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Journal of Business Finance & Accounting, 20(3), April 1993, 0306-686X 30 7

CAPITAL INVESTMENT APPRAISAL TECHNIQUES:A SURVEY OF CURRENT USAGEA L A N S A N G S T E R *

INTRODUCTIONOrganisational change, fuelled by the expansion of information technology,may have contributed to the erosion of the previously established relationshipbetween company size and the quantitative investment appraisal criteriaselected. T his pa pe r com pares the results of a survey of the 500 largest Scottishcompanies with the findings of earlier UK studies and finds that companiesare using more methods together, that usage of the more sophisticateddiscounted cash flow techniques is higher, and that usage of the less theoreticallysound accou nting rate of return technique is lower, than previous studies wouldhave suggested for companies of the size involved. It concludes that a size/method selection relationship may only be identifiable when the companiesinvolved are all part of one study, o r the studies com pared are contem poraneous.

The paper begins with a consideration of the process of organisational change:accounting is not a closed system. It exists within an environment (theorganisation) and is subject to changes in that environment. It is also subjectto changes in the wider environme nt outside the organisation. T hu s, accountingchange will result from events arising within the organisation in which it isoperating, and from events arising in the organ isation's external e nvironm ent.

There is a natural resistance to organisational change: 'old habits die hard'.After an event occurs from which change may arise, it is often very difficultto foresee what changes may result. The reaction may be to ignore the event:'w ha t's it got to do with m e? '; it may be to absorb it while leaving the ideologiesof the organisation unchanged (for example, a change in the standard rate ofV A T w ould probab ly be treated in this way ); the organisation ma y abso rb thechange and adjust its ideologies; or, where the organisation as a whole hasavoided any reaction, the event may be absorbed by a part of the orga nisationand then spread from within: the 'trojan horse' effect.'Despite the accountant's image of being infiexible and old-fashioned,accounting has not stood still. As Hopwood et al. (1990, p. 102) state:'acco un ting has not jus t evolved . . . [it] ha s respon ded in a more p ositive way

to external as well as internal pressures and circumstances, internalizing intoitself residues of events and disruption in the contexts in which it operates'.

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308 SANGSTER(implementation); and internalisation (acceptance that the new way is'no rm al') . Th is would tend to be a somewhat slow and draw n out process:hard to detect initially, but ultimately obvious. The pace of accounting changewas fairly slow up until the 1970s but, fuelled by the information technologyexplosion, it is now occurrin g far more quickly than was previously the case.

More specifically, Hopwood (1990, pp. 12-13) states that computer-basedtechnologies (i.e. information technology) have resulted in an amazingintensification of organisational chan ges; and that this has caused organisationaltrends (i.e. change) to be speeded up, rather than to be replaced by new ones.Fu rther, 'the impact of new technologies on accou nting is likely to be m ediatedand influenced by the organisational and cultural terrains into which thetechnologies are introduced'. Hopwood goes on to state (1990, p. 15) that:'organisa tions are being change d in the na m e of [efficiency, value for m one y,cost effectiveness and the m ark et] a nd . . . new calls are bein g m ad e for theextension of modes of economic calculation to objectify and operationalise theabstract concepts in the name of which change is occurring. Accounting andrelated bodies of techniques are important means for such operationalisation'.

Information technology has, therefore, been said to be responsible forspeeding-up the rate of change within accounting. Changing external andinternal pressures have resulted in a higher appearance of objectivity beingrequired when change is being considered and decisions are being made. Tothese two factors can be added a third: the enormous growth in managementeducation over the last few years, particularly through the provision of MBAcourses on a full-time, part-time and, distance-learning basis. Such op portunitieswere few and far between, now they are available throughout the UnitedKin gdo m. As a result, m anag ers are becoming m ore aw are of the decision aidsat their disposal, and are m ore equ ipped to apply the benefits of the informationtechnology explosion in order to meet the higher requirement for apparentobjectivity that now exists.

Yet, why should such environmental changes have led to any change inaccounting practices? Could existing practices not jus t have been refined, rathe rthan replaced by more sophisticated ones?Scapens (1985) implies that replacem ent would arise when he refers to w hathe calls the 'costly truth' approach: 'truth' being the accounting system thatough t to be used, given all the relevan t costs and benefits of doin g so. H e states(Scapens, 1985, p. 121) that 'the necessary information may not be availablewithin the constraints imposed by cu rrent information technology and the abilityof existing management. Furthermore, even if such information could be

provided, the costs of doin g so may be extremely high . . . the costs . . . shouldnot outweigh the benefits to be obtained therefrom.' Thus, when the costs of

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CAPITAL INVESTMENT APPRAISAL TECHN IQUES 309. . . ' (p. 128) 'The choice of a particular model will depend on the costs andbenefits of that model, relative to the costs and benefits of alternative models.It would be q uite rea sonable for a decision m aker to select a very simple model,if the costs of using the more complex alternatives exceed their benfits.'

The information technology explosion has served to reduce the costs of theprovision of inform ation. As a result, it is now rationa l to acq uire informa tionwhen previously it may not have been. That information may provide theopportunity to adopt methods and practices that were previously irrational.In addition, utilisation of increased education opportunities has had the effectof increasing the knowledge a nd skills of manag em ent. These two factors wouldsuggest that the environmental changes referred to earlier could have led tochanges in accoun ting practice. Such changes would have occu rred first in thoseorganisations which would have been the first to find that the benefits ofobtaining the information deriving from such change exceeded its cost. Thus,when computers first appeared, it was only the largest companies, those whohad the greatest economies of scale, who used them. Then, as costs fell inrelation to computational power, more and more companies viewed them asbeing a cost-effective information source. Thus, information technology-ledaccounting change would tend to start in the largest companies and then trickledown to smaller and smaller ones until, ultimately, all companies had changed.

AREA OF INTERESTO ne area w here these changes may be hav ing an effect upon accounting practiceis quantitative capital investment appraisal. There have been a number ofarticles during the last decade concerning corporate practice in this area. Studieshave been undertaken both in the UK and overseas and some attention hasbeen given to comparisons between UK and US practice (see Mills, 1988a).In addition, attempts have been made to detect trends in the use of thesetechniques (see, for example, Kim et al., 1986).

