The Use Of Capital Budgeting And Cost Of Capital Estimation Methods In Swedish-Listed Companies

Abstract

In this paper Swedish listed companies' use of capital budgeting and cost of capital estimation methods in 2005 and 2008 are examined. The relation between company characteristics and choice of methods is investigated and both within-country longitudinal and cross-country comparisons are made. Larger companies seem to have used capital budgeting methods more frequently than smaller companies. When compared to U.S. and continental European companies, Swedish listed companies employed capital budgeting methods less frequently. In 2005 the most common method for establishing the cost of equity was by asking the investors what return they required. By 2008 CAPM was instead the most utilised method, which could indicate greater sophistication. The use of project risk when evaluating investments also seems to have gained in popularity, while the use of company risk declined. Overall, the use of sophisticated capital budgeting and cost of capital estimation methods seem to be rising and the use of less sophisticated methods declining.Keywords: Capital Budgeting Method; Cost of Equity; Project Risk; Swedish-listed Companies INTRODUCTIONophisticated capital budgeting methods are often "highly recommended" by financial management textbooks, e.g. net present value (NPV), whereas others that are simpler are not, e.g. undiscounted payback (e.g. Brealey and Myers, 2003;Lumby and Jones, 2003;Ross et al., 2005;Smart et al., 2007). Theoretical advice is also given on how to estimate the cost of capital. Estimation models like the capital asset pricing model (CAPM) are frequently referred to and instructions how to calculate project discounts rates, contingent on the underlying risk of the project, instead of using a single company discount rate, are presented (e.g. Brealey and Myers, 2003;Lumby and Jones, 2003;Ross et al., 2005;Smart et al., 2007). Furthermore, multinationals are advised to consider risk factors such as political and foreign exchange risk (Shapiro, 2002;Eiteman et al., 2006). Still, the practical use of economic models can, as earlier research has shown (Graham and Harvey, 2001;Sandahl and Sjögren, 2003;Brounen et al., 2004;Danielson and Scott, 2006), deviate from what is prescribed by normative theory. Management, possibly with other goals than the principal (Jensen and Meckling, 1976), decides whether the recommended methods should be employed or not. The goal incongruence together with the information asymmetry between management and the shareholders, might lead to different practical behaviour than what is recommended by textbooks (Narayanan, 1985). And moreover, also in an ideal world where the principalagent problem does not exist or is limited, there might be a discrepancy between theory and practice. Methods that from a theoretical perspective at first sight have flaws can in practice namely be efficient and lead to shareholder wealth maximisation. Guthrie (1997, 2006) showed, for example, that the employment of the payback method could be rational since the payback time approximates the optio...

What Determines the Use of Capital Budgeting Methods? Evidence from Swedish Listed Companies

“…The use of capital budgeting methods by U.S. and European listed companies has been studied extensively (e.g., besides those already mentioned, Pike, 1988Pike, , 1989Pike, , 1996Pike and Sharp, 1989;Sangster, 1993;Block, 2007;Hermes et al, 2007). [1] There have also been some earlier studies of Sweden (Renck, 1966;Tell, 1978;Yard, 1987;Andersson, 1994;Segelod, 1995;Sandahl and Sjögren, 2003;Holmén and Pramborg, 2009;Hartwig, 2012).…”

“…[2] Most studies thus explore only use or non-use, or the frequency of use, of capital budgeting methods, and not the association between use and independent variables. When relationships between use and independent variables have been studied (e.g., Hartwig, 2012), only descriptive statistical methods such as correlation analysis and independent-samples t-tests are utilised, so the results cannot be interpreted causally [3].…”

Influence of Business Characteristics on Selection of Investment Evaluation Techniques: The Case of Tanzanian SMEs

“…Several researchers have highlighted different business characteristics and their influence on investment decisions practices for large as well as small businesses (Graham & Harvey, 2001;Anand (2002); Brounen et al,2004;Fernando, 2005;Danielson & Scott, 2006;Leon et al,2008;Truong et al, 2008;Brijlal & Quesada, 2009;Pal & Verma, 2011;Daunfeldt & Hartwig, 2012;Hartwig, 2012;Pratheepkanth et al,2013;Ahmed, 2013;Yasmin, 2015;Swarnapali, 2015).…”

“…The size of the business in different studies has been expressed in terms of the number of employees, sales revenue, value of assets, and turnover of the business. Studies conducted by Graham and Harvey (2001), Anand (2002), Brounen et al (2004), Danielson & Scott (2006), Brijlal and Quesada (2009), Daunfeldt and Hartwig (2012), Hartwig (2012), Pratheepkanth et al (2013), and Ahmed (2013) observed that the size of the business influence the choice of investment evaluation techniques. However, there are few studies which contrary to the observation of the above studies observed that size does not affect the choice of investment evaluation techniques (Fernando, 2005;Truong et al, 2008;Leon et al, 2008;Swarnapali, 2015, andYasmin, 2015).…”

“…Danielson and Scott (2006) noted that gut feel was used extensively by businesses in the service sector. Hartwig (2012) observed that sector of business had an effect on the choice of investment evaluation techniques. Brijlal and Quesada (2008) found that payback period to be the most method used in manufacturing businesses while NPV to be used in service and retail businesses.…”