How Firms ’ Capital Budgeting Methods Differ as Knightian Uncertainty and Controversy Vary : Bower and Brealey & Myers Are Both Right , Sometimes

Capital budgeting is a contentious subject in both research and managerial practice. Financial economists such as Brealy & Myers advocate using NPV and related quantitative approaches that comprise what we refer to as the standard capital budgetting model (SCBM); by contrast, strategy scholars such as Bower have argued that socio-political conflicts interfere with such financially-oriented capital budgeting methods and often render them ineffective. We reconcile these competing views by extending the behavioral theory of the firm (BTF) – particularly the notions of Knightian uncertainty and controversy that are central to the BTF – to encompass capital budgeting methodologies. In doing so, we develop a more general organizational capital budgeting model (OCBM) that incorporates traditional capital budgeting theories along with consideration of the firm’s organizational processes and the degree of uncertainty underlying the assumptions that firms must make in their capital budgetting activities. Fourteen structured qualitative case studies of capital budgeting projects in Korean Chaebols provide evidence that the traditional arguments apply at particular levels of uncertainty and controversy: For low Knightian uncertainty and low controversy, the financially-oriented SCBM works well; under high Knightian uncertainty and high controversy, firms instead turn to more qualitative socio-political methodologies. We then complete the uncertainty and controversy matrix with two other combinations: High Knightian uncertainty and low controversy (which we label the plausibility approach), plus low Knightian uncertainty and high controversy (the negotiation approach). The OCBM broadens the traditional capital budgeting model and helps explain firms’ heterogeneous choices of capital budgeting approaches. How Firms’ Capital Budgeting Methods Differ as Knightian Uncertainty and Controversy Vary: Bower and Brealey & Myers Are Both Right, Sometimes 2 Capital budgeting is a key management capability (Segelod, 1998; Maritan, 2001) with major impact on firms and economies (Baldwin and Clark, 1992; Porter, 1992). Two competing views promote alternative capital budgeting methods. One approach emphasizes financially-oriented analyses such as net present value and internal rates of return (Brealey, Myers, and Allen, 2005; Ross, Westerfield, and Jaffe, 2002), which we refer to as the standard capital budgeting model (SCBM). The major alternative focuses on qualitative socio-political processes (Bower, 1970). In practice, firms use both the SCBM and sociopolitical approaches, as well as hybrid methods. Although numerous studies find heterogeneity in capital budgeting practices, there is little consensus about what factors lead firms to use different approaches. Two social concepts that are central to the behavioral theory of the firm (BTF) – Knightian uncertainty (Knight, 1921; Keynes, 1921) and controversy (Cyert and March, 1963; Burton, DeSanctis, and Obel 2006) – can help reconcile this lack of consensus. The two polar approaches, the SCBM and the socio-political approach, either under-emphasize or over-emphasize how these two social factors can interfere with standard capital budgeting. The financially-oriented tools of the SCBM underestimate the importance of Knightian uncertainty and organizational controversy, while the socio-political approach assumes that these social factors are always present, salient, and paramount. Knightian uncertainty arises when parameters around cash flow estimates are doubtful, while controversy arises when sub-groups have differing goals and/or beliefs about states of the world. We reconcile the competing views by extending the BTF to encompass capital budgeting methodologies. In doing so, we develop a general organizational capital budgeting model (OCBM), in which the SCBM and socio-political approaches are special cases. The paper proceeds as follows. We first develop propositions that address how variation in Knightian uncertainty and controversy influence capital budgeting choices. We then turn to a rich set of structured qualitative studies based on 14 projects at seven Korean Chaebols that explore the propositions. THEORY: ORGANIZATIONAL CAPITAL BUDGETING MODEL Capital budgeting models are methods that firms use to decide which capital projects to assess and how to allocate internal investment resources among projects. Scholars such as Baldwin and Clark (1992, 1994) and Porter (1992) argue that capital budgeting has a major impact on firms and economies. How Firms’ Capital Budgeting Methods Differ as Knightian Uncertainty and Controversy Vary: Bower and Brealey & Myers Are Both Right, Sometimes 3 Maritan (2001) argues that developing and implementing capital-budgeting methods is an important higher-order firm capability, while Segelod (1998) points out that good investment practices assist strategic and financial