In particular, much attention has been given to the use of discounted cashflow (DCF) in its principal forms of net present value (NPV) and internal rateof return (I R R ). T he case has often been mad e that com panies should be usingone or other of these techniques,* preferably NPV.^ However, these are moretime consuming and, therefore, more costly to use than the other principaltechniques payback and accounting rate of return (ARR). In the UK, studieshave consistently shown that payback is used more often than either of the D C Ftechniques: a finding which is in keeping with the 'costly truth' hypothesis.The theorist 's recommendation that NPV be used rather than IRR was

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310 SANGSTERuse of the DCF techniques was being depressed by managerial ignorance (see.Pike, 1982, pp. 5354), there was a general rise in the number of methodsused, and in the use of one method in particular, namely, IRR. He suggestedthat the level of sophistication of the methods used was related to companysize but, as his 1975 and 1980 data were derived from a questionnaire whichasked for details of historic (i.e. 1975) and cu rren t (i.e. 1980) usag e, this wouldnot satisfactorily explain the changes he identified. Some other factor had tobe responsible and this he provided, by implication, when he stated that anexpanding firm would require to use superior investment appraisal techniquesin order to han dle the increasing complexities that the expansion was gen erating(Pike, 1982, p. 80): he took the view that ex pansion-led o rganisation al changewas responsible for the shift in practice between the two dates which his studyconsidered.

When Mills and Herbert (1987) compared their 1984 data with those fromother studies, including Pike's, they also found that company size was asignificant factor in the range and type of techn ique used. T he y did not considerthe possibility that organisational change over time could have contributed tothe differences they detected, preferring rather to treat all the data ascontemporary. On the basis of Pike's findings, it may be that this wasinappropriate: their analysis may have been affected by the undetected influenceof organisational change upon the choice of techniques selected.In response to a question concerning future changes. Pike's surveyrespondents made reference to wider use being made of computers (see Pike,1982, pp . 789). As those respon den ts had an ticipated , information technologydeveloped extensively during the 1980s. This had not been difficult to foreseein 1980/81 as these developments had been having a marked impact uponworking practices since 1975. In 1979, the first electronic spreadsheet(Visicalc) was introduced and many others followed. These have been regularlyenhanced since they first appeared in order to make use of the vast increasein computing power that has arisen since the Apple microcomputer was intro-duced in 1977 and, given the benefits to be derived and the awareness thatPike identified, it is reasonable to suppose that corporate practice in the areaof capital investment appraisal reacted accordingly. For example, it is likelythat the use of the IRR technique, which is many times easier to apply usinga computer than manually, will have risen during the five years or so sincethis was last examined. The impact of organisational change over time upontechnique selection should be more apparent than ever before, and should bedetectble where results contradict the earlier findings on size.Thus, earlier studies had suggested three possible causes for differingorganisational practices in this area: company size, managerial knowledge, and

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CAPITAL INVESTMEN T APPRAISAL TECH NIQU ES 31 1overcome these restraints and, ultimately, the new technologies will be fullyutilised by all: ultimately, the only ones not using the more sophisticatedtechniques will be those who perceive that they have no need to do so. If thatis the case, the impact of size upon the choice of appraisal criteria may bebecoming far less apparent than previously. Also, if managerial knowledge isbeing improved through more education of managers, then this may lead tocurrent criteria selection being more theoretically sound than in the past.

With this in mind, it was decided to conduct two surveys of current practicein companies operating in Scotland: one covered 'large' companies, the other'small', their relative size being on the basis of turnover,' The survey soughtto answer the following questions:1, What is the current usage of the four most commonly citedquantitative m ethods of capital investment a ppraisal payback, IR R ,NPV and ARR?2, What changes have occurred in usage since the date of the last studies?3. Do larger companies make greater use of the more sophisticated DCFtechniques than smaller companies?4. Is ARR maintaining its popularity despite its theoretical deficiencies?'Th is pape r considers the data derived from the 'large' Scottish com pany studyand relates them to the earlier larger company studies of Mills and Herbert,Pike, and the earlier smaller company study of Mclntyre and Coulthurst. Itseeks to show that earlier findings suggesting a relationship between size andthe method of capital appraisal selected may now only be valid when the sizedifference is great, and should only be valid when the studies compared arecontemporaneous. It suggests that information technology-led organisationalchange may have eroded this previosly established relationship, and that it islikely to continue to do so. The 'small' Scottish company study'" comprisedcompanies which were smaller than those studied by Mclntyre and Coulthurst.

Where appropriate, the data from it have been included in order to enhancethe comparison between the (larger company-based) 'large' Scottish companystudy and that of the (smaller company-based) study conducted by Mclntyreand Coulthurst (1985),

SURVEY METHOD AND DISCUSSION OF THE RESULTSThe survey, carried out in Spring 1989, involved the largest companies (onthe basis of turnover) registered and operating in Scotland: they were identifiedin the 1987 volume of Jo rd an 's 'Scotland's Top 500 Companies'. Turnover ranged

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312

Criterion:

SANGSTERTable t

Comparative Sizes of the Study PopulationsCriterion:

LargeMediumSmallCriterion:

LargeMediumSmall

Mills & Herbert%261856

Mills & Herbert%272746

Capital Expenditure(1984)

Turnover(1984)

Pike (1980/1)%151471

Current Study (1989)%1297

Compan ies Act Definition (indexedfMclntyre &

Current Study (1989) Coulthurst (1984)

LargeMediumSmall81181 100

Note." See note 11.companies, with the next most common classifications being distribution (13per cent) and engineering (11 per cent),A total of 491 questionnaires were sent and 107 were returned completed,of which 94 were usab le: this represents a response r ate of 21,8 per cent whichcompares favourably with the 18,8 per cent achieved by Mclntyre andCoulthurst (1985) in their 1984'^ survey of medium-sized British companies.

