Survey of capital budgeting: theory and practice
TL;DR: A comparison between the theory and practice of capital budgeting can be found in this article, where the authors discuss the nature of the gap and the reason for its existence, and suggest ways of modifying theory to make it more operationally meaningful.
Abstract: THERE EXISTS A WIDE DISPARITY between the theory and practice of capital budgeting. During the past fifteen years, the theory of capital budgeting has been characterized by the increased application of such analytical techniques as utility analysis, mathematical programming, probability and statistical theory. The practice of capital budgeting has no doubt changed at the same time, but business executives do not appear to have adopted many of the new techniques. The purpose of this paper is to compare current theory with practice: (1) to discuss the nature of the gap and the reason for its existence, and (2) to try to lessen this disparity by suggesting ways of modifying theory to make it more operationally meaningful. To aid discussion, this paper is divided into four sections: objective of financial management, risk analysis in investment decisions, profitability criteria for investment selection, and conclusions. It is difficult, if not impossible, to characterize the current theory of capital budgeting in a few words. By current theory, I shall mean the type of work on capital budgeting that appears in journals such as Management Science, Journal of Finance, Journal of Financial and Quantitative Analysis, and Engineering Economist. These theories generally make use of modern quantitative tools. By current practice, I shall present the findings of case studies I conducted during the summer of 1969. In all, I interviewed eight medium and large companies in the following industries: electronics, aerospace, petroleum, household equipment, and office equipment.' I held full-day discussions in each company interviewed. Because of the small sample I do not wish to put forward any statistical generalizations about current practice. However, since the companies studied were chosen for the efficiency of their management, they do give a preliminary view of current capital budgeting practices in firms with progressive management.
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TL;DR: In this paper, the authors attempted to explain Bowman's risk return paradox in terms of recent research in behavioral decision theory and prospect theory, emphasizing the role of reference, or target, as a predictor.
Abstract: This study attempted to explain Bowman's risk–return paradox in terms of recent research in behavioral decision theory and prospect theory. The research emphasized the role of reference, or target,...
677 citations
Cites background from "Survey of capital budgeting: theory..."
...Indeed, the evidence (Kahneman & Tversky, 1979; Laughhunn et al., 1980; Mao, 1970; Siegel, 1957) suggests that when returns have been below target, most individuals...
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01 Jan 2007
TL;DR: The Handbooks of Management Accounting Research (HOMAR) as discussed by the authors is a collection of three volumes of management accounting research, including three volumes from the American Accounting Association (AAMA) notable contribution to management accounting literature.
Abstract: Winner of the Management Accounting section of the American Accounting Association notable contribution to Management Accounting Literature Award Volume One of the Handbook of Management Accounting Research series sets the context for the Handbooks, with three chapters outlining the historical development of management accounting as a discipline and as a practice in three broad geographic settings. Volume Two provides insights into research on different management accounting practices. Volume Three features contributions from some of the most influential researchers in various areas of management accounting research, consolidates the content of volumes one and two, and concludes with examples of management accounting research from around the world. Volumes 1, 2 and 3 are also available as individual product. * ISBN Volume 1: 978-0-08-044564-9 * ISBN Volume 2: 978-0-08-044754-4 * ISBN Volume 3: 978-0-08-055450-1 * Three volumes of the popular Handbooks of Management Accounting Research series now available in one complete set * Examines particular management accounting practices and specific organizational contexts * Adopts a global perspective of management accounting practices Award: "Winner of the Management Accounting section of the American Accounting Association notable contribution to Management Accounting Literature Award."
482 citations
TL;DR: In this paper, a new asset pricing model that generalizes earlier results in the downside risk literature is developed and empirically tested using a multivariate approach, and the new model cannot be rejected against an unspecified alternative for a large set of target rates of return.
