectscan be decided on thebasis of choosing the system that will do the job withthe lowest presentvalue of future costs; this is the DCFcriteriaon whichutility companiesbasetheirinvestmentanalysis. (See BrighamandPettway [3] .)

What Trends in Capital BudgetingMethodologydo the CompaniesAnticipate?To obtain the companies' views on future projectselectionprocedures,we askedthe questionsgiven n Ex-hibit 8. Consistent with trendsshown in earlierstudies,companies today rely more heavily on quantitativeanalysis in general,and DCF in particular, han in thepast, and they expect this trend to continue. Mostcom-panies that do not expect to use DCF more heavily inthe future generally indicated that they are alreadyscreeningmost projectsby DCFcriteria.Morestriking s the interest in quantifyingrisk: 96%of the questionnaire espondentsexpect theircompanies

Exhibit 8. Trendsin CapitalBudgetingMethodologyQuestion: Various researchershave observed a trend towardgreater quantificationof the financial decision pro-cess. Has your companytended to give greaterem-phasis to quantitativeversus qualitativefactors inrecent years?If so, is this trendlikely to continue?

Yes NoIn general,we rely moreheavilyon quantitativeanalysis in thefinancialarea)than we did fiveto ten yearsago.DCFprojectselectioncriteriaaregivenmoreweight than wastrue five to ten yearsago.

92% 8%

88 12Is your company ikely to movein the followingdirections:

Towardheavieruse of DCF?Towardmorequantificationof projectrisk (e.g., simu-lation, sensitivityanalysis,etc.)?Towardgreateruse of mul-tiple hurdle rates?Towardmorefrequentre-visionsof hurdle rates?

73 27

96 4

50 50

50 50

to move in this direction, and in interviewsexecutivescontinually stressed(1) that they do recognizeriskdif-ferencesamongprojectsand (2) that they want to mea-sure these differencesin some manner and incorporatethem into the decision process in a non-arbitraryman-ner. Based on these reactions, one might anticipateamajormovement toward formal risk analysisin capitalbudgeting,at least for largerprojects.Although the questionnairedid not ask for forecastsof the analytical methods firms think will be used toquantify risk in the future, comments both on thequestionnairesand in interviewsdid providesomeinfor-mation on this point. First, several respondentsmen-tioned thepossibilityof usingHertz-typesimulation[7].In a recent article,in the Winter1974 issue of FinancialManagement, Hastie [6] concluded that Hertz-typeanalysis is generallynot operationallyuseful, and that"its use will probably continue to decline." Hastiestronglyadvocated a second approach,sensitivity analy-sis, which involvesestimatinga project'sprofit sensitivityto changes n key input variables.Nothingin oursurveycould be interpreted as either confirming or refutingHastie'sconclusions.However,based on discussionswithrespondents, t seemslikely that a third approach-"op-timistic, pessimistic, most likely" analysis-which lies

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somewherebetween Hertz'sfull scaleprobabilistic imu-lation and sensitivityanalysis,maywell be the dominantmethod of risk analysis n the future.(Some preliminaryideas on this issue arepresentedin Barry,Brigham,andCrum[2].)Regardlessof how risk is quantified,half of the re-spondents feel that their companies will use multiplehurdle rates more extensively in the future, and halfalso expect to make more frequentrate revisions. n thecase of multiple hurdle rates, this low percentage issomewhat inconsistentwith the movement towardquan-tifying risk. If companiesdo developprojectriskindices,they will probablyuse this information n settinghurdlerates. Thus, we can expect an increasingemphasisonquantifyingrisk to be accompaniedby an increaseduseof multiplehurdlerates.

Respondents'Reactions to the StudyA draft version of the paper was sent to each ques-tionnairerespondent,alongwith arequestfor comments.Thecommentsvariedconsiderably.The "multiplehurdlerate" companies seemed generally to agree with thethrust of the paper, but the "singlehurdle rate" com-panies gave some very cogent argumentsagainstmorequantitativeriskanalysis n generaland againstmultiplehurdle rates in particular.The following excerpts areoffered partly for the insights they offer and partly tooffset anybiasthispapermightexhibit:1. "Mostrespondents(includingthis one) indicated