As has commonly been found with surveys in this field (see Mills, 1988b),the results are not directly comparable with others previously reported. Thesample surveyed in each case comes from a different po pula tion. For exa m ple,81 per cent of the companies included in jhe current study'^ were larger thanthose of Mclntyre and Coulthurst who used a sample of 'medium-sized'companies as defined in the Companies Act 1981,''*

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CAPITAL INVESTMENT APPRAISAL TECHNIQUES 313Table 2

Significance Levels for Differences Between the Earlier Studies Usage ofDCF Techniques (Based on a One-tailed Test of Proportions)"

Mills/ Mclntyre/Herbert Pike Coulthurst(1984) (1980/1) (1975) (1984)IR R 99% 99%'>99.9% 99.9%99.9% 99.9%9 5 % 95%

99.9% 99.9%99% 99%NPV 95 % 95 %99.9% 99.9%99% 99%D C F n/a" 99.9% 99.9%95 % 95%Notes: HI: larger companies make greater use of IRR/NPV/DCF techniques in general.'' For IRR usage, there is a 99 per cent significance level of difference between these two studies.' No data is available on this for the Mills and Herbert study.

between their survey results and others, used three different criteria to definecompany size: capital expenditure; turnover; and profit before interest andtax. '^ Table 1 shows how the various studies can be compared in terms ofcompany size using the first two of these criteria and the Companies Actdefinition.O n the basis of the data contained in Table 1, it appears that Mills andHerbert 's companies were relatively larger than those of Pike; both Pike, andMiUs and Herbert, were deeding with larger companies than those in the currentsurvey, and Mclntyre andCo ulthurst w ith sm aller ones. It has been suggestedby Pike and by Scapens et al. (1982) that there is an association betweencompany size and the use of DCF techniques. This was confirmed by Millsand Herbert (1987, pp. 74-77) and is supported byMclntyre and Coulthurst 'sresults. T ab le 2 shows the significance levels for differences in the usage of D C Ftechniques between the earlier studies (based on a one-tailed test ofproportions), '^ The percentages appearing at the ends of each horizontal line

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314 SANGSTERTable 3

Usage of Quantitative EvaluationMethods Found in the Current ScottishLarge Company Study

IR RN PVPaybackA R RD C F

%5848783173=

Rank

2314

Note:" NP V but not I R R [15 per cent] + IR R but not N PV[25 per cent] + both N PV and IR R [33 per cent] = 73per cent.

If there had been no change through time in the choice of approaches adop ted,it would be expected that use of DCF techniques, particularly IRR, would belower, whether as a primary'^ or secondary method, in the current study thanin the case of Pike and (more markedly) of Mills and Herbert, as the currentstudy companies are smaller. On the same basis, as the current study companiesare larger than those in the Mclntyre and Coulthurst study, use of DCFtechniques would be expected to be higher in the former than in the latter.

Analysis of the data from the earlier studies revealed a statistically significantdifference in the application of NPV between the large company study of Millsand Herbert and two smaller company studies: Pike (both data sets) andMclntyre and Coulthurst ,A comparison of the results from the two current Scottish studies revealedno significant difference in the frequency of usage of NPV between the largeand small companies. It could be argued that the Scottish studies findings showthat size may no longer have the major impact upon organizational practicethat the above analysis of the earlier study data revealed. More specifically,as the relative size of the companies in the Mclntyre and Coulthurst's 1985study lies between those of the two Scottish studies: it may be appropriate tosuggest that the 'size factor' is not relevant to any comparison of the use ofN PV between the findings of M clnt yre an d Cou lthurst and the current study.If this is the case, it may be that any differences between the current study

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CAPITAL INVESTMENT APPRAISAL TECH NIQU ES 315T a b l e 4

U sa g e o f Q u a n t i t a t i v e E v a l u a t i o n Me t h o d s : Co m p a r i s o n w i t h O t h e r S t u d i e s

CurrentStudy1989Mclntyre/Coulthurst1984

Mills/Herbert1984 Pike1980/1 1975

IR RNPVPaybackA R R

58487831

28368233

68517844

54387951

42327151DC F 73 45 69 60O t h er 2 4 7 5N on e 8 0 0 4

As can be seen, the most popular of these four methods is payback with 78per cent usage am ong the com panies. It is used by 34 per cent mo recompanies than IRR, the second most popular method. However, paybackis used by only seven per cent mo re com panies tha n D C F techniqu es in generzil(N PV , or I R R , or both). Tab le 3 is expanded in Table 4 to include the findingsof the three earlier studies.

Comparison of the current study with Mclntyre and Coulthurst 's results inTable 4 reve2ils a statistically significant difference (based on a one-tailed testof proportions, at the 99.9 per cent confidence level) in the usage of the moresophisticated IRR technique. Table 5 shows the data and levels of significanceof difference in respect of the Mclntyre and Coulthurst study and both thelarge and smaill current company studies.As can be seen, a statistically significant difference (at the 99 per centconfidence level) was found in the frequency of usage of IRR among thecompanies in the curren t study and those drawn from a population of companiessmaller than those in Mc lntyr e and C ou lthu rst's study (i.e. those in the Scottishsmall company study). This would seem to confirm that size is a relevant factor.Yet it is interesting to note that usage in the Scottish small company studywas higher than in that of Mclntyre and Coulthurst, and the degree ofsignificance was lower (99 per cent as opposed to 99.9 per cent) despite theM clntyre and C oulthurst study comprising larger companies. In addition, no

statistically significant difference was found in the usage of NPV between theScottish small company study and either of the others, yet, there is evidence

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316 SANGSTERTable 5

Evaluation Methods Used: Comparison Between the Two Scottish Studiesand that of Mclntyre and Coulthurst

IR Rsignificance:"

N PVsignificance:"Paybacksignificance:''ARR^D C Fsignificance:"

Current LargeCompany Study(1989)%58 9 9 9 %

9 9 %48 95%78

99%3173 99.9%

9 9 %

Mclntyre/Coulthurst(1984)%2899 9%

369 5%8299.9%334599 9%

Current SmallCompany Study(1989)%39

9 9 %42569 9 9 %

9 9 %2654

9 9 %Notes:" One-tailed test, H I : larger companies make greater use of IR R /N PV /D CF techniques in general.Tw o-tailed test HO: there is no significant difference in proportion ate usage of a me thod betweenthe studies." A two-tailed test of proportions revealed no statistically significant difference between these threestudies in the usage of ARR.A one-tailed test was used for the tests on IRR, NPV, and DCF as previous study findings hadsuggested that there may be a relationship between company size and technique selection. A two-tailed test was used to test the other metho ds as no such e vidence existed to justify use of a one-tailed test.