planning, as well as help create a common corporate language. In turn, capital budgeting influences the ongoing evolution of firms’ boundaries by determining choices of internally organized transactions versus markets for capital and other resources. The organizational capital budgeting model in this paper extends our understanding of firms’ capital budgeting choices. The most prominent capital budgeting techniques rely on the financial assessments of the standard capital budgeting model. The OCBM incorporates the SCBM, while highlighting variation in capital budgeting methods as a response to deal with varying levels of Knightian uncertainty and/or controversy in the firm. The OCBM presumes that, when a firm selects combinations of valuation strategies and investment opportunities, four considerations arise: Perceived value, net accuracy, Knightian uncertainty, and controversy. The following discussion defines these concepts. The OCBM assumes that firms optimize their goals by choosing valuation methods and investment opportunities that attempt to balance the four considerations (Kang, 2009). We develop a set of orienting propositions that address how different combinations of Knightian uncertainty and controversy will lead to different choices of capital budgeting models, beginning with the SCBM and then moving to the other three approaches within the OCBM. The orienting propositions draw on existing theory to provide direction for our study, while still providing room for exploratory investigation of the concepts within the propositions – by combining deductive and inductive logic, this approach generates both empirical understanding and conceptual development. We regard Knightian uncertainty and controversy (social factors) as stable and exogenous functions of the choice set pair of a capital-budgeting method and an investment opportunity. The states of social factors, in which we investigate a firm’s choice about capital budgeting, are characterized with stable parameters such as how sensitive a goal is to the social factors and how sensitive the social factors are to the chosen pair of a capital-budgeting method and an investment opportunity. Therefore, our investigation is free from reverse causality or endogeneity (we can provide a formal model on request). Simply put, at any time and place, a default state of social factors exists that individuals accept as given. Subsequent longitudinal studies could How Firms’ Capital Budgeting Methods Differ as Knightian Uncertainty and Controversy Vary: Bower and Brealey & Myers Are Both Right, Sometimes 4 investigate how the social factors change and how capital budgeting responds dynamically, which are beyond the scope of this paper. Table 1 summarizes the central concepts in the propositions. ********** Table 1 about here ********** Standard Capital Budgeting Model: Low Knightian Uncertainty and Low Controversy The SCBM is the application of following formula: Perceived value ≡ E(CashFlow) RCC*Investment. Perceived value is the estimated value calculated when a valuation method is applied for an investment opportunity where, in this case, the valuation method is the SCBM. E(CashFlow) is expected cash flow arising from a project. RCC denotes the opportunity cost of capital. Investment is the size of investment that a project will require. In the SCBM, these variables are quantified with probabilities that capture the risk for a project. As risk increases, decision-makers seek to reduce E(CashFlow) (Black and Scholes, 1973; Dixit and Pindyck, 1996), increase RCC (Brealey, Myers, and Allen, 2005), or decrease Investment (Jorion, 1997), because risky projects are less desirable. Standard textbooks (e.g., Brealey, Myers, and Allen, 2005; Ross, Westerfield and Jaffe, 2002) argue that the SCBM, especially net present value (NPV), is the most accurate method of ordering projects to maximize firm value and stockholder equity. The standard argument suggests that the SCBM achieves the greatest net accuracy, where net accuracy is the weighted distance between gross accuracy and the effort required to accomplish gross accuracy. Gross accuracy can be measured “in terms of the percentage attained of the optimal weighted adding value” (Bettman, Luce, and Payne, 1998), that is, how close to a theoretical optimum a decision-maker would be able to come if they expended full effort. The notion of net accuracy reflects the point that decision-makers must expend resources in order to make estimates, which reduces the benefit of the gross accuracy. The point here is that the SCBM, when it can be applied, is an efficient means of valuation and generates high net accuracy. The SCBM is efficient because it offers flexible options. Decision-makers can determine how to segment expected cash flows, costs of capital, and investment parameters, and can also chose among multiple assumptions in order to define the parameters. Implicitly or explicitly, decision-makers choose among options for SCBM calculations by considering how much time and effort an analysis will re