that in the futurethey expect their firmsto placeheavierrelianceon quantificationof riskin theirevaluationpro-cedures. Assumingmost were individualslike myself,they may be primarily ndicatingtheir hopes or goals,with continuing acceptanceof new analytical methodsby operatingpersonneldependenton how good anedu-cational ob they do."2. 'The whole financialanalysisprogramof a busi-ness is to support, aid, and assistmanagement n exer-cising its businessjudgment. The analytical techniquesused by those of us who work in this area must be un-derstandableand meaningfulto those people who havethe authority to make and bear the responsibilityforoperatingdecisions."Mostof our importantcapital expenditureshave atime cycle of about five years.Generally,we canpredictquite accurately how much capital funds will be re-quired to accomplish a given program.Our degree ofaccuracy goes down when we estimate how much thefinished product will cost at different points in time(even ignoring inflation). The cash proceeds are evenmore difficult to estimate because they are even morebeyond our control. How many will the marketabsorb,and at what price? Whatwill be the reactionof direct

competition?What about indirectcompetition or othertechnologythat may come into the marketplace?"We believe that decisionmakersshould be given asmuch usable informationas possibleregarding isks,butit may sometimes be more harmfulthan good to pushquantificationtoo far. Wemake an effort to explain allimportantassumptions,and to provide"whatif" calcu-lationswhererisksappear o be significant."3. "Likemany efforts in life, the desireto achieve soften not sufficient to overcomea basic lack of ability.By lack of ability, I refernot to lack of anunderstandingof the methodsbut to a lackof confidence in the qualityof the necessaryinputs. It is my experience(and con-firmed by a good many of my peers) that it is damnedtough to obtain reliable data for a singledeterminationof return,let alone obtain a set of datafor probabilisticrisk analysis. To do the latter requires the capitalbudgeterto be a highly skilled psychologistand inter-viewer as well as an extremely competent teacher.Fewof us possess these skills. The marketingman, engineer,

purchasing agent, etc., must be taught and convincedthat a method produces improvedresults before he willacceptit andparticipateeffectivelyin its use."4. "As to establishingvarioushurdlerates,I submittwo argumentson why this is not a more widespreadpractice.First, we'd like to do it, but franklywe do notknow how to meaningfullyapplyknown cost of capitalmethods to each business n our mix. All the approachesrequire approximations. Like allocating corporate ex-penses, these approximationscreate controversy and,therefore,cast heavy doubts on the partsof the variousgroupexecutives."Second, I'm not convinced that in an inflationary,volatile world we knowhow to definitivelymeasurecostof capital. Compounding he problemof an impreciselymeasuredcost of capital, with a wide range,is the factthat projectreturnshave largestandard rrors.This situ-ation tends to minimizethe need (1) to establishdiffer-ent hurdle rates for different projects and (2) to alterhurdle ratesmorefrequentlythan once ayear."As indicatedabove, these are someof the morenega-tive (but perhaps ealistic)statements.Otherrespondentsare movingtowardmore riskquantificationand towardmultiplehurdlerates.

ConclusionsAs noted at the outset, the primarypurposeof thisstudy is to determineto what extent businesses'capitalbudgeting practices are consistent with the academicliterature, and if major inconsistenciesappear,to sug-gest modifications in either what businessmendo oracademicians each, or both. Basedon a seriesof inter-views, and a questionnaire survey of 33 firms, wereachedseveralconclusions.

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First,in general, he DCFmethodologyrecommendedin the academic iteratureappears o be usefulin a prac-tical sense, and sophisticated techniquesfor quantifyingrisk analysisare also gaining ground.Businessfirmsdohave trouble obtaining the data to implement someacademicprocedures,but the task seems not to be im-possible, and at least some firms are approaching he"textbookcase."