company study and that of Mclntyre and Coulthurst, might be ascribed tothe impa ct of organisational change over the five years between the two studies:any previous effect of size having been reduced (IRR) or eliminated (NPV),as usage is greater in the former th an in the latter, larger com pany-based study.Size could, therefore, be held to have less relevance than was previously thecase. Table 6 shows the results of one-tailed significance tests upon thedifferences between the earlier studies and the current Scottish large company

study in respect of their usage of the DCF techniques.Consideration of the results contained in Table 6 suggests that the use of

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CAPITAL INVESTMENT APPRAISAL TEC HNIQ UES 317Table 6

Significance Levels for Differences Between the Current Study and Eachof the Earlier Studies in Respect of Usage of DCF Techniques (Based on

a One-tailed Test of Proportions)"

IR RNPVD C F

Mills/Herbert(1984)

n/a' '

Pike(1980/1) (1975)CurrentStudy(1989)

9,')%99 .9%

Mdnlyre/Coulthurst(1984)99 q%

9 5 %99,9%

Notes:" HI: larger companies make greater use of IRR/NPV/DCF techniques in general,' ' No data is available on this for the Mills and Herbert study,

company study has suggested that any remaining relationship is weaker thanwas previously the case.The NPV result also suggests that size may no longer be relevant to itsselection. A s Tab le 2 showed, th ere was a statistically significant differencebetween the Mills and Herbert study and both the Pike data points, but onlyat the 95 per cent level for the Pike 1980/81 data, as opposed to the 99.9 percent level for the 1975 data: clearly this suggests that, even then, the impactof size was diminsh ing. Tab le 2 also revealed a statistically significant differencebetween the Mills and Herbert and Mclntyre and Coulthurst studies whichwere both conducted in 1984. The relative difference in company size wasmarked and the result suggests that, for relative size differences of thatmagnitude, size was relevant to the choice of method made at that time. Nostatistically significant difference in usage of NPV between the Scottish smallcompany study and any of the others was identified. This seems to suggestthat there is now a different relationship between the use of N P V and com panysize from that previously reported. It may be that no relationship exists or,more plausibly, that the level of usage in each of the company size groupingshas chang ed.. W hich eve r is the case, any differences detected be tween thecurrent and previous studies in the use of NPV is due to factors other thansize, most likely arising out of the impact of organisational change over time.

D C F usage is derived directly from the usage of I R R and N P V . As a result.Tables 2, 5, and 6 reveal a similar picture for DCF to that they portray forthese techniques individually.

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318 SANGSTERTable 7

Significance Levels for Differences Between the Studies ' Usage of Paybackand ARR (Based on a Two-tailed Test of Proportions)^

PaybackARR

Mills/Herbert(1984)

9 5 %

Pike(1980/1) (1975)

9 9 %9 9 %

9 9 %9 9 %

CurrentStudy

(1989)

9 5 %9 9 %

9 9 %

Mclntyre/Coulthurst(1984)

9 5 % ' '

9 9 %9 9 %

Notes:' HO: there is no significant difference in proportionate usage of a method between the studies.'' For Payback usage, there is a 95 per cent significance level of difference between these twostudies.

with those of Pike, Mills and Herbert found that smaller firms (Pike's) usedARR more than larger ones (Mills and Herber t ' s ) . In their 1980 survey,Scapens et al. found that ARR was ranked lower in large companies and, whenMills and Herbert (1987, p. 23) com pared their study (which involved relativelylarger companies) to that of Scapens et al., they found that ARR was morepopular with companies in the latter study. In order to determine whether sucha relationship can be supported by the data , a one-tailed test of proportionson the differences between the studies' usage of payback and ARR wasconducted. It revealed no statistically significant differences in the usage ofARP_, and only one in respect of payback: at the 95 per cent level betweenthe Pike 1975 data and that of Mclntyre and Coulthurst. Were size a factorin determining the usage of payback then it would surely have been evidencedby the existence of a statistically significant difference between the usage ofpayback reported by the contemporaneous Mclntyre andCoulthurst and Millsand Herbert studies. That none was found suggests that, as with ARR, thereis no inverse relationship between company size and the usage of payback.

Examination of the data in Table 4 does suggest, however, that there maybe statistically significant differences between the usage of these techniquesamo ng the studies. A two-tailed test of proportions on the differences in usageof payback and ARR was carried out. Table 7 shows the result.The previously held view that size and the use of A R R are inversely related,

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CAPITAL INVESTMEN T APPRAISAL TECH NIQUE S 31 9the current and Pike studies (see Table 7), would seem to suggest that therehas been a marked decline in the popularity of ARR since 1980. It also suggeststhat some of the difference between the 1980/81 and 1984 studies could havebeen due to the impact of organisational change rather than merely to companysize, as was suggested by Mills and Herbert.

Payback usage is only statistically significandy different in one case: betweenthe Pike 1975 data and that of Mclntyre and Coulthurst. As had been foundusing a one-tailed test of proportions, the result shows a 95 per cent level ofsignificance. Consideration of the result from the Scottish small company study(given in Table 5) indicates that size is probably a factor, but in the oppositedirection to that suggested by the Pike 1975 data. Payback is the most usedmethod within the Scottish small company study, but, as with all the methods,it is less used by the com panie s in that study th an by those in the Scottish largecompany study. It may be that previous analysis, which suggested the existenceof a relationship between size and usage, may no longer be applicable tocompanies of size ranging from those in the Mclntyre and Coulthurst studyto those in the study by Mills and Herbert. It seems that size is a factor whenconsidering difference in usage of payback between companies lying withinthat size range and smaller ones, but that it is a positive relationship, ratherthan the inverse one previously suggested.