Abstract: A new asset pricing model that generalizes earlier results in the downside risk literature is developed and empirically tested using a multivariate approach. By specifying risk as deviations below any arbitrary target rate of return, the generalized Mean-Lower Partial Moment (MLPM) model overcomes the limited appeal of earlier formulations, and, moreover, a large class of extant pricing models using alternative risk measures (variance, semivariance, semideviation, probability of loss, etc.) becomes special cases of the new framework. Empirical tests indicate that the new model cannot be rejected against an unspecified alternative for a large set of target rates of return. The traditional CAPM, on the other hand, is rejected as a well-specified alternative. The MLPM target rates inferred from market data appear to be related to equity market mean returns rather than to the riskfree rate, the target rate that is implicit in the CAPM and explicit in earlier downside risk formulations. The attractiveness of downside risk measures for decision-making purposes has been noted in the financial economic literature for over a quarter of a century.1 Risk, from this perspective, is measured in terms of deviations below some exogenously prespecified "target rate of return," and a formal analysis of these risk measures for various utility functions has been presented by Bawa (1975) in terms of the lower partial moment (LPM) of the asset distributions. The appeal of these risk measures has been based, in part, on their consistency with the way individuals actually perceive risk. Notwithstanding its intuitive appeal, this area of research has been virtually neglected in recent years. We believe that this disaffection with downside risk models tends from two sources. First, earlier models of this genre exogenously specify the target rate to equal the risk-free interest rate. In the absence of a satisfactory theory for explaining how investors establish their target rates, this assumption, as argued herein, has been motivated more by technical reasons than economic considerations. Second, empirical tests
476 citations
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TL;DR: In this paper, the authors present a body of positive microeconomic theory dealing with conditions of risk, which can be used to predict the behavior of capital marcets under certain conditions.
Abstract: One of the problems which has plagued thouse attempting to predict the behavior of capital marcets is the absence of a body of positive of microeconomic theory dealing with conditions of risk/ Althuogh many usefull insights can be obtaine from the traditional model of investment under conditions of certainty, the pervasive influense of risk in finansial transactions has forced those working in this area to adobt models of price behavior which are little more than assertions. A typical classroom explanation of the determinationof capital asset prices, for example, usually begins with a carefull and relatively rigorous description of the process through which individuals preferences and phisical relationship to determine an equilibrium pure interest rate. This is generally followed by the assertion that somehow a market risk-premium is also determined, with the prices of asset adjusting accordingly to account for differences of their risk.
17,922 citations
TL;DR: In this paper, the authors investigated the properties of a market for risky assets on the basis of a simple model of general equilibrium of exchange, where individual investors seek to maximize preference functions over expected yield and variance of yield on their port- folios.
Abstract: This paper investigates the properties of a market for risky assets on the basis of a simple model of general equilibrium of exchange, where individual investors seek to maximize preference functions over expected yield and variance of yield on their port- folios. A theory of market risk premiums is outlined, and it is shown that general equilibrium implies the existence of a so-called "market line," relating per dollar expected yield and standard deviation of yield. The concept of price of risk is discussed in terms of the slope of this line.
4,470 citations
2,196 citations
TL;DR: In this paper, the authors derived the probability distribution of the present worth, annual cost, or internal rate of return of the proposed investment under certain assumptions, and used this information for an accurate appraisal of a risky investment.
Abstract: The amount of risk involved is often one of the important considerations in the evaluation of proposed investments. This paper is concerned with the derivation of the type of explicit, well-defined, and comprehensive information that is essential for an accurate appraisal of a risky investment. It is shown how, under certain assumptions, such information in the form of the probability distribution of the present worth, annual cost, or internal rate of return of the proposed investment can be derived. The derivation and use of this information is then illustrated by an example.
304 citations
TL;DR: In this article, the authors considered five alternative measures of risk: the expected value of loss, the probability of loss; the expected absolute deviation, the maximum expected loss, and the semivariance.
Abstract: Markowitz's [2] portfolio selection model was originally concerned with financial investments, but the model's implications for capital budgeting are now well recognized. Markowitz's basic idea is that the optimal portfolio for an investor is not simply any collection of good securities, but a balanced whole, providing the investor with the best combination of “return” and “risk.” Return and risk are to be measured by the expected value and variance of the probability distribution of portfolio return. Although financial writers have generally accepted Markowitz's measure of return, they have not been completely satisfied with his suggested measure of risk [1]. In fact, Markowitz himself had reservations about choosing variance as a measure of risk.1 Besides variance, he considered five other alternative measures of risk:(1) The expected value of loss;(2) The probability of loss;(3) The expected absolute deviation;(4) The maximum expected loss; and(5) The semivariance.
199 citations