Applied Economics and Finance
Vol. 3, No. 2; May 2016
ISSN 2332-7294 E-ISSN 2332-7308
Published by Redfame Publishing
Capital Budgeting Theory and Practice:
A Review and Agenda for Future Research
Lingesiya Kengatharan 1
1 Department 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
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
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,
Applied Economics and Finance Vol. 3, No. 2; 2016
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,
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
Applied Economics and Finance Vol. 3, No. 2; 2016
– 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
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?
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
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
Applied Economics and Finance Vol. 3, No. 2; 2016
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
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