Thus , analysis of the data in Table 4 leads to the conclusion that there appearsto have been an erosion in the impact that company size has upon the selectionof appraisal criteria: there may have been a 'trickle down' effect the largestcompanies used the more sophisticated techniques first, then the next largest,then the next largest, etc. There is far greater usage of the DCF techniquesevidenced by the current study than would have been the case had the sizerelationship been as before and nothing else changed. There is also far lessusage of ARR than would have been suggested by the findings of previousstudies relating size to usage. These results suggest that companies have beenexperiencing organisational change of a type which has led to a change in theselection of appraisal criteria. The hypothesis that this change may be derivedfrom the information technology explosion of the last decade, along with animprovement in the general level of education of decision makers, matches theseresults and would account for the changes identified. These changes would applyto all companies and it is probable that usage has also changed in companiesof the size studied by Mills and Herbert, and Pike. Indeed, this would needto have happened if size is still a relevant factor in the selection of appraisalcriteria by the larger company. This analysis of the current study results suggeststhat size difference cannot explain differences in criteria selection between itand the earlier studies. A survey of companies of the size of those studied by

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320 SANGSTERTable 8

Comparisons of Primary Quantitative Method Usage (Using a Two-tailedTest of Proportions)^

P a y b a c k

I R R

NPV*^ARR

significance:significance

significance:

CurrentStudy 1989

%48(1 )*>9,'i%23(2 )9 9 %9 9 %17(3)14(4)9 9 9 %

102''

Mills/Herbert 1984

%38(2)43(1)99%21(3)20(4)

9 5 %J22

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CAPITAL INVESTMENT APPRAISAL TECH NIQUES 321other method. IR R , which was the most popular prim ary method in the otherstudies, was found to be in second place. It m ay be that this difference in ran kingbetween payback and IRR is due, in part, to the difference in company size:the relatively smaller companies in the current study preferring to use the'cheaper' payback technique rather than the more sophisticated IRR technique.

The analysis of the data in Table 4 suggested that IRR is being used moreby companies than was previously the case. The data in Table 8 suggests thatthis change in usage may have involved IR R being used as a secondary methodwhere previously it was not used at all.The different primary usage of ARR shown in the Mills and Herbert andPike surveys (20 and 32 per cent respectively) was attributed to different relativecompany size (see Mills and Herbert, 1987, pp, 2627), When comparing

their results with those of Pike, Mills and Herbert found that smaller firms(Pike's) gave ARR primary ranking more often than larger ones (Mills andHerbert's), These earlier findings suggested that size and the use of ARR asa primary method are inversely related, A one-tailed test of proportionssupported this hypothesis at the 99 per cent confidence level for the differencebetween ARR ranking in the Pike, and Mills and Herbert studies. On thatbasis, the current survey, which dealt with smaller companies than the othersin Table 8, would have found ARR to have been used more as a primarymethod than in either ofthe other two studies. The fact that the opposite wasfound, and that the difference was statistically significant, would suggestconfirmation ofthe conclusion reached upon consideration ofthe results shownin Table 7: that there has been a marked decline in the popularity of ARRsince 1980, Again, it may suggest that some of the difference between the1980/81 and 1984 studies could have been du e to the impact of organisationalchange rather than merely to company size, as was suggested by Mills andHerbert ,

The Scottish small company study also found that payback had the highestprimary ranking (42 per cent), Mclntyre and Coulthurst 's study involved thesmallest com panies of all the other studies. It does not include information onprimary method selection. However, in those companies which use a singlecriterion only, they found that payback was most frequently used. Paybackwas the second most popular prim ary m ethod identified by Mills and He rbertand P ike (though it was the most pop ular overall me thod in both these studies:see Table 4), This seems to suggests that payback is more likely to be theprimary method in smaller companies, than in larger ones.

When decision makers claim to use more than one method, it is the primarymethod which is used to perform the initial vetting ofthe proposal. The othermethods being applied, as appropriate, either to perform further vetting, or

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322 SANGSTERexam ple, payback within three years. W ere the impo rtance ofthe two methodsto be switched, for example, as a result of a change in company policy arisingout of an increase in interest rates, then the sequence of application would bereversed. The lower the importance rating of a criterion, the less it would beapplied in the appraisal process: only being used when circumstances required.For example, if ARR is ranked fourth it would probably only be used whenthe other criteria were unable to differentiate between mutually exclusivealternatives. Even where the primary method is not the first applied, bydefinition, it will always have precedence over the other methods in determiningacceptance/rejection.

T hus , the key in any combinatorial application lies mainly in the selectionof primary method. The lower the importance placed upon a criterion withina com bination of criteria, the less its impac t will be upo n the appra isal p rocess.Nevertheless, all criteria included in a combination will be applied whenappropriate and their selection within that combination indicates that somefaith is placed in their ability to assist in the appraisal process.^ The use ofmore than one criterion is indicative of caution. Prudence would suggest thatthe more methods used in the appraisal process, the better, because thepossibility of an inappropriate decision being taken is reduced as the numberof checks implemented is increased. Organisations are changing: they arebecoming more sophisticated, have available a vastly improved range of decisionmaking aids, and their managers are becoming better educated. It is possiblethat, as a consequence of these organisational changes, criteria are now beingapplied, where previously they were not (see the previous discussion regardingprimary method selection of IRR), and that greater care is now being takento ensure that the most appropriate decisions are taken. Th e usage ofthe variouscombinations of the four main methods is shown in Table 9,

Analysis of this table revealed a statistically significant difference in thenumber of methods used by companies between the current study and thatof Mclntyre and Coulthurst (using a two-tailed test of proportions, at the 99per cent level for two or more methods, and at the 99,9 per cent level for threeor more methods), A similar result was found between the Pike 1980 data andthe Mclntyre and Coulthurst study, though the significance levels were switchedto 99,9 per cent and 99 per cent respectively for the two-or-more and three-or-more method sets. No statistically significant difference was found between thecurrent study and either ofthe Pike study dates. Nor was any found betweenthe two Pike study dates.

In the current study, 23.5 per cent ofthe firms surveyed are shown to usea single evaluation method, the main method, as in Pike's 1980/81 study, beingpayback. The use of two methods at 25,5 per cent is considerably lower than

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CAPITAL INVESTMENT APPRAISAL TECH NIQUE S 32 3Table 9

Comparisons of the Frequency of the Use of Combinations of theQuantitative Evaluation Methods

No MethodSingle MethodPayback

ARRIRRNPVTwo MethodsPayback + A R RPayback + IR RPayback + N PVA R R -1- IR RA R R + N PVIR R + N PV

Three MethodsPayback + AR R + IR RPayback + A R R -i- N PVPayback -I- IR R -hN PVA R R -1- IR R -H N PV

