Capital Budgeting Models And Planning: An Evolutionary Process
Authors: Hoyle Robert S. 
Published: December 2007

Introduction

Capital budgeting is at the very heart of virtually all financial planning. In many instances this perspective is not fully appreciated because the term "capital budgeting" has become too associated with the mechanics of DCF economics and yearly, short-term budgeting. In fact, however, the bottom line, key decision of any planning process—short term, operational or long term, strategic—is the determination of which "projects" will be funded and pursued to meet the corporation's goals. This is a pursued to meet the corporation's goals. This is a capital budgeting decision; it is the basic part of planning. planning. In order to assist management in this high-level decision-making, capital budgeting models have been proposed for use in the evaluation of various proposed for use in the evaluation of various quantitative criteria. Techniques such as present value economics, risk analysis, "what if" financial models, and mathematical programming have been around for some time; unfortunately, their use in capital budgeting and planning activities has not been as widespread as some have predicted.

The purpose of this article is to propose that there is, however, a definite growth trend in the use of capital budgeting models as a major tool in the general planning activity; and that elements of an evolutionary process are apparent. Some points are discussed on the historical growth rate of currently used capital budgeting models and on where this trend might be leading. Finally, some thoughts are presented on what might be done to accelerate this presented on what might be done to accelerate this evolutionary process—mainly by more fully appreciating management's perspective and recognizing organizational politics.

EARLY STAGES OF THE EVOLUTION

The earlier approaches to capital budgeting models were concerned mostly with the economic evaluation of individual capital projects. Primarily these efforts concentrated on which methods and procedures were the most appropriate for calculating procedures were the most appropriate for calculating economic criteria. In fact, the concentration at this time was so heavy toward "the mechanics of project evaluation" that it overlooked many aspects of capital budgeting models as the basis of a more broadly defined planning process. However, at least it was a start, and in retrospect, perhaps a very good start.

DCF Models

Considerable work has been generated on DCF economic models. Perhaps the earliest "modern" treatment of this subject was in 1930 by Irving Fisher, a noted economist of the time. His writings today still are recognized as laying a large part of the foundation for current capital budgeting models. Another of the classic works in this field was in 1951 by Joel Dean, a management consultant working with several oil companies. He elaborated on Fisher's basic approaches and established a still-used modeling framework for capital rationing.

Many other articles and books too numerous to mention have been written on this subject (for an extensive list, see Swalm; another less comprehensive list is presented in Ref. 4). Most authors were concerned with (1) the relative merits of discounted vs nondiscounted evaluations (payback, ROI), (2) which of the discounted methods (present value, rate of return, etc.) were the most accurate, and (3) the mechanics of computing the ECF indicators.

Several industry surveys of capital budgeting practices reveal that the proliferation of writings practices reveal that the proliferation of writings on DCF economic criteria had a slow but definite effect. Notable among those surveys are those of Istvan, Christy, Williams, Klammer, Davey, and Petty, which all showed the percentage of surveyed Petty, which all showed the percentage of surveyed firms using DCF models. Fig. 1 graphically displays the recent growth in the acceptance of these methods. This acceptance also has been supported by the author's own experience within his company and some knowledge of the corporate procedures in similar companies.