Second,whilesome of the companiesarealmostcom-pletely consistentwith the academic iterature,most arenot. In particular,although94%of the samplefirmsuseDCF methodology, only 62%use a hurdle rate basedonthe cost of capital, only 53%use more than one hurdlerate (in spite of admitted risk differentials amongprojects), and less than half change their hurdle rateseven once a year.Finally, the inconsistenciesare causedby two prima-ry factors.First,some of the techniquesnow beingadvo-cated in the academic iteratureare relativelynew, andnot all of the operating personnel in the firms are"checked out"on these techniques.The respondentsare,

however, generallyreceptive to most of the new ideas,and over time many of the inconsistencieswill probablydiminish. The second cause of the inconsistencieshas todo with the difficulty of measuring he averagecost ofcapital, project risk, and appropriaterisk-adjusteddis-count rates. But here again, the sample companies aregenerally trying to overcome these measurementprob-lems, and assuming hey canget a better fix on the basicdata, one can anticipatea further reduction of the ob-served inconsistencies. Data problems may, however,keep Hertz-typesimulation from ever being widely usedin industry.In closing,we should reiteratethat these conclusionsarebased on asampleof 33 large,relativelysophisticatedfirms, so no inferences canbe drawnaboutthe practicesof industrialfirms in generaland smallbusiness in par-ticular. However, to the extent that firms such as theones in the sampletend to lead others,the datamaywellindicate the directions in which capital budgeting ismoving.

REFERENCES1. Moustafa Abdelsamad, A Guide to Capital Expendi-ture Analysis,New York, AMACOM,AmericanManage-mentAssociation,1973.2. C. B. Barry,E. F. Brigham,and R. L. Crum,"Perspec-tives on Risk Analysis in CapitalBudgeting,"paperpre-sented at Southern Finance Association Meeting,NewOrleans,November,1975.3. Eugene F. Brighamand RichardH. Pettway, "CapitalBudgetingby Utilities,"FinancialManagementAutumn1973).4. George A. Christy, Capital Budgeting-Current Prac-tices and Their Efficiency, Eugene, Oregon, Bureau ofBusiness & Economic Research, University of Oregon,1966.5. Gordon Donaldson, "StrategicHurdleRates for Capi-tal Investment," Harvard Business Review (March/April1972).6. K. Larry Hastie, "OneBusinessman'sView of CapitalBudgeting," Financial Management (Winter 1974).7. David B. Hertz, "Risk Analysis in Capital Invest-ment," HarvardBusiness Review (January 1964).8. Donald F. Istvan, Capital Expenditure Decisions:How They Are Made in Large Corporations, Blooming-

ton, Indiana,Bureauof BusinessResearch,IndianaUni-versity, 1961.9. Donald F. Istvan,"The EconomicEvaluationof Capi-tal Expenditures," The Journal of Business (1961).10. J. R. Lyon, "UsingMultipleCutoff Rates for Capi-tal Investment," Journal of Petroleum Technology (July1975).11. Thomas P. Klammer,"EmpiricalEvidence of theAdoption of Sophisticated Capital Budgeting Tech-niques," Journal of Business (July 1972), pp. 387-397.12. Terry J. Nolan and FrederickA. Banda, "An Em-piricalStudy of the CapitalInvestmentDecisionMakingProcess in Selected Ohio Companiesin 1971-Part I,"Akron Business and Economic Review (Spring 1972),pp. 10-16; Part II, Akron Business and Economic Review(June 1972).13. Norman P. Pflomn, "ManagingCapital Expendi-tures," Studies in Business Policy, 107, New York, TheNationalIndustrialConferenceBoard, 1963.14. George Terborgh, Business Investment Management,A MAPIStudyandManual,Washington,D.C.,Machineryand Allied ProductsInstitute and Council for Techno-logicalAdvancement,1967.

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Appendix. Sample companiesCompanies 1974 Assets n MillionsAgway,Inc. $ 456AlliedChemicalCorporation 1,968ArmcoSteel 2,542ClarkEquipment 1,006ContainerCorporation f America 862Crown-Zellerbach 1,269Deere&Company 2,022Esmark, nc. 1,266F. S. Services, nc. 122GeneralMills 1,117Goodrich 1,647GulfOil 12,503HanesCorp. 183IBM 14,027KeystoneConsolidated ndustries 196MaytagCompany 123MinnesotaMining&Mfg.Co. 2,841MontgomeryWard 2,151SCMCorp. 647Sears,Roebuck&Co. 11,339SignodeCorp. 247SouthernRailwayCo. 2,024ShellOil 6,129StaleyMfg.Co. 285StanleyWorks 278StandardOilof Indiana 8,915SybornCorp. 419Tenneco 6,402TRW, nc. 1,698Unio Oil 3,459UniversalOilProducts 443Weyerhaeuser 2,327WilliamsCompanies 1,286

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