Four MethodsPayback + AR R + IR R +N PV

CurrentStudy1989%8

1424.53

23.53136.521

25.5

5.54.520131

12

Mclntyre/Coulthurst

1984%

037

424

47

125

10

2231

2259

13

Pike1980/1%0

11843

26121263

1337

10610127

10

1975%4

12146133

10.510,55123

32

768122

9

Mclntyre and Coulthurst 's findings that NPV was more popular than IRRand that a combination of payback and NPV was a popular choice when twome thods only were used, (T heirs was the only UK survey to have found this,)The trend shown between Pike's two time points, whereby the use of twom ethod s rose from 32 to 37 per cent, is clearly reve rsed and replaced by a shifttowards the greater use of three and four methods . Analysis ofthe three-m ethod

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324 SANGSTERTable 10

Methods Adopted in Multiple Usage Companies:Comparison of Study Results

PaybackA R RIR RN PVD C F

CurrentStudy1989

9442786695

Mclntyre/Coulthurst

1984

9457516477

Pike1980/1

8957665185

frequency with that of payback with IRR and ARR. This again points to thereduction in the usage of ARR which was identified earlier.One difference between the current survey and that of Mclntyre andCoulthurst is striking. Their survey showed that 47 per cent of companies useda single method, compared to half that number (23.5 per cent) in the currentstud y. (A two-tailed test of pro po rtion s found this to be statistically significantat the 99.9 per cent level, as was the difference in the levels of three methodusage between these two studies.) This difference could be due to the differentrelative size of the companies in the two surveys but, as 18 per cent of thecomp anies in the current survey were ofthe same relative size as the M cln tyr eand Coulthurst companies, this hypothesis would require that only 18.34 percent ofthe other companies in the current survey used a single method.^' TheScottish small company study found 28 per cent usage of a single method andthis would seem to confirm that, du ring the five years which have elapsed sincethe M clntyre and Coulthurst survey was und ertaken, companies have increasedthe num ber of method s they apply i.e. m ore data are now being generatedto be used in the capital investment decision making process than was previouslythe case.

Table 9 also reveals that the position regarding ARR shown in Table 4,whereby the usage of A R R remained virtually unchang ed between M clnty reand Coulthurst's study and the current one (33 and 31 per cent respectively),concealed the true picture. It is virtually unused by companies using a singleme thod and only 25 per cent ^ of those using two metho ds are found to include

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CAPITAL INVESTM ENT APPRAISAL TECH NIQUE S 32 5Table 11

Method Usage Comparison: Multiple Usage Companies (m)and Single Usage Companies (s)

PaybackA R RIR RN PV

CurrentStudy1989

m% s%94 5942 978 1866 14

Mclntyre/Coulthurst

1984m% s%

94 7757 951 564 9

Pike1980/1m% s%89 4457 3166 1551 10DCF 95 32 77 14 85 26

or all three of the others. Thus, while its overall usage is not statisticallysignificantly different between the current and Mclntyre and Coulthurst studies,the way in which it is used has changed.T he propo rtional usage ofthe four m ain m ethods by compa nies which apply

more than one method is shown in Table 10,It reveals that those companies using more than one of these methods 69 per cent^^ (1989); 52 per cent (1984); and 74 per cent (1980/81) appearto be making greater use of NPV (29 per cent increase since 1980/81), IRR(18 per cent), D C F in general (12 per cent) and payback (6 per ce nt), and lessuse of ARR (26 per cent decrease). Payback seems to have established itselfas virtucJly a m and atory me thod whenever more than one method is to be used:this is a not unexpected situation given its historical popularity, its simplicityand the increasing awareness of the importance of cash flow management inbusiness today.

Ta ble 11 expan ds on the analysis of Ta ble 10 to show the comparison betweenthose companies that use m ore than one me thod, and those that use a single one.All three studies show that companies which use more than one of thesemethods make far greater use of the DCF techniques than those that restrictthemselves to one method only, (The current study shows, for the first time,that DCF among companies using multiple methods is more popular thanpayb ack, thou gh only ju st and ce rtainly not significantly so,) Such a result isonly to be expected if it is assumed that lack of the use of multiple methodsis partly due to an unwillingness to apply the more sophisticated methods; that

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326 SANGSTERand sophistication of computer spreadsheet packages, capable of easilyperforming whatever data analysis decision makers choose. Prior to 1979, suchanalysis was typically performed by hand. It was time consuming, repetitive,tedious to produce, and prone to error. There was considerable disincentiveto apply D C F techniques and evidence exists that suggests that m anag ers w erealso rejecting these techniques because of ignorance surrounding theirapplication and suitability (see Pike, 1982, pp, 5354), It is not surprising,now the psychologiccd and educational barriers to their use have been removedand lifted, that the application of DCF techniques appears to be increasing.Ta ble 11 also suggests that even the comp anies using a single me thod migh tbe moving towards the more sophisticated methods, A comparison betweenthe current survey and that of Mclntyre and Coulthurst reveeils a differencein single method usage which cannot be entirely due to the difference in therelative sizes ofthe companies. The difference in single method usage betweenthe current study and Pike's cannot be the result of company size differenceas the change in the usage of DCF techniques is an increase, not a decreaseon that shown by Pike,

SUMMARY OF FINDINGSThe current survey set out to examine the usage of quantitative techniquesfor capital investment appraisal in Scotland's largest companies and the resultscan be summarised as follows:

1, payback is the most pop ular m ethod , then IR R , followed by N PV an d,finally, ARR;2, DCF techniques are almost as widely used as payback and, in companiesusing more than one of the four methods, the DCF approach may bemore popular than payback;

3, IRR is more popular than NPV despite the theoretical superiority ofthe latter;4, over 40 per cent ofthe companies surveyed use three or four methods;5, ARR is mainly used with other methods: it is used by only nine percent of those companies using a single method.Comparisons with earlier studies suggest that:(a) A R R is being used less than previously;(b) DCF techniques are gaining in popularity;(c) N PV is increasing in popularity at a faster rate than IR R ;(d) payback is consolidating its position as the most used of the four

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CAPITAL INVESTMENT APPRAISAL TECH NIQUES 327companies which has resulted in the erosion of this previously identifiedrelationship;

(g) prev ious findings tha t suggested an inverse relationsh ip existed betweensize and the use of ARR may no longer be valid.So far as these findings are concerned; the reasons why payback remainspopular despite its theoretical limitations have been covered elsewhere, bothempirically (see, for example. Pike, 1982) and theoretically (see, for example.Van H o m e, 1986, p. 130). Th e decline of A R R has been advocated for sometime. The only surprise is that its demise has taken so long to come about.Although almost one third of the companies surveyed continue to use it, theydo so more as an additional criterion measure rather than as the principalcriterion. The move towards increased use of DCF techniques was expected.T he fact th at th ere is also evidence of a possible shift in em pha sis tow ards N PVsuggests that rather more than simply organisational change fuelled by thegrowth of information technology is the cause. A change in attitude towardsthe more theoretically sound of the DCF techniques would seem to indicatethat man agers are becoming more aware of the theoretical advantages of NPV,in relation to IR R . If one accepts that the theoreticians a re correct, the qualityof managerial decision making should be being enhanced as a result.^'*

CONCLUSIONSAs already stated, comparisons with other studies in this area are difficult. Allthe studies are different in terms of the me thod of analysis used, th e p opu lationsampled, and, to a lesser extent, the questions asked.^^

Mills and Herbert were at least partially successful in their attempt toovercome these difficulties through the alignment of their survey research tothat of Pike and of Scapens an d Sale (1981). While direct compa rison betweenthe survey results remained imprecise, they were able to adopt the sizedefinitions applied to test for association between company size and the useof D C F techniques for their own survey da ta and thereby confirmed the previousstudies' findings. However, it was not possible to eliminate overlap of sizebetween the studies (see M ills and H erb ert, 1987, p . 14) and it therefore provedimpossible for them to state more than that one study concerned proportionallylarger companies than another. In addition, they failed to undertake much ofthe analysis performed in the other studies (for example, the data containedin Table 9 above).

This analysis has attempted to overcome these difficulties by identifying whereeach study lies in a company size continuum ranging from the largest (Mills

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328 SANGSTERCou lthurst studies. Pike had suggested that organisational changes had occurredbetween 1975 and 1980/81. The later studies had ignored this factor, preferringto pursue the size hypothesis. This study reopens the question of the impactof organisational change upon the choice of technique selected. It has testedthe accepted size hypothesis in order to demonstrate that technique selectionhas chan ged, and that such change could be the result of infonnation technologyled, and 'costly truth' motivated, organisational change. In doing so, it hasshown that the situation has changed, for otherwise the size hypothesis couldnever have been valid: companies of the size examined in the current studyare using more sophisticated techniques, more techniques overall, and arem aking less use of the less theoretically valid A R R techniqu e than would havebeen expected from the results of earlier studies.

Conclusions drawn can only be directly related to companies of the size thecurrent study examined and, until one of the studies is repeated using similarsurvey populations, questions and analysis methods, conclusions cannot bedrawn regarding changing attitudes and practices of companies outwith thesize covered in the current study. Nevertheless, it is illogical to suggest thatsuch chcinge wUl not have occurred . T he inference from the curre nt study resultsis that change has probably occurred in companies of all sizes. However, theexact natu re of tha t change wUl rem ain u nkno wn untU further research is carriedout.It is plausible that these changes are the result of the expansion of facilitiesbased on information technology (i.e. computers and computer packages), forthis is an area of management decision making which ideally lends itself tothese developments. It is also possible that the growth in management educationin recent years has led to the m ore theoretically sound techniques be ing ado ptedto a greater degree than previously, particularly in response to the increasedneed to appear to objectify decisions of this type. Whatever the cause, it is clearthat there has been a change and that there is a move towards greater use of

the more sophisticated tec hniqu es. It also appea rs that the earlier work on theimpact of size may have been subject to organisational change between thevarious survey dates. It would seem that further research in this area wouldbe appro priate , pa rticularly as the vastly reduced cost of hard wa re and softwarehas, among other things, made the use of DCF techniques a relativelystraightforward task for even the smallest of companies. A facility which mayeventually contribute to the complete erosion of the relationship between sizeand the selection of quantitative appraisal techniques.

N O T E S

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C A P I T A L I N V E S T M E N T A P P R A I S A L T E C H N I Q U E S 329and Scott Morton (1988). This has contributed to an enormous growth in the use of informationtechnology over that period. This growth can be illustrated by Hndings such as those ofGurbaxani and Mendelson (1990) who found that data processing expenditure in the US(in 1972 dollars) rose from $30 billion in 1975 to $59 billion in 1987 allowing for a 30per cent compound cost performance growth factor, the 1987 figure bought the performanceequivalent of $1,375 billion in 1975, i.e. a 45-fold purchased performance growth over theactual 1975 purchase. Of more direct relevance to the current study, Brancheau andWeatherbe's (1990) study of spreadsheet adoption among 500 professionals working in corporatefmance and accounting departments showed a rise in usage of over 900 per cen t, from a baseof 35 users in 1981 to over 300 in 1987.4 See, for example, Merrett and Sykes (1973, pp. 9 2 - 1 0 2 ) .5 See, for example. Levy and Sarnat (1986, p. 90).6 See, for example, Hopwood et al. (1990, p. 69).7 When the words ' large ' and ' small ' are used to differentiate the two Scottish studies, it ispurely in the dictionary sense; there is no intention to suggest any more than that, on thebasis of turnov er, the companies in the 'larg e' study were larger than those in the 'small' study.

8 Th e aim was to determ ine overall usage, rath er than specific usage in relation to , for example,types of investments, ranges of funding, or levels of risk.9 See, for example, Ross and Westerfield (1988, pp. 2 8 2 - 8 4 ) .10 The companies in the Scottish 'small ' company study were all drawn at random from apopulation comprising companies which would be defined as ' small ' under the CompaniesAct definition (see note 11 for details of this definition). A total of 303 questionnaires weresent, of which 68 useable returns were received: a response rate of 22.4 per cent.11 When a company satisfies two or more of the conditions relating to a size category then itis defined as coming within that category. The categories in May 19990 were:Turnove rGross AssetsEmployees

Small

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330 SANGSTER16 Th e turnover levels used to determine com pany size used by Mills and He rbert (see note15) are approximately 200 times greater tha n those of the Com panies Act (see note 11). Almostall the companies in the current study which were classified as 'large' according to theCom panies Act criterion were classiFied as 'me diu m ' or 'sm all ' und er the Mills and H erbe rtturnover criterion.17 A test of prop ortions was used for significance testing thro ugh out . A Ch i-sq uar e test wasalso conducted in each case, with broadly similar results.18 Th e 'prim ary ' method is that which the survey respondents indicated was the most importan t.(The current, Pike, and Mills and Herbert studies all specifically asked for this information see note 25.)19 78/58= 1.34 =5 difference in usage of 34 per ce nt. This approach is adopted throughout wheneverpercentages are compared.20 For examples of how companies use multiple methods in practice, see Pike (1982, pp. 8695).21 For every 100 com panies in the cur ren t survey , 18 are of the same size as those in M cln tyr eand C oulth urst 's survey; 47 per cent of 18 = 8.46. If nothing has chang ed betw een the twosurvey dates, 8.46 per cent of the current survey companies would be expected to use a single

method because they are of the same size as those in the Mclntyre and Coulthurst survey.Th at w ould mean that 18.34 per cent[(23.5 pe r cent8.46 per cent)/82] of the other companiesin the current survey used a single method.22 Ta ble 9 gives this to be 23.5 per cent and that for M cln tyr e and Co ulthu rst as 45.2 per cent:these differences are due to rounding.23 Tab le 9 gives this to be 68.5 per cent and that for M clnt yre an d Cou lthurst as 53 per cent:these differences are due to rounding.24 No evidence exists to supp ort the hypothesis that the adop tion of the m ore sophisticatedtechniques brings about superior performance. Nevertheless, if these methods are more soundtheoretically, all other things being equal, their use should provide the opportunity to achievea superior performance. In addition, Moore and Reichert (1989) found that managerialsophistication, as reflected by the adoption of selected analytical practices and widespreadencouragement of the use of microcomputers for financial analysis, positively affects thelikelihood of better than average firm performance.25 Th e cur ren t study ques tions were based upon those in the Pike study. All the studies usedbroadly similar questions though, as can be seen below, those of Mills and Herbert andMclntyre and Coulthurst went into more detail than the others in the principal question.Interestingly, Mclntyre and Coulthurst did not include any request for ranking. The principalquestion in each survey was:

Current studyIn evaluating capital investment proposals please indicate the method(s) used and rankthe importance of each using 1 for the most important, 2 for the next, etc:(a) Payback(b) Internal rate of return(c) Net present value(d) Accounting rate of return(e) Others (please list)PikeWhat investment appraisal criteria do you use? (Please indicate priorities by giving a 1to the most important, 2 the the next etc.)(a) Payback period(b) Average rate of return(c) Discounting internal rate of return(d) Discounting net present value(e) Other; please specify

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C A P I T A L I N V E S T M E N T A P PR A IS A L T E C H N I Q U E S 3 3 1(1) Net present value(2) Internal rate of return(3) Accounting rate of return(4) Payback period(5) Qualitative/non-fmancial(6) Other, please specifyMclntyre an d CoulthurstPlease indicate the evaluation formula/formulae which you usually use for evaluating theprospective returns on your projects: Few Most AllProjects Projects ProjectsPaybackD C F : IR RD C F : N P VAccounting rate of returnOther: please specify

R E F E R E N C E SBenjamin, R.I. and M.S. Scott Morton (1988), 'Information Technology, Integration, andOrganizational Change' , Interfaces, Vol. 18, No. 3 (1988), pp. 86 -9 8 .Branch eau, J .C . and J .C . W etherbe (1990), 'T he Adoption of Spreadsheet Software: Te stingInnovation Diffusion Theory in the Context of End-user Computing', Information SystemsResearch, Vol. 1, No. 1 (1990), pp. 11 5-1 43 .Carnall, C.A. (1990), Managing Change in Organizations (Hemel Hemptstead: Prentice Hall

International (UK) Ltd., 1990).Gurbaxani, V. and H. Mendelson (1990), 'An Integrative Model of Infonnation Systems SpendingGrowth ' , Information Systems Research, Vol. 1, No. 2 (1990), pp. 23 -4 6.Hopwood, A. (1990), 'Accounting and Organisation Change', Accounting, Auditing and A ccountability,Vol. 3, No . 1 (1990), pp. 7- 17 ., M. Page and S. Turley (1990), Understanding Accounting in a Changing Environment (HemelHempstead: Prentice-Hall International (UK) Ltd., 1990).Jordan & Sons (1987), Scotland's Top 500 Companies, 1987 (Bristol: Jor da n & Sons Ltd., 1987).Kim, S.H., T. Crick and S.H. Kim (1986), 'Do Executives Practice What Academics Preach?',Management Accounting (USA), (November 1986), pp. 49-52.Laughlin, R.G. (1991), 'Environmental Disturbances and Organisational Transitions andTransformations: Some Alternative Models ' , Organizational Studies, Vol. 12, No. 2 (1991),pp. 2 0 9 - 2 3 2 .Levy, H. and M. Sarnat (1986), Capital Investment and Financial Decisions, 3rd edition (London:Prentice-Hall International (UK) Ltd., 1986).Mclntyre, A.D. and N.J. Goulthurst (1985), 'Theory and Practice in Capital Budgeting' , BritishAccounting Review (Autumn 1985), pp. 2470.Merrett A.J. and A. Sykes (1973), Capital Budgeting an d Company Finance, 2nd edition (London:Longman Group Ltd. , 1973).Mills, R.W . (1988a). 'Capital Budgeting Techniques Used in the UK and the USA ', ManagementAccounting, Vo l. 61 , No . 1 (1988), p. 26.(1988b), 'Capital Budgeting the State of the Art' , Long Range Planning (August 1988),pp. 7 6 - 8 1 .

. and P.J.A . H erbert (1987), Corporate and Divisional Influence in Capital Budgeting (London:CIMA, 1987).

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3 3 2 S A N G S T E RRoss, S.A. and R.W. Westerfield (1988), Corporate Finance (St Louis: Times Mirror/MosbyPublishing, 1988).Scapens R.W. (^\9a). Management Accounting: A Review of Recent Developments (London: MacMillPublishers Ltd., 1985).and J . T . Sale (1981), 'Performance M easurem ent and Formal Capital Expenditure Controls

in Divisionalised Companies' , Journal of Business Finance & Accounting (Autumn 1981), pp.3 8 9 - 4 1 9 .. and P.A. Tikkas (1982), Financial Control of Divisional Capital Investment (LondonCIMA, 1982).Van H om e, J . C . (1986), Financial Management and Policy, 7th edition (London: Prentice-HallInternational (UK) Ltd., 